Startup Legal Due Diligence: A Brief Guide for Investors and Founders

After the phenomenal collapse of FTX, one of the largest cryptocurrency exchanges, investors from all over the world were spurred to deeply reexamine the “well-being” of their prospective portfolio companies. As a result, what we can see now is a rising number of investors’ requests to carry out strict due diligence procedures before making any investments. Such procedures involve a comprehensive analysis of the financial, product, strategic, and legal aspects of the company’s operations, especially if they pertain to the current developments in cryptocurrency.

We expect that the upcoming year will bring in a new era of conscientiousness for the investor and a heightened level of transparency regarding the solvency and intentions of a company. At the same time, we believe that in order to adapt and prepare proactively, it is vital for investors and startup founders to have an easy-to-understand guide of what to contemplate and prepare for within the legal realm of due diligence.

This brief guide centers on the legal aspects of due diligence, which refers to the process of collecting and assessing a company's legal documents to identify risks for both the company and its investors before entering into an investment agreement. In the following sections, we will cover the major aspects of legal due diligence related to the company’s intellectual property and outline the 10 most common mistakes.

For your convenience, at the end of this guide, you will find a comprehensive due diligence checklist designed for investment and simple M&A transactions.

How to Prepare for the Upcoming Legal Due Diligence Process

Once a potential investor has analyzed the substance of a project and made a positive decision to invest, the next step is legal due diligence (“DD”). While every investor might have their own focus of interest within the DD process, they all will engage in a review of the company’s legal documents.

The range of the requested documents varies and is dependent upon the level of investor scrutiny. However, virtually all legal DDs involve a review of the company’s charter documents, actual capital structure, IP assignment agreements, employee relationship structure, history of litigation, previous investment documents (if any), and materially important contracts with suppliers, partners, or customers.

IP Protection

The main value for each company, especially technological startups, is its intellectual property (“IP”). Therefore, in this section, we’ll break down the most common features of legal due diligence related to the company’s IP as a cornerstone of each project.

Consolidation of IP

In the U.S. standard market practice, virtually all equity financing term sheets and investment agreements stipulate that all intellectual property developed within the project must be transferred to the investment recipient, which means that:

1. All founders must sign the IP assignment agreement;
2. All employment and services agreements must contain the IP assignment clause;
3. If the company has any subsidiaries in other jurisdictions, all intellectual property assigned to these entities by the local employees must also be transferred to the US entity; and
4. All domain names must be registered on the name of the entity, and not its founder.

Trademarks

Trademarks serve as an indicator of the source of goods or services. Trademark registration confers certain privileges, such as constructive notice to market participants of the company’s ownership of the trademark (the right to use the ® symbol) and additional rights in the event of litigation.

Thus, if the company has any trademarks, it is vital to assess the following criteria during the DD process:

1. The ownership, validity, scope, and enforceability of the company’s trademarks;
2. Any possible risks of trademark infringement posed by the use or registration of the company’s trademarks; and
3. The ability to expand the use and registration of the trademarks to other goods and/or services provided or to be provided by the company in the foreseeable future.

If the company doesn’t have any trademarks, founders and investors should evaluate whether the actual stage of the company’s development requires trademark protection for the goods or services provided. If yes, check whether the desired name is available for trademark registration.

Patents

To avoid situations where larger tech companies copy the company’s idea, certain IP should be properly patented. As a rule of thumb, patents are issued for inventions (such as processes or machines) that are new, useful, and non-obvious, as well as for industrial designs.

Startup founders and their investors often inquire about the applicable national boundaries placed on their patent or if they can obtain a patent on the startup’s invention, especially in terms of patenting certain software. The most important points to consider in this regard are:

1. Software can sometimes be patentable in the U.S. The patentability of software is still a hot topic discussed by the courts and the USPTO. Generally, if the company’s software implements technical improvements to the computer system, it might be able to obtain a patent registration with the help of a competent patent attorney.
2. U.S. patents are effective only within the U.S. If the company operates in several markets, it might be necessary to obtain a patent registration in each applicable jurisdiction.

For DD purposes, make sure that you have timely access to all the information about the patents registered in the company’s name, including its scope, date of registration, expiration date (if any), and the essence of the invention.

Top 10 Legal Mistakes in Startup Documents

1. The Company Is Not in Good Standing with the State of Incorporation

One of the most common mistakes we’ve witnessed is when a company submits its documents for legal review and the first thing that pops up is that the company has lost its good standing with the state of incorporation. For Delaware entities, there can be two major reasons behind such outcomes: (1) failure to timely pay franchise tax, and (2) failure to appoint a registered agent.

Thus, before initiating the due diligence process, make sure that the company has paid all the state-imposed taxes. Investors are advised to request a Certificate of Good Standing (“CoGS”) issued by the state from the company beforehand. If you’re a startup founder, before ordering a copy of a CoGS, we recommend looking up your entity on the state’s website and checking whether it has paid all taxes due and has a registered agent appointed.

Failure to timely pay state-specific taxes or appoint a registered agent may lead to forfeiting the company’s active status. In Delaware, a forfeited status lasting for more than 2 years may lead to the administrative dissolution of the entity. Therefore, be extremely attentive to state-specific regulations, and, if you plan to invest in a certain project, don’t hesitate to ask for the documents confirming the company’s good standing before writing a check. Otherwise, in the words of Charles Perrault, “At midnight, it all will turn into a pumpkin.”

2. Investment Agreements and Stock Purchase Agreements Are Not Approved by the Company’s Board of Directors

Our experience in due diligence audits tells us that in 90% of cases, companies fail to approve stock transfers by the board of directors.

To avoid this, remember the general rule: almost each and every transaction involving the present or future sale, purchase, or transfer of shares must be approved by the company’s board of directors. Stick to this rule and you’ll avoid disputes relating to the validity of the stock transfers in the future.

3. Cap table Contains a Reference to the Employee Stock Option Plan While None Is Actually Adopted

Another common mistake we see in every second cap table is the allocation of certain shares for the purposes of the employee stock option plan (“ESOP”) without any documents approving its actual implementation. One should keep in mind that it is not enough to create a corresponding line in the cap table titled “Option Plan.” If the company hasn’t granted any options yet, the ESOP must contain at least three mandatory documents:

1. The ESOP itself outlining the rules for granting and exercising the options;
2. Board approval of the ESOP;
3. Shareholders’ approval of the ESOP.

If the company has verbally agreed to grant options to certain employees, it is a slippery path. Without any documented evidence of such intention, the company may revoke its offer at any time without any consequences other than losing a valuable employee and damage to the team morale.

Therefore, once someone is granted an option to purchase the company’s shares, such option grant must be confirmed by the corresponding Option Grant Notice, Option Agreement, and Exercise Agreement set aside until the moment of actual exercise of the option. And, it is worth repeating it: each option grant must be accompanied by the corresponding board resolution.

4. Cap table Contains References to Persons Who Have No Documentary Allocated Stock

This mistake often occurs when shareholders transfer a portion of their stake to another person. For example, a company has signed a term sheet with the first angel investor that stipulates that aside from the SAFE to be entered into between the investor and the company, the founder also undertakes to transfer a portion of their shares of common stock to the investor. However, after receiving the investment amount, the founders just changed the numbers in their cap table without taking any additional actions to ratify the transfer.

One should always remember that term sheets are aimed at documenting the intent to enter into certain agreements and are generally not legally binding. Therefore, if there was some kind of reallocation of shares within the company, always secure it with a corresponding stock transfer agreement and a board resolution.

5. Documents Are Not Signed or Lost

The general path for each transaction should contain 5 simple steps: (1) negotiate, (2) draw up an agreement, (3) sign it, (4) immediately upload it to the company’s data room, and (5) send a signed copy to your counterparty.

Nevertheless, in a rush toward the project’s commercial success, founders often forget about proper bookkeeping and signing the essential documents. While preparing for or conducting DD, ensure that each and every document has all necessary signatures. For board resolutions, check that all directors have signed the documents. If the directors were not able to reach a unanimous decision and it was taken by the majority of the board, check that the resolution itself contains this information.

Another case is when the founders use several methods of document signing and thereby store the signed versions of the documents in several different places: someone’s cabinet, DocuSign account, email, photos gallery, etc. As a result, when it comes to due diligence, it takes weeks or even months to compile all the documents in a single place. Such a delay may be qualified as a red flag by the investor making him reconsider his investment decision.

If you’re a founder, remember that consistency is the key: try to keep all of your documents in a specific data room, be it created via an additional platform or on the company’s Google Drive.

6. Documents Are Signed by Persons Having No Authority to Do So

As a general rule, the company’s CEO is the only signatory, unless other officers or employees are specifically granted such rights.

However, it is not uncommon as part of DD to see stock purchase agreements or other agreements signed by a member of the board or any other corporate officer who have no such signatory rights. This is especially the case when the document is supposed to be signed by one person (CEO) from both sides in its capacity as the company’s CEO and shareholder. Nevertheless, it is a standard market practice and the document will not be voided just because it was signed by the CEO twice.

While checking the signatures on the company’s documents, verify that the signatory was allowed to sign by virtue of the company’s bylaws, board resolution, or the power of attorney valid as of the date of signature.

7. The Number of Issued Shares of the Company Exceeds the Number of Authorized Shares

This mistake is usually repeated by the newly incorporated companies at the pre-seed or seed stage. The company’s Certificate of Incorporation always states the maximum amount of shares that the company may distribute among its shareholders at any time in its existence. However, we often see that the companies with 10,000,000 authorized shares of common stock in their cap table distribute 12,000,000 or even 17,000,000 shares among their shareholders.

One should remember that the number of issued shares can never exceed the number of authorized shares. If the number of issued shares in the company’s cap table is approaching the number of authorized shares, the company should either repurchase a portion of shares or file a Certificate of Amendment of Certificate of Incorporation with the state to increase the overall number of shares available for further distribution.

8. The Documents Are Signed as of the Date Earlier Than the Date of the Company’s Incorporation

This mistake usually appears in connection with vesting schedules. Founders sometimes choose the date of vesting commencement as of the date they created the project even though this date is sometimes multiple years before the actual date of incorporation. Some lawyers agree that the vesting commencement date can be indicated before the incorporation, while others argue that a non-existent entity cannot be a party to any agreements prior to its incorporation. We usually advise founders to recalculate the vesting schedule starting from the date of incorporation rather than explaining to investors’ lawyers why it is set 2 years prior to the company’s formation.

9. No Employment or Services Agreements Are Signed with the Team

When it comes to key employees, it is standard practice to offer them an employment agreement that is effective for a certain term and provides them with certain guarantees. At the same time, for non-key staff, it is more common to use service agreements instead of employment agreements.

If none of these agreements are present and the team receives its compensation based on verbal agreements, it reveals two major red flags:

1. All intellectual property created by non-employed team members remains the sole property of its creator even after they decide to leave the project; and
2. Nothing prohibits direct competition for the duration of employment with the company and for a few years thereafter.

10. The Company Plans to Acquire Investments Through SAFEs and Convertible Notes While Being an LLC

Be careful with the entity type you plan to use as an investment recipient. The most common investment agreements such as SAFE, KISS, and Convertible Notes work out only with C-Corporations. While it is theoretically possible to create a legal Frankenstein in a form of the Convertible Note designed for LLCs, it will make no practical sense because it places an unnecessary tax burden on both the company and its investors.

If you do not plan to attract additional investments but rather sell the whole business at a certain stage or are unsure what entity type will suit your needs best, feel free to consult our Legal Guide for Startup Founders.

Startup Legal Due Diligence Checklist

Throughout the years, we were involved in 300+ legal due diligence reviews on multiple sides, be it a startup or the investor’s legal team, different parties to M&A transactions, etc. As a result, we compiled our best legal due diligence practices into a checklist of must-have documents for every U.S.-incorporated entity. The proposed checklist does not take into account the peculiarities of a particular project, but it has proven to be viable in many projects. Just follow each line and check the box across the relevant documents while going through the company’s data room.

Download Startup Legal Due Diligence Checklist >>

Quick tip: if you are a company’s founder, you can use the sections of this checklist as a guideline to structure your company’s internal documents database long before the due diligence procedure is even on your radar. This will save you a few nerves when the time for due diligence comes.

This article was written by Anastasiya Belyaeva and Polina Karachentseva, with some editorial help from Roman Buzko and Robert Lynch. The authors are lawyers at Buzko Krasnov, a law firm that advises entrepreneurs and investors under US law with a focus on new technologies and investment deals.