Who Should Bear the Due Diligence Costs in Venture Capital Investments?

The responsibility for paying the due diligence lawyers bill can vary based on the agreement between the investors and the startup. This article explores the common scenarios and how these costs are typically handled in venture capital deals.

Investor Responsibility

In many cases, especially in venture capital deals, investors may cover the costs of due diligence as part of their investment process. This is often seen as a necessary expense to assess the viability of the investment. By covering these costs, investors are better informed and more confident in their investment decisions, potentially reducing the risk of investing in a startup that may not succeed.

Startup Responsibility

Conversely, sometimes the startup may be responsible for the due diligence costs. This is more common when the startup is seeking funding from multiple investors or when the deal structure specifies that the startup will bear these costs. Startups may see these costs as an investment in their own due diligence, ensuring that they are thoroughly vetted before finalizing any deal.

Negotiated Agreement

Frequently, this responsibility is a matter of negotiation between the parties involved. The terms regarding who pays for legal fees should ideally be outlined in the term sheet or investment agreement. Clear communication and transparency during this negotiation process can help prevent misunderstandings later on.

It is important for both the startup and the investors to discuss and clarify these responsibilities upfront. This can prevent potential disputes and ensure a smoother investment process. Clarifying who will bear the cost of due diligence helps to protect the interests of both parties and fosters trust in the relationship.

How Costs Are Paid in a Typical US Venture Capital Investment

In a typical US venture capital investment, the company often pays the legal expenses of one counsel representing the investors, subject to a cap. The money comes out of the proceeds of the financing. If the deal doesn’t close, the investor is often stuck with the bill, but this can be negotiated in the term sheet.

If an investor in a syndicate wants a separate counsel to look at the deal independent of the “counsel of the investors,” the investor typically pays for that extra counsel. As for technical consultants, those may or may not be paid by the company from the proceeds, more often not in my experience.

Financial Implications and Practical Considerations

Financially, it makes no difference who pays for the transaction costs of an investment. Whether the funds are transmitted from the investor or the portfolio company, the source of the money is the investor, and the costs are factored into the investment decision and pricing.

In the US venture finance model, it is simplest and most practical for the investor to hire the lawyers and other professionals to handle the investor’s side of the transaction, pay their lawyers' bill, and then deduct those fees out of the funds paid at closing, subject to a negotiated fee cap. This approach simplifies accounting and setup on the investor end, as the costs are paid out of the fund itself rather than the fund manager’s account as an operating expense.

There are some secondary issues that are negotiable, such as a break-up fee or an advanced loan or bridge financing to tide the company over while the investor makes its decision. Costs in excess of the fee cap are generally paid by the investor or absorbed by the service providers as unbillable work.

It's a little like asking who pays sales tax or auction commissions or real estate broker fees. Regardless of who actually collects and remits the money, these expenses are all factored into the price, thereby ensuring that both parties are aware of the total cost and can make informed decisions.

Conclusion

The responsibility for paying the due diligence lawyers bill can be a point of contention, but clear negotiations and agreements can simplify the investment process. Understanding who should bear the costs in advance can lead to smoother negotiations and a more transparent investment process.

Investor Responsibility Startup Responsibility Negotiated Agreement US Venture Capital Investment Scenarios