The general partners (GPs) of the firm have a legal and ethical obligation to act in the best interests of the limited partners (LPs) or investors. This involves ensuring that the companies in which the fund invests adhere to financial, legal, and regulatory standards. Venture capitalists (VCs) typically carry out due diligence (DD) to meticulously examine and verify the accuracy of past performance and compliance data of potential investments. This process helps to mitigate risks and make informed investment decisions.

What is generally covered in DD:

Legal Due Diligence

• DPIIT registrations
• Compliance under Corporate Laws and Labour Laws
• HR documentation - Founder/ Promoter contracts, Employee Contracts, Consultant Contracts
• Customer documentation 
• Intellectual Property - registrations, validity, status etc of trademark, domain names, IP (if any), etc
• Litigation, if any
  
  

Financial and secretarial Due Diligence

• P&L, BS, and Cash flow
• Share Capital
• Contingent Liabilities
• Related Party Transactions
• MIS, Internal Controls
• Direct Tax & Indirect Tax
• Secretarial compliance

In venture capital (VC) investments, the party responsible for paying due diligence costs can vary depending on the deal's terms and the relationship between the investor and the startup. Here’s an overview of common practices:

1. VC Firm (Investor) Pays

• Standard Practice: In most cases, the VC firm covers the due diligence costs, as it’s part of their internal investment process. This includes legal, financial, and technical evaluations to assess the startup's viability.
• The VC is the one deciding whether or not to invest, so it’s generally considered their responsibility to bear the cost of verifying the information provided by the startup.
  
  

2. Shared Costs (Negotiated)

• Middle-Ground Approach: In some cases, particularly for later-stage or larger deals, the VC firm and the startup might negotiate to share due diligence costs, especially for extensive or specialized reports (e.g., environmental or IP audits).
• Shared costs might be proposed when the startup already has strong relationships with investors or if the due diligence is unusually expensive.
  
  

3. Startup Pays (Most Common in India)

• Early-Stage: With early-stage startups, the norm is that the startup covers due diligence costs. However, this is with the caveat that the VC invests in the startup. In some cases, the Investor can decline to cover the DD costs even if the investment does not go through.
  
  

4. Reimbursement after Investment

• Reimbursement Clauses: Sometimes, the VC firm pays the costs upfront but includes a clause to reimburse those expenses once the investment is made. This ensures that the VC is not left out of pocket if the deal proceeds while the startup bears some responsibility if they receive funding.

In most cases, the VC firm assumes the costs, but this can be negotiated. The terms should always be clearly defined in the term sheet to avoid disputes.
To avoid disputes, we believe the best approach would be to establish a tripartite agreement involving the Investor, the startup, and the due diligence (DD) firm. This agreement would outline that if the investment is successful, the DD firm will receive payment from the funded startup, ensuring that the Investor is not financially burdened. Additionally, if the investment falls through for any reason, the venture capital (VC) fund will be responsible for compensating the DD firm for their due diligence services.