editione1.0.1Updated September 19, 2022
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founderIt is not uncommon for founders to form companies themselves, without any legal assistance. In almost all situations this means the founders have missed something. It is not uncommon for founders who try to do it themselves to not timely file 83(b) elections, fail to adopt bylaws, fail to execute stock purchase agreements at all, and other mishaps.
If you are reviewing the corporate documents for a startup, you should see at least the following documents:
Certificate of Incorporation, or Articles of Incorporation
Organizational Consent of the Initial Directors of the Corporation
Consent of Incorporator (if the Articles or Certificate of Incorporation was signed by the incorporator)
Stock Purchase Agreements for each subscriber to the company’s shares
Intellectual Property assignments for each founder
Equity Incentive Plan or Stock Option Plan (if the company has adopted one)
copies of Section 83(b) elections the founders filed with the IRS, if the founders’ shares were subject to vesting
A few key items to add to your legal due diligence checklist:
Key person life insurance. What if you invest in a company where one founder is key to the company’s business, such that if the founder died or became disabled your investment would suffer a serious setback? What should you do to protect yourself? Consider requiring the company to buy key person life insurance. You could require the company not only to buy the insurance, but require it to expend the insurance proceeds redeeming the investors’ shares if the founder died.
Conflicts of interest in founder compensation. If you are going to invest in a company, it is a good idea to think about how the founders are going to be compensated. Before an outside investment, many founders are taking no salary. You should have a conversation with the founders about when they expect to take a salary and how much before you invest. This is part of the use of funds review. In order to be able to insure that founder compensation stays within the expectations set between you and the founders, you may want to require in your investment documents that at least two independent directors or the majority of the independent shareholders review and approve conflicted party transactions.
Lack of ownership. You want to make sure that the founder or founders are motivated to continue to be committed to the enterprise. If the founder gets too highly diluted (check the cap table) too early on, they may decide that there is not enough upside to keep grinding it out for little salary and long hours. This can happen if the company has to raise too much money early on before they can justify an increase in valuation.
We discuss boards of directors in detail in Boards and Advisory Roles. For the purposes of creating a legal due diligence checklist, here are the key things to look out for:
Board of directors size. The board of a very early startup should be small. A board of directors that is too big (anything greater than five members is unusual) means that the representative of the investors in a particular round may have less influence over important issues that come before the board; a large board also makes it hard to schedule meetings, which may be monthly rather than quarterly for early-stage companies.
Board of directors makeup. Boards make extremely important decisions for the company, and if the board of directors is made up of the founders and their friends, that might make you nervous. Investors should be well-represented on the board, and ideally there would be one or more independent board members who both sides respect. Founders who control the company and show no ability to seek out and heed the advice of others are a warning sign.
Unusual control provision. Google (now Alphabet) and Facebook are two examples of large companies in which the founders still have a very high degree of control, because they have engineered special classes of stock that give them outsized voting rights.* Many critical corporate transactions typically require stockholder approval (including approving the board of directors) so beware of any company that has an irregular voting, shareholder or proxy agreement that gives one individual near total authority over the affairs of a company.
cautionIt can be tempting for early-stage companies to try to save money on payroll taxes by categorizing employees as independent contractors. This can result in problems. In general, if a person works only for one company and they work physically at that company every day and their boss is an employee and directs their work, then they will likely be considered an employee by the taxing authorities and not an independent contractor. Any improperly classified independent contractors can create a tax liability for the company. Make sure to ask the entrepreneur who is an employee and who is a contractor. While use of some contractors is normal, beware of companies where the majority of the team working at the office are classified as contractors.
All employees should have signed an offer letter or employment agreement, and also an IP assignment agreement and a confidentiality or non-disclosure agreement.
The intellectual property assignment agreement (or IP assignment agreement) ensures that all the work produced by the employee belongs to the company, with customary exclusions that anything they do on their own time with their own equipment belongs to them, as long as it is not directly related to the business of the company. There is usually an addendum where the employee lists any of their own prior inventions or IP that they want excluded from the assignment.
danger IP assignment is really important, because you don’t want a key employee to leave and take their work, including all their code, to a competitor or their own startup. Founders should have similar agreements assigning their relevant work that was done before the startup was legally formed to the startup.
Employment agreements should also make it clear that employment is “at will,” meaning that they can be terminated at any time.
A confidentiality agreement (or non-disclosure agreement of NDA) prevents employees from discussing information pertaining to their work at the company, including the status of the company or its customers. The confidentiality agreement is typically included as part of an employment agreement.
It is very common for startups to use contractors for all kinds of services like website or app design or building, logo design, software development, and so on. Since they are scrappy and generally preserving cash, many of these arrangements may be informal. Check that the agreements have the following provisions:
Work-for-hire, meaning that all rights to the work belong to the company once the contractor has been paid
Confidentiality or Non-disclosure Agreement
Intellectual Property Assignment or Proprietary Rights Agreement
If there are no written agreements or those agreements lack key provisions, you can ask the entrepreneur to get them in place or amended before closing the investment.
cautionMake sure to ask about any founders or employees who are no longer with the company. If the company is successful, there is a tremendous incentive for those involved early on to make a claim. Many expensive lawsuits have arisen from former early employees who might have been promised stock or who had not vested their stock before they were terminated or quit. Here are some questions to ask:
Did the ex-employees sign IP assignment agreements and NDAs? Typically this would be a single agreement called a Proprietary Information Assignment Agreement or similar.
Are any severance payments owed?
Are there signed termination agreements? An important part of a severance or termination agreement is a release by the former employee of the company of any claims for any additional compensation. It is painful to see a portfolio company pay a severance to a former employee and still get sued for some bogus wrongful discharge claim. This is an unforced error.
Were there other advisors or people who contributed to the early product or company’s intellectual property who never signed on formally but might have a claim?
Check that a company is not carrying accrued or deferred salaries on its balance sheet. It is a good idea to ask the founders if they have any unpaid compensation. Founders are not necessarily accounting experts, and they may not have hired an accounting or CFO equivalent service.
cautionLook out for founders who intend to use almost the entire proceeds of the offering to pay themselves back for foregone salaries or unreimbursed expenses or other accrued liabilities; as an investor, you usually want to fund growth, not pre-existing liabilities. This can also arise when a company has already accepted funds to provide a good or service at a later date. Many Kickstarter campaigns have turned into liabilities investors do not want to fund, for example.
Most people procrastinate on their taxes. Entrepreneurs are busier than most of us, building a company and a product and hiring and selling and raising money. With a small team, there may be no one focused on finances and accounting and taxes. Entrepreneurs tend to focus on how much cash they have and how quickly they are burning through it.
caution That said, you don’t want a big chunk of your investment going to pay taxes owed. Even if the company has no revenue, it may still need to file tax returns; and even if it is not making a profit, sales and payroll taxes still accrue.
founderWe discuss the various corporate forms (C-corp, S-corp, LLC) and the tax implications in detail (you can also visit Appendix B for further information on the differences between these entities, which will be helpful for founders). You can check in the public record whether a company has tax liens filed against it (or any other lawsuits). But here are the general tax issues to look into as part of your legal due diligence: