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Does your heart leap from playing a risky game of a startup founder?
Do you wish your business to be on the edge, scale fast, and relate to the famous quote: “Want to be a billionaire? Impact a billion lives”, but you know you cannot do it alone? You realize you will need to raise venture capital now or at some point.
This means your company will be subject to due diligence eventually. We’ve got you!
These guidelines can help you prepare and excel in this process.
In 2022, global venture capital investment totaled $500.8 billion.[i] VC funds invest in startups and early-stage businesses that have high growth potential but are not commercially successful yet. The goal of VC funds is to invest in companies that have great potential to become profitable in the long run. Investors act with the hope of earning a high return on their investment when the company eventually gets acquired or goes public.
Even though the VC global market is massive, finding a VC fund that will invest in the startup can be very hard at the early stage. For that reason, you must convince VC funds that investment in your startup will make a high return. Of course, your business idea and the business plan are essential. However, the other side of that coin is your startup’s compliance with the law. Regardless of how innovative the idea is, investors want to be sure that the company is not exposed to significant legal risks.
Therefore, startups must prioritize legal compliance as they seek funding from VC funds. Let’s see what you can do to prepare for the legal due diligence process.
VC funds that are considering investing in a startup typically conduct both business and legal due diligence. Business due diligence involves analyzing the company’s product and business model, as well as financial and operational performance. On the other hand, legal due diligence involves reviewing the company’s legal documents and identifying any legal risks that may impact the investment.
Typically, Venture Capital funds initially conduct business due diligence. At this stage they assess wheatear the business idea and overall impression of the startup’s business show the potential to be profitable. If your startup passes this stage, the flowing step is legal due diligence.
Legal due diligence usually starts with the due diligence request list. In other words, the VC fund will provide you with the list of documents and information they want to investigate initially. The purpose of the request list is to help the investor to identify any potential risks.
The scope of the request list depends on the VC fund’s internal policies and management.
Of course, during the due diligence procedure, Venture Capital funds may ask additional questions. Nevertheless, as the first step in finding a VC investor, you can prepare your company for due diligence and make sure that your company has adequate documents in the above-mentioned fields.
In case you wish to check your company’s legal health, get in touch with us.
Depending on a Venture Capital fund and a startup, potential VC investors will seek different documents and information. However, several main areas of law will most likely be subject to detailed analysis in the due diligence report. Preparing answers to these questions in advance will help your startup to send out a well-organized one.
In the field of corporate law, legal counsels who work on due diligence will seek documents regarding company incorporation and good standing. Therefore, you should make sure that you have in your records all documents proving that the company is registered and duly exists. Another thing that is crucial for VC funds in this domain is voting rights and decision-making. In this regard, VC investors will review all documents that may affect voting in the company’s General Meeting.
For example, Mickle and Peter are the founders of the startup. Mickle has experience in a specific industry, and the founders agreed that he will generate more corporate profit. On the other hand, Peter invested more money initially, and he has more power in making corporate decisions. Information like this will be essential for VC investors.
Regardless of preparation for the due diligence process, you should be sure that your startup has all the necessary licenses. Depending on the type of product that the startup is developing, you might need to obtain a license. For instance, if the startup develops an app related to financial services, it likely needs a license to provide the services.
Also, ensuring regulatory compliance is essential. Violation of relevant laws often results in potential monetary fines, and this could be a red flag for investors.
Startups usually do not own real estate. However, if your case is different, you should prepare documents confirming the ownership.
On the other hand, it is likely that a startup rents business premises. Investors will be interested in examining the commercial terms of the lease agreement.
For example, it will be important for the investor to be aware of the terms of the lease agreement, the termination clause, and potential contractual penalties in case of termination.
Investors always check if employment documents are compliant with the law. For that reason, you should prepare employment agreements and internal employment policies. Also, for the IT industry, NDA with employees is a must-have! If you did not conclude NDAs with employees yet, you should do it as soon as possible.
If your employees have some benefits, make sure that you are transparently presenting them. For instance, this includes bonus schemes, ESOP, private health insurance, or any other benefit that your employees have.
IP Due Diligence is probably the essential part of the due diligence of a startup. Namely, in most cases, IP is the startup’s main product. This means that if the ownership of the IP is not properly documented, the company’s value will be significantly decreased. Also, it could lead to the VC fund’s decision not to invest in the startup.
Work of authorship made by an employee must be properly transferred from the employee to the employer. The best and easiest way to do so is to include a detailed IP clause in the employment agreement. Such a clause ensures that IP developed during employment is owned by the employer.
It is equally important to conclude agreements with your clients that regulate IP transfer. For example, if your startup’s product is software, you will conclude a software licensing agreement. Software licensing agreements define terms and conditions for the use of the software, as well as the duration of the license, fees, restrictions to use, etc. Our IT contracts lawyers can assist you in drafting agreements that fit your business model and protects your startup’s interests.
Likewise, you need to think about your intellectual property protection. Important questions will be:
When it comes to commercial contracts, investors will review any material agreement the company has concluded. The reason for this is to make sure that such agreements will not limit a company’s ability to grow or expand in the markets. For example, VC funds’ counsels will look for limitations arising from non-solicitation or non-compete clauses, exclusivity clauses, etc.
To illustrate, during the due diligence process, the investor realizes that one of the agreements contains an exclusivity clause that prohibits the company from providing services to any company in the same industry. If companies from such an industry are potential users of the service in a considerable number, such a clause is likely to be identified as a red flag.
Also, you should ensure that all contracts are properly entered into and stored. Mistakes that seem minor, such as missing signatures, or lack of information in SOW, could also lead to red flags.
With the advent of GDPR[i], protecting personal data has become one of the priorities for companies across the globe. Companies can no longer afford to overlook the importance of data protection. However, it often happens that data protection is neglected. This especially happens at the early stage of business.
If you did not consider this aspect of your business, now it’s the moment to do it and make sure that your startup is compliant with data protection regulations. Even though you may not be aware of it, you almost certainly process personal data. For example, if you have an app that requires login, you are probably processing personal data.
Monetary fines for breaching data protection regulations are significant, and it could be a red flag for investors.
Last but not least, VC fund’s counsels will likely investigate past and ongoing disputes that can impact the financial and operational performance of a startup but also cause reputational damage. If you have any ongoing disputes, make sure that all documents are preserved adequately.
For example, a startup is facing a dispute with a former employee over IP rights. Reasonably, such a dispute would be analyzed in detail.
Legal due diligence is one of the last, but crucial parts of the VC fundraising process. It can greatly impact the success or failure of a startup. With the majority of startups failing, careful preparation for legal due diligence could increase the chances of a startup’s success. By ensuring legal compliance, startups can present themselves as attractive investment opportunities to VC funds.
Even though preparation for due diligence can be complex and time-consuming, it is an essential step toward securing VC funding. However, it does not have to be a burden or obligation. It can be seen as an opportunity for startups to evaluate their legal and regulatory compliance. By taking a proactive approach to preparation for legal due diligence, startups can increase their chances of securing funding and also set themselves up for long-term success.
Don’t let legal due diligence intimidate you! With the right preparation and guidance, you can set your startup up for prosperity and be part of the Hall of Fame!