How to avoid contractual chaos during the due diligence process

What is due diligence?

Before investors buy or invest in a company, they put the company through its paces. This careful examination is called "due diligence" (literally: "due care"). The aim of due diligence is to minimize the risk of the investment. To this end, all potential weaknesses must be identified and any problems disclosed.

Due diligence is usually carried out by experts acting on behalf of the buyer. They analyze all relevant company documents and data. The review focuses on various sub-areas such as financial, legal and commercial, but can also include ethical and sustainable practices - depending on what is relevant to the transaction. You can find out more about this in the course of the article.

Due diligence is often used as part of mergers & acquisitions (M&A) or when entering into strategic business partnerships. The scope and depth of the audit are individually adapted to the objectives of the respective transaction.

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Central to due diligence: the contract

In addition to pitch decks, financing plans, cap tables and one-pagers, investors are primarily interested in contracts. This is because all the important success factors and most of the risks of a company are in the form of contracts:

• Future income in the form of contracts with customers
• Resources in the form of licences, contracts with suppliers, ...
• Financial liabilities in the form of loan agreements, leasing agreements, ...
• Business risks in the form of guarantee agreements, contractual clauses and the like
• Personnel situation of the company in the form of employment contracts
• etc.

Contracts play into all areas of due diligence, from commercial to legal. Let us briefly look at the most important topics:

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The 4 pillars of start-up due diligence

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Commercial due diligence

• Product: Purpose and use cases of the product
• Market: market size, competitive situation, clientele
• Profitability: turnover, costs, upselling potential, etc.
• Distribution: distribution channels, strategic partners, etc.

Important contracts in commercial due diligence are:

• Contracts with customers, including agreed prices, general terms and conditions, warranty conditions, etc.
• Contracts with suppliers and their fixed and variable costs
• Marketing contracts, for example for software, agencies, etc.
• Contracts with sales partners

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Technical due diligence

• Assets: intellectual property in hardware, software, etc.
• Scalability: ability to scale the technology
• Protection against competition: Resistance to imitation
• Quality: Assessment of the technology roadmap, quality of research & development

In technical due diligence, the following contracts are of primary interest:

• Patents, trademark rights, licences of the company
• Employment contracts with developers
• Contracts with freelancers and partners

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Financial due diligence

• Accounting: quality and correctness of financial accounting; detailed analysis of accounting accounts
• Financial planning: Financial KPIs such as liquidity, margins, ROI, etc. including forecasts
• Cash flow: Usual payment cycles, default risks, general cash flow management
• Taxes: Audit and tax reports (also international)

This is not so much about specific contract types, but about easy access to all contracts:

• Vouchers and contracts for individual items in the balance sheet or income statement
• Statistical evaluation of contract sums, e.g. expected turnover by customers, sum of fixed monthly payment obligations, etc.

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Legal due diligence

• Legal basis: basic contracts, agreements with investors, etc.
• Legal opinions: Legal opinions regarding cases with business implications
• Contracts: Detailed review of all contracts
• Negotiating positions: Terms and conditions for future events, e.g. with regard to the planned later exit

Legal due diligence brings a cold sweat to the brow of every contract manager. Here, literally every shred of all contracts is scrutinised in the merciless light of legal expertise:

• Contracts with clients
• Contracts with suppliers
• Licence agreements
• Contracts with partners
• Employment contracts

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Frequent reality: Chaotic contract management in the due diligence process

In all too many companies, contracts are filed in a decentralised manner: in Leitz folders, in individual employees' local drives, on a SharePoint drive or even just as an attachment in the email inbox.

The reason for this chaotic handling is the extremely high number of contracts that companies conclude today:

• Licences for software, platforms, data subscriptions and the like
• Agreements and contracts with freelancers
• All types of contracts with clients
• Rental agreements for properties, technical equipment, etc.
• Leasing agreements
• etc.

In everyday life, employees hardly give it a second thought: Once the contract is concluded, they concentrate on using it and forget about it for the time being.

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Run your contracts as if due diligence is starting next week

If you wait until the due diligence auditors come with their enquiries, you generate an enormous amount of stress for yourself and all your colleagues.

So the smart thing to do is to file and manage the contracts centrally right from the start. This only costs you a few minutes and saves a lot of research work and hassle in the end:

• You have a complete overview of all contracts. None will be forgotten or "discovered" until later.
• You can be sure that you have the currently valid version of the contract in front of you.
• You can access the contracts in a flash, without lengthy searches and queries with colleagues.

During due diligence as part of a financing round, investors are also expected to provide so-called data rooms. For this purpose, all information, data and documents required during the due diligence must be made available to the investor's auditors.

If you manage your contracts digitally and centrally, it will be easy for you to fill the data room with structured and well-organised overviews of all liabilities.

Contract management software such as ContractHero combines all these requirements in a single software solution.

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Tool for central contract management in the due diligence process

ContractHero allows you to manage your contracts centrally and digitally. You can store your contracts in digitalised form, provide them with metadata, categorise them, sort them and evaluate them statistically.

ContractHero's contract management software offers many functions that make your work with contracts during due diligence much easier:

• A well thought-out classification system that records all contracts uniformly and presents them clearly
• A dashboard with the key data of the contracts
• Individual options for categorisation
• Flexible reports
• Recording of individual information from contracts e.g. "change of control clauses". 

ContractHero supports your workflow with smart functions. For example, contracts can also be imported by simply forwarding an email with the contract attached. To ensure you don't miss any notice periods, you can store contract-specific reminders, which you are reminded of not only in the dashboard, but also by email and browser notification.

Systematically recording contracts saves you a lot of time and nerves, as you have a complete overview of your contracts at all times. So you can look forward to the next due diligence with confidence.