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Advanced planning for an early stage equity financing can significantly smooth the path for startups, helping to identify opportunities and avoid setbacks. A critical part of the process is the investor’s legal due diligence.

It’s important to remember that the legal diligence typically happens after the term sheet is signed. Term sheets start with the valuation of your company, usually determined after business diligence, and propose a price-per-share for the investment in your equity. Divide the amount invested by that price per share and you’ll know how many shares you’ll need to issue: the higher the valuation, the fewer the shares for a fixed investment amount, and less dilution to founders. The valuation of your company in that term sheet will in nearly all cases be your best offer from that investor.

Investors almost never increase the valuation after legal due diligence. Thus, it’s important to recognize there is only downside here, and you will want to pre-emptively plug the holes in your legal bucket, so to speak, that could drain value from your company and cause you unnecessary dilution.

To assist with this, a due diligence checklist can be your “frenemy” because, notwithstanding the difficulty in answering those at times uncomfortable legal questions, such a checklist can be a guide to what investors and their attorneys care about.

Legal and Business Due Diligence

What are typical topics covered by legal diligence, and why are they important? One common request is a comprehensive report of your corporate records. These include your charter, bylaws, all the minutes of your meetings, and records of all the actions of the board and the shareholders. Then the question arises, did you actually have meetings? Did you take minutes?

At least one stockholder meeting per year is required by law, but the remedy for failure to hold one is typically only that your stockholders can sue you and force you to do so. So unfortunately, for legal compliance issues we see many privately-held companies do not hold meetings until someone insists. Some matters do in fact require shareholder approval, but many of these matters end up approved by written consent instead of at a meeting. That then raises the question, was everything approved that needed approval?

Issuance of stock or options is a typical area where the appropriate approval is not always obtained. Board approval is nearly always required to issue stock or options, and sometimes shareholder approval is also required. These approvals have to appear in your corporate records. Failure to get this approval at the right time can create issues if the value of your stock has gone up since the time you committed to grant the option.

Other questions may ask who your main suppliers and customers are, and request a copy of the related contracts.

Investors also want to know what exclusive relationships you have. I had a client who sold itself a number of years ago. They had agreed to an exclusive distribution arrangement in Europe, and the buyer already had a European distributor. The buyer had to resolve that conflict before it could close the deal. How does that apply to a financing? Well, when someone wants to invest in you and sees you have an exclusive relationship, that exclusive relationship could limit the universe of potential acquirers, which in turn can reduce your chances for funding.

Intellectual property, or IP, is another area of inquiry. Do you own your key IP assets, such as trademarks and patents? As attorneys working with startups, we ensure that ownership of key IP is transferred from the founders into the company.

The best practice from there is to also have your employees sign agreements assigning to the company any IP they create that is related to your business. If your company doesn’t own the original IP, or what your employees created along the way, but that’s the value driver of your company’s business, it’s like selling the Brooklyn Bridge. Your company doesn’t really own it, and so you can’t expect the company to get paid for it.

The Due Diligence Process

What does due diligence look like? Again, it happens in stages. The top-level business diligence that occurs prior to an investor giving you a term sheet is an analysis of the market you’re in and your position in it, your capacity for revenue and earnings growth and the like. The next stage is, again, legal diligence post-term sheet. At that point the attorneys get involved and the questions get more pointed, so being ahead of that process, with the help of your frenemy due diligence checklist, helps.

The final stage is in the definitive purchase agreement (the agreement pursuant to which you are selling stock). That agreement in is typically twenty, thirty pages or longer, with a big part of that agreement being dedicated to “representations and warranties.” These are promises, usually drafted by your investor’s attorney, that you’re asked to make about your business, covering all kinds of legal and business topics.

 A form of purchase agreement can also therefore be a “frenemy” since they can tell you what those representations are typically about. These representations serve a diligence purpose in that the representations are typically stated in such a way as to say, for example, “except as you have disclosed to the buyer, there is no ongoing litigation.” If there is in fact litigation, you would be obligated to disclose it to the buyer, who would then, of course, ask about the relevant details. If the details aren’t pretty, that can reduce the perceived value of your company, causing you to have to issue more shares for the investment and causing additional dilution for prior owners.

If any of those representations turn out, after the closing, to not be true, that will lead to unhappy investors and possibly a renegotiation on price that probably should have happened pre-closing, with the founders again suffering more dilution. So getting your hands on such an agreement and understanding what questions will be asked can help you be prepared.

Conclusion

It’s important to stay on top of these legal issues before you begin the funding process. Keeping up with legal requirements may not always build value, but it can help you hold on to the value you worked hard to create. Attorneys cost money, and that is a real issue with early-stage startups. Still, not addressing some of these issues early on can come back to bite you in a significant way once the funding process begins, and, as they say, an ounce of protection is worth a pound of cure.