Investor Due Diligence

When considering whether to make an investment in a privately owned company, determining the right questions to ask of the company offering the investment can be problematic. Formulating the questions will depend on the company being investigated, and, of course, every company is unique. Such an investigation falls under the category of the widely used phrase, “due diligence,” which arose out of the Securities Act of 1933, which, in turn, arose out of the Great Depression, and has come to be generally applied in a variety of contexts where someone conducts a careful investigation of, well, just about anything.

But, back to private investments. While the questions to be asked will depend on the exact company being investigated, there are certain questions that are routinely asked, and documents that are routinely requested. In this article I’ll set forth some of the most common types of each — that is, questions and documents — requested by potential investors conducting their investor due diligence as to private investments.

I’ll use the example of a corporation, as opposed to an LLC, offering equity to a potential investor who isn’t buying the investment through a third party broker-dealer or through a crowdfunding placement agent, and where the issuing company hasn’t provided all of the offering materials to the potential investor in a formal investment packet, such as a private placement memorandum. That is, this scenario would be as close as possible to independent parties negotiating an arms-length private money investment, where an outside party is considering investment in a privately held company.

Investigating Inside the Company

A potential investor typically conducts a due diligence investigation of the company’s internal documents. Examples of documents commonly requested include the following:

Taxes & financials

• Copies of company tax records, including recent federal and state tax returns;
• Recent balance sheets and profit and loss statements; and
• Financial projections and market analyses.

Offering documents

• Company business plan;
• Terms of the proposed equity offering, including compliance with state and federal securities laws; and
• Management biographies.

Corporate documents

• Articles of Incorporation (other states, such as Delaware, refer to the formation document as a Certificate of Incorporation);
• Bylaws;
• Shareholder agreements;
• Minutes, consents, and resolutions;
• Capitalization table and stock ledger;
• Description of all authorized and issued equity, and other related investment documents;
• Employment equity compensation records; and
• Records as to any assumed business names, parent, subsidiary, or affiliated companies, and an organizational chart explaining the relationship of each.

General company records

• Information about any litigation, whether pending or threatened, or any obligations owed by the company under any former lawsuits or settlements;
• Any outside claims against company property, including secured interests;
• Real property records;
• Intellectual property records (trademarks, patents, and copyrights);
• Licensing records; and
• Employment or compensation agreements with key company officers.

While the above list is by no means exhaustive, it would serve as a good starting point to keep the conversation going with the offering company, and the responses and documents produced by the offering company would provide a good litmus test as to whether to investigate further or instead walk away from the opportunity.

Investigating Outside the Company

Plenty of public information should also be readily accessible. Aside from simple Google searches about the company, its principal officers, directors, and key employees, there might be other public records worth searching, to find out whether the company’s representations and disclosures are consistent with such records. All companies registered to do business in Oregon, for example, must disclose certain information about their company, including whether it’s authorized to do business in the state in the first place. That information can be searched here. Most other states also provide similar public databases, albeit sometimes at a small cost.

Also at the state level in Oregon, UCC searches can be run, in order to find out if any outside parties have secured any of the company property — that is, that they have a claim to it. That information can be found here. And, if there is any suspicion whether the company may be involved in litigation, public records of Oregon state court filings can be found here, and a similar system exists at the federal level; it’s called PACER.

From a securities law perspective, at the federal level all offerings must either be registered or be exempt from registration. If the company offering equity is engaging in a Regulation D offering, the Securities and Exchange Commission’s EDGAR database can be searched to see whether the offering company has filed a Form D, and, if so, what information has been disclosed, and whether such information is consistent with the company’s representations and disclosures to the potential investor. Here in Oregon a copy of the Form D must also be filed with the state, so a potential investor could also run a search of the state’s securities filing records. An easy way to search state securities filings is to search the electronic filing depository records at the North American Securities Administrators Association, but note that the depository doesn’t include a record of all state notice filings, at least as of the time of this writing.

Additional Thoughts

For companies operating in highly regulated industries — here in Oregon, cannabis companies are an obvious example — investigating the offering company’s compliance with applicable regulations is critical. For example, cannabis companies must comply with strict licensing regulations at the state and local level, and they have unique tax situations due to Section 280E of the Internal Revenue Code, which severely limits the deductions and credits that a cannabis company may claim on its federal tax return. Therefore, a potential investor in a cannabis company would be well served to examine the company’s tax filings to ensure compliance with Section 280E.