Just as you do not buy a pig in a poke (or 'a cat in a bag'), a venture capitalist does not buy shares without kicking the tires of a startup. In this post, we cover what legal questions need to be addressed in your pitch deck and how to prepare for the legal due diligence in a financing round.
Besides the business case and the team behind a startup, there are critical legal questions entrepreneurs should have an answer for:
From specifying the time after which you need to delete personal data to mandating the minimum size of a mirror in the restaurant lavatory, politicians can get very creative when it comes to regulating business activity. Sometimes, the regulation will simply inflict additional cost to doing business, but other times an entire business case is not viable because of the high regulatory barriers to entry.
If your startup is in a highly regulated industry such as FinTech or MedTech, or if a lot of personal data is involved, be sure to do your research and have a slide ready to address the regulatory questions head-on.
Venture capitalists want to invest in companies with a sustainable competitive advantage. If the barriers to entry are low for competitors, the profit margins will suffer and so will the share price.
If your business case rests on IP, you should therefore have a clear idea on what type of IP this is (e.g., patents, domains, copyright, data, design, trademarks) and how this is or can be protected, and whether anyone else has protected the same IP before you.
Especially in early stages, VCs invest to a large part in the team rather than in the business idea as such. The departure of a key team member or a co-founder dispute is one of the most common reasons for startup failure, so the VCs need to test for long-term commitment and stability. There are two potential red flags in the response:
If the investor gets serious about investing, there are still a few legal checkboxes to tick before the money is wired to your bank account. Besides the negotiation of all the legal documents (which we cover in another post), there will be a so-called 'due diligence', basically a review of whether the legal house is in order and if there are any hidden legal risks. Typically, investors distinguish between major and minor issues on one axis and curable and non-curable issues on the other axis. Needless to say, try to avoid landing in the major, non-curable issue quadrant.
The due diligence is more or less thorough, depending on the risk appetite of the VC, the stage of the company, and the size of the investment. Our CRICH model is a great guide to what will be covered in any legal due diligence:
Cap table: Who currently owns shares in the company? Are there any outstanding promises to provide future shares, e.g., under convertible loans, employee stock, or phantom stock agreements? Are there vesting provisions for co-founders?
Share transfers: Were all share transfers done in proper form (written assignment) and correctly documented (chain of assignment)?
Are there any major risks in critical agreements (e.g., the patent licensing agreement with the University in case of a spin-off)? Risks may include early termination rights, purchase options or onerous patent prosecution obligations on the startup.
Is there a solid customer contract template used consistently with all customers?
Does the business have all the necessary licenses to operate?
Is the social security, pension plan, and tax situation properly set up? In particular, employee participation plans can lead to tax liabilities that are often overseen by founders.
Is there a basic personal data compliance in place?
Is the intellectual property properly protected?
Does the company actually own all IP? Especially IP that was generated by the co-founders before incorporating the business is often not properly transferred to the company.
Are there any competing IP rights, e.g., patent registrations, either in the current market or in potential future markets?
Is there a written and complete agreement with all employees and freelancers, and does the company properly distinguish between the two? Especially the IP has to be assigned to the company, also with freelancers, and the termination notice period for non-essential employees should not be too long as this can incur significant cost in case of a restructuring Also, contracting persons as freelancers that are in fact employees can be a costly mistake.
Are there any former employees that may have any claims against the company? There may be former co-founders that still have a claim to the IP or the shares of the company (watch The Social Network for more on this).
There is an excellent due diligence list provided by SICTIC here that also covers non-legal topics.
The legal preparation for a financing round is not rocket science, it is just hard work that needs to be done properly to improve your chances to get funded. This goes from preparing a pitch deck in which obvious legal questions are addressed thoroughly to ensuring your legal house is in order when the investors come knocking.