Turkish start-ups are very attractive due to the arbitrage opportunities. World-class creative-minded talent is available at a fraction of the cost you would get in the Valley. However, a sense of timidness strikes due to unstable equilibriums of Turkish economy and the fact that you are investing into an "uncharted" jurisdiction you do not know much about. Follow the simple advice in this article to decrease your exposure of risk.
- Make sure to work with a local lawyer knowledgeable in VC deals.
First, you should make sure to work with a lawyer who has a level of depth specifically in venture capital deals. Avoid the types who market themselves as if they can handle every matter (there are plenty in developing countries). It will be much beneficial for you to work with a lawyer who, at least, has affinity with the industry in general and a particular understanding of Turkish start-up ecosystem, its actors, dynamics and a grasp of the general relevant business intelligence (i.e. who are the right people to do business with, who are to be avoided etc.).
Moreover, to be able to conduct a proper due diligence and perhaps manage the post-investment phase, you need a trusted advisor who has a strong understanding on the niche commercial and technological aspect of technology start-ups, especially if such are relatively more IP based with complex tech behind them, often times requiring a sophisticated legal infrastructure.
- Have your lawyer investigate how "healthy" your target start-up is.
A corporate entity's corporate documents and other related data are like a mixture of identity card, financial, criminal and health records of a person, but for companies. As an investor you will become a shareholder in your target start-up (become an owner) and it is imperative for you to examine every essential document made available to you. Even when you are buying clothing, you usually inspect and check if there is anything wrong with the material or if there are any defects. The process called "due diligence" is similar to this inspection, where you, an investor, before pouring in hundreds or maybe millions of dollars, looking at your target start-up's records to see if there is anything out of ordinary.
For example, if the target company claims that it received previous rounds of investment, you must have your lawyer look in the official public trade gazette registries to see if the official records match the claims.
In another example, founders, promising you great acceleration and great returns may not actually be your partners, as they may not even be the actual shareholders of your target entity. In Turkey, Joint Stock companies operate on "secrecy". This is why, -if current shareholders have indeed transferred their shares to third parties shortly before or they had never even been a shareholder in the target entity- the only reliable way to tell the current shareholding structure of the company is to examine its share ledger, which is not something available online.
So you should definitely examine the following documents during due diligence, (i) shareholders agreements and all other agreements regarding the shares of the shareholders in the target company, (ii) general assembly meeting resolutions book, board of directors' resolutions book and share ledger, (iii) signature circular and internal regulations on the representation of the target company, (iv) articles of association of the target company (v) documentation of loans, emission premiums and capital commitments paid by the shareholders to the target company.
- Examine the material agreements in force between your target start-up and third parties.
All important agreements that the company has already signed should be examined. This step is highly important, because as an investor you may be investing to your target company hoping that said start-up is a party of a specific agreement such as a service contract with a huge client, or not a party to some types of agreements such as an exclusive license over the company's intellectual properties or a million dollar consulting agreement with a related party to the founders.
Therefore, following agreements must be examined, among others, in the due diligence processes: (i) Purchase, supply, sale and/or service agreements worth above certain thresholds, (ii) licensing agreements, (iii) long term warranties, if any, (iv) non-compete agreements, (v) agreements providing exclusive rights to third parties territorially and/or industry wise, etc.
Furthermore, Information on all agreements (and their provisions) of the target start-up which (i) are dependent on the guarantee or security of any other person, (ii) are acted as guarantor or surety for a loan, liability or undertaking, (iii) could, in consequence of the due diligence project, result in monies becoming repayable or an interest in assets and/or properties being encumbered, terminated, acquired or otherwise affected, (iv) contain exclusivity provisions or provisions that would restrict competition, (v) will be avoided, terminated, amended upon change of control of the start-up and lastly (iv) defaults relating to the above mentioned-agreements should also be examined during the due diligence process, to be aware of any potential claims that may arise after the investment.
Moreover, change of control provisions may, at times, affect the contemplated investment. Change of control provisions usually give certain rights to third parties (such as notification, consent, payment or termination) in connection with a change in the ownership or management of the other party to the agreement. For example, if a material agreement of your target start-up has a change of control provision which enables the other party to terminate without any consequences, this termination may potentially harm the start-up to the extent that it renders the investment obsolete. For instance, such material agreement may be a critical license required to produce the main product of the target start-up.
- Examine the employees and the employment contracts of your target start-up.
Examining employment contracts is also an important step for venture capital investments. For instance, stock option agreements are an exceedingly popular way of attracting, motivating, and retaining employees, especially when the start-up is unable to pay high salaries. Another way of attracting and motivating employees when companies unable to pay decent salaries can be phantom stock agreements. Whereas in stock option agreements, employees usually acquire a percentage of the companies' shares, in phantom stock agreements, employees only receive a pretended stock which only provides the actual monetary benefit of a regular stock rather than an actual equity ownership. All these pools may have been designed in a way that dilutes your shareholding in case they are actually issued to option holders, moreover such rights may not have been provided on an arm's length basis. You must be aware of these.
Your lawyer must review, (i) the standard employment agreement, copies of employment agreements deviating from the standard model of the target company and the additional policies the employees are subject to, (ii) stock option plans/agreements of the target company, (iii) phantom stock plans/agreements of the company, (iv) non-disclosure and confidentiality agreements (all employees and executives must be bound by confidentiality and non-compete provisions).
- Examine the ongoing or potential litigation and/or other disputes.
Let's assume that you invested in a start-up which had an ongoing lawsuit concerning its primary intellectual property, at the time of the investment. What if third parties manage to prevent the start-up from using its main asset, that is the fundamental intellectual property rights? Let's go one step further and assume that there is another ongoing lawsuit or a potential claim for a million dollars worth of damages by way of such IP violation, what if this lawsuit results in great loss of capital and reputation for that start-up? This will be a disaster for your investment.
To avoid this kind of misfortune, following points should be looked into in due diligence, (i) details of any existing, pending or threatened lawsuits, prosecution proceedings, administrative proceedings, execution/enforcement proceedings, insolvency proceedings or arbitration involving the target company or any circumstances which may give rise thereto with an indication of the amounts involved which if adversely effected, may have a negative effect over the business of the target company, (ii) judgments, awards or settlements of legal proceedings which have had or are continuing to have a material impact on the business of your target company.
- Make sure that the intellectual property even exists and properly protected in the first place.
It is natural for you, as an investor, to desire investing on a start-up whose ideas and intellectual properties are protected and are within the company itself. This is because, in start-ups, investors are usually investing on an idea. An unprotected intellectual property may lead to unfair use by third parties and more importantly competitors. Unfair use of intellectual property can make it harder for your target start-up to benefit from its own intellectual property.
Because of these reasons, you should analyse the following matters in due diligence, (i) details of registered or unregistered intellectual property rights (i.e. trade marks, industrial designs, patents, utility models and any other kind of copy righted material (including rights in computer software and in manuals and other written or graphic materials), databases, software, domain names, know how) owned by the target company and provide details concerning their status, including but not limited to validity, use, termination, etc., (ii) details of all intellectual property Rights (registered and unregistered) not owned by the target company but used in its business, and provide details concerning their status, including but not limited to validity, use, termination, etc., (iii) details of arrangements with employees who have or are likely to create, write, invent, design, etc. and/or who have any access to Intellectual Properties, and whether such arrangements exists to ensure that any Intellectual Property Rights deriving from work done accrue to the target company, (iv) details of any suspected or alleged infringement, whether past, current or potential, of third-party rights by the target company, (v) information on license agreements on computer hardware, network and other information technology used by the target company pursuant to any license agreement.
Ready to invest!
You have checked the most essential items in your due diligence checklist. You have looked into the shareholding structure, the agreements and so on. But what will happen if you discover a risk during your inspection? In the event that you detect risks and/or defects during the due diligence phase, you can state those defects as conditions precedent and can request these conditions precedent to be fixed before the closing of the investment.
Moreover, it is wise to still keep in place an article in which the founders make umbrella representations and warranties about all their claims to be unproblematic (any of which you also may not have found out during due diligence). With such provision, you can claim from the founders to compensate if any unexpected problem arises.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.