As a startup founder, you have worked hard developing your product and building your team. Finally, years of grind and countless rejections pay off, and the dreams of rapid growth are coming to life with the first venture capital investor coming in. The terms of the letter of intent sound great, and the whole team is thrilled about the new horizons. The last thing you want now is to have the investors pull out after legal due diligence because of the startup’s poor paperwork practices and legal messes. But worry not; much of this can be prevented early on or remediated. In this article, you will learn what venture investors seek in a startup’s legal paperwork to ensure you pass due diligence with flying colors. Even if you do not plan to attract investment, this article will help you protect your business’s legacy and better equip you for success.
As a part of the pre-funding process, venture capital investors will conduct a thorough business and legal due diligence analysis of the target company. They will analyze the capitalization table, corporate records, agreements related to capital stock and its issuance, contracts with employees, regulatory filings, agreements relating to intellectual property, the startup’s standing with state and federal authorities, and more. At a high level, investors’ primary goals in pre-funding legal due diligence are:
- To establish the current and expected ownership structure and
- To ensure that their prospective return on investment is not significantly tainted by any risk of losses. Investors seek to minimize their investment risks and ensure that the target startup has good title to the property on which it relies for profits, is not exposed to risks of regulatory fines or potential costly disputes with stockholders, employees, or third parties, and is generally well-governed and trustworthy.
Prior to closing a funding round, VC investors will often request a legal opinion letter from a lawyer confirming that the startup is in good legal standing. Moreover, stock purchase agreements will usually contain representations and warranties addressing the many facets of a startup’s legal standing and requiring that it disclose any potential issues and indemnify the investors against any undisclosed legal risks.
Extra Insight: For a comprehensive example of what legal matters investors are likely to focus on, visit the Representations and Warranties section of the Stock Purchase Agreement template on the National Venture Capital Association’s (NVCA) website.
Unfortunately, investors can be deterred from funding a startup if its legal paperwork is not in order or if its unaddressed legal needs expose the company to risks of losses. Whether you seek venture capital investment or not, this article’s key considerations will be helpful in ensuring that your startup is in good legal shape.
- Capitalization Table. The first document VC Investors usually request in legal due diligence is the capitalization table (“cap table”). A cap table is a spreadsheet showing a startup’s ownership structure. Without an up-to-date cap table, it is nearly impossible to track how much stock is issued or made available in the startup, especially if it uses complex instruments like restricted stock or stock options or has attracted angel capital. A cap table is a valuable tool for keeping track of stock option pools, ownership percentages, and equity commitments, visualizing various ownership scenarios, determining which stockholders can constitute the requisite majority for corporate decision-making, and more.
- A Straightforward Stockholder Structure. In addition to the good record-keeping practices outlined above, investors prefer to see a transparent and straightforward stockholder structure (classes of stock). The earlier the VC funding round stage (A, B, etc.), the simpler the prior stockholder structure is expected to be. Early-stage companies that did not previously attract venture capital are usually expected to only have a Common class of stock. Preferred Stock (Classes A, B, etc.) that prioritizes its holders in the dividend/capital distribution and voting is not usually issued before the first “priced” funding round (a round where a price per share is established). Angel investment (convertible loans, SAFEs) does not usually convert to stock until the nearest future priced funding round. An overly complicated (or “creative”) stock class structure can deter investors, especially if it involves multiple classes of stock with different rights and preferences. Investors prefer transparency and simplicity, as it helps them assess the potential risks and rewards of their investment.
- Good Standing with State Authorities. Good standing with the state of incorporation and states in which the startup is authorized to do business is required to maintain the corporate entity with the privileges it brings, including the right to transact business and own property as that entity, separated from its owners. For a company to remain in good standing, most states require the timely filing of annual reports and payment of franchise taxes. Franchise taxes can be a flat fee or be based on the number of shares, net assets, or attracted outside capital. It is not uncommon for states to impose strict penalties or administratively dissolve corporations if annual reports are not filed, and franchise taxes are not paid in a timely manner. Besides, being in good standing instills confidence in investors. It signals that the founders and management team are diligent, responsible, and proactive in adhering to legal obligations.
- Incorporation/Domestication in Delaware. VC investors normally prefer that target companies be incorporated in Delaware due to its established business-friendly, flexible, and predictable corporate law and specialized court system. If your startup is incorporated in a different state, it is usually possible to change the state of incorporation (“domesticate”) to Delaware by adopting and filing certain paperwork and paying a domestication fee with the Delaware Division of Corporations.
- Timely Corporate Resolutions. Corporate resolutions are a necessary part of corporate governance. Adopting periodic corporate resolutions (such as annual minutes appointing corporate officers and directors) is often required by applicable state law. Major transactions, such as funding rounds or substantial sales/acquisitions, also often require formal approval by stockholders or directors. Timely and orderly corporate resolution practices help establish the legitimacy of the startup’s decisions and reduce the likelihood of disputes and uncertainty. Adopting corporate resolutions promotes transparency and accountability within the startup and provides a clear record of major decisions, who made them, and how they were approved. Although it is often possible to ratify transactions retroactively, the importance of adopting timely corporate resolutions should be underestimated, as it sends a signal to investors that the startup takes governance seriously and is committed to following established procedures.
- Intellectual Property Rights. VC investors want to see that target companies have the rights to all intellectual property (“IP”) (technologies, trademarks, content, know-how) they use in commerce and rely on for profits. All IP created by a startup’s founders, employees, or contractors should be properly assigned to the company through advisor, employment, services, or assignment agreements. IP used by a company should not infringe on third parties’ IP rights and, depending on the subject matter, should be protected by patents, copyrights, trade secret regimes, or non-disclosure agreement.
- Note: the latest NVCA Stock Purchase Agreement template’s suggested representations and warranties include a section on Generative AI. Investors may seek affirmations that the startup complied with applicable laws when using generative AI and did not use it in ways that would compromise its confidential information or intellectual property rights.
- Equity Incentive (Stock Option) Plans. VC investors prefer that any employee/contractor equity compensation be issued under a comprehensive equity incentive plan and any stock option agreements follow an appropriate harmonized template. Stock options issuances must also comply with securities and tax laws.
- Compliance with Securities Laws. Investors want to see that any prior angel funding in the company complied with federal and state securities laws. VC investors want to invest in startups that have followed the law to avoid potential legal complications or regulatory issues that could threaten the company’s operations. For example, usually, startups must file Form D notices with the Securities and Exchange Commission and state securities commissions to report the investment details and ensure any unregistered securities are only sold to accredited investors.
- Compliance with Telecommunications Laws and Regulations. If the startup operates in a regulated industry such as telecommunications, investors will want to ensure that it complied with all the applicable laws and regulations. For the telecommunications industry, this includes obtaining all the required licenses and certifications, making timely filings and payments with the FCC and state agencies, and avoiding (or proactively addressing) agency enforcement proceedings or investigations.
Addressing all the startup legal considerations might seem overwhelming, but it is crucial to remember that most issues can be resolved or addressed proactively with the proper legal guidance. A pre-funding legal cleanup is often recommended to avoid complications during the funding round and show the seriousness of the startup’s intentions.
The CommLaw Group Can Help!
With a proven track record in commercial law, our firm will be happy to become a trusted advisor in preparing your startup for the next significant venture capital investment. Don’t let any postponed legal issues derail your success story; let us help you navigate the complexities of startup law so that you can focus on what you do best – building your business. Contact us today to set your startup on the path to success and ensure your legal matters don’t deter potential investors.
Please contact Jonathan Marashlian or Diana Bikbaeva if you have any questions.
DISCLAIMERS: This publication may be considered Attorney Advertising in certain jurisdictions. The determination of the need for legal services and the choice of lawyer are extremely important decisions and should not be based solely upon advertisements or self-proclaimed expertise.
