When Attracting Private Equity Investment, Is Cash Really King?

Haylen Ann Pong
Mar 20, 2024
3 min read

You started up a business with a fantastic product, decent revenue and customer base, and you are looking for investors and funders to deploy their capital. Or maybe they have found you!

Then came due diligence.

The potential investors engaged in a meticulous process of examining every aspect of the business, including financial statements, product development, operational policies and processes, marketing plans, strategic goals, to understand the overall health of the business, its growth potential and any material risks involved. But somewhere during legal due diligence, the deal fell through. What happened? ❓

Legal due diligence is a critical component of the acquisition process. A thorough investigation is conducted into a target business/company's legal, governance, and compliance framework to understand what risks and consequences may arise. This might include reviews on:

every single contract entered into, including customer agreements, supplier contracts, employment contracts, leases, or other legal agreements. Are there obligations that are difficult to comply with or impact the company's financial health and liability?
every internal policy document governing operational processes, such as codes of conduct or data handling. Are internal processes compliant with laws, and could there be serious incidents like a data breach affecting the company?
what intellectual property rights exist and how they are protected. Could any future claims mean the business does not own the product it sells?
compliance with any applicable legislation/regulation that is material. This might include both local and international laws in areas like privacy/data protection law, labor/employment law, competition and consumer law, sanctions/export law and even ESG. Could a regulatory body issue fines and penalties?
employee-related and workplace issues. What could affect a company's operations and reputation?
litigation and claims history. What could damage reputation or lead to financial liability?
internal documents like bylaws, articles of association, board resolutions. Is there even a right for the target business to be acquired?

Despite the beguiling promise of profit and growth, legal due diligence could make or break a deal. A failure to conduct this process properly has dire consequences for both investors and the target business/company.

For investors, undisclosed legal risks will ultimately erode the value of an investment and harm the potential return. Since the myriad of legal risks could equate to legal proceedings, regulatory fines, financial liability and reputational damage capable of crippling a business, where there is a higher potential for these consequences, there will be a higher chance of a liquidity event falling through.

For sellers of a target business/company, not disclosing issues during legal due diligence can have serious pitfalls as well. A business or share sale agreement will commonly include a range of warranties and representations about the business, and where these prove to be incorrect or false, or unforeseen liabilities arise later, the investor can seek remedies and redress directly from the seller.

Yes, cash is usually the first consideration in the world of investment. But good cash flow is a baseline requirement! A successful liquidity event occurs after both parties are fully informed and accept the associated risks of the transaction.

For investors, working closely with legal experts to uncover these risks will be important.

For business owners, preparing for legal due diligence might only begin when seeking investors for a liquidity event. This is far too late and very expensive. Imagine having to:

repaper hundreds of different contracts because the business signed bad contracts to bring customers, suppliers, or employees in!
rebuild new operational processes because data was not handled properly and could bring about regulatory fines!
redrafting all the internal policy documents to reflect the current state of play!

These are just a few examples and it highlights a burdensome process that could interfere with daily business performance as the focus will be shifted from selling a fantastic product to selling the business or company.

Instead, work with legal experts from day one.

Yes, your focus is on bringing in business but bring it in RIGHT. Your business needs processes that protect it, customers that respect and love the product, suppliers that provide quality, and employees that are well-treated. Also recognize that making changes when the business is small will take less time and is the best opportunity to lay good foundations.

It will make finding an investor that much easier later!

For any inquiries or guidance, please don't hesitate to contact Pongan Legal

Contact Pongan Legal