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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Legal due diligence refers to the process of reviewing a company’s legal documents to ensure that the company has not made and is not making any legal errors that will put the investment at risk.
Legal due diligence is separate and distinct from business due diligence; its purpose is to make sure that there is no reason from a legal perspective that an investment should not proceed. You typically turn to legal due diligence after you have completed your initial business due diligence and have come to terms on the transaction.
Should you hire a lawyer to help you with legal due diligence? This depends a lot on the circumstances of the company you intend to invest in, and your own comfort level. We discuss when it might be appropriate to hire a lawyer a bit later—whether or not you do, it’s wise for the person making the investment to have some familiarity with the topics and issues that might need to be looked into during this stage.
You may find it helpful to take a look at the legal and financial due diligence checklist from the Angel Capital Association.
It is a typical part of legal due diligence to review a company’s charter documents.
In the corporate context, charter documents are a company’s articles or certificate of incorporation, bylaws, and any other corporate agreements, such as shareholder agreements, voting agreements, and so on.
dangerMake sure the company is in “good standing”—that is, the company has not let its corporate charter lapse. You can usually find out if a company is in good standing by reviewing the Secretary of State’s website in the state in which the company is formed. Similarly, if you wanted to, you can check that the company has the appropriate business licenses.
Most startups incorporate in Delaware as C corporations, if not in the state in which they are headquartered. Delaware is a common choice because of its corporate law history and business-friendly laws.* In fact, many VC firms require that companies be incorporated in Delaware or reincorporate as a Delaware company.
dangerBeware of companies that are incorporated in places other than either Delaware or their home state. For example, if a company is headquartered in California but incorporated in Nevada, it might be a red flag that the corporation is trying to avoid California income tax. State taxes do not depend on where you are incorporated, and so this is a fruitless strategy. Companies incorporated in unusual places may also incur additional legal cost and expense as a result of their bespoke domicile choice.
Cap tables are critical in understanding a business.
The capitalization table (or cap table), is a document showing each person who owns an interest in the company. Usually this is broken out by the name of each equity holder, and shows what type of equity instruments they hold. It is set up as a ledger, so that all share issuances and transfers can be tracked. Many companies use Excel or services like Carta to keep their capitalization table. They will create a worksheet for each type of equity security outstanding, such as common stock, Series A Preferred Stock, Series B Preferred Stock, and so on, including convertible debt and equity instruments that are issued. Included in the cap table is the stock ledger, showing all issuances of equity from the company to equity holders and all transfers of equity from one equity holder to another. There may be multiple ledgers for each type of stock or convertible security the company has ever issued.
founder The company’s cap table should show you everything having to do with the equity structure of the company—not just who owns how many shares, and what type of shares they own. If the company has issued convertible notes, there should be a note ledger; if the company has issued SAFEs, there should be a SAFE ledger. Done correctly, the ledgers will tell the complete story of the company’s life, including all of the company’s stock issuances from inception, and all of the stock transfers of all shareholders, for the entire life of the company. For example, the first entry on the stock ledger would be the company’s first stock issuance, to the founder who received stock certificate number 1.
It can be enlightening to see how the company has allocated stock among its founders. You can also get insight into whether all the key personnel are adequately incentivized.
caution One cause for concern may be a large amount of stock that is owned by an early founder or employee who is no longer with the company. This suggests that the company may not have had a stock vesting plan in place for founders early on. You will want to make sure at a minimum anyone who has already left has signed an IP Assignment Agreement. We’ll discuss employee issues later.
danger If the company has not maintained its cap table appropriately, it is a red flag. You need to know how much of the company you are going to own after you invest. You can’t know this unless the company’s cap table is complete and correct and reflects all outstanding ownership. Many, many companies have wound up in protracted and expensive lawsuits because they did not carefully document stock ownership, and then someone made a claim that they were owed a certain amount of the equity of the company.
founderEvery time a company issues stock or options or warrants to anyone, it has to either register the securities with the SEC or a state securities regulator (a very expensive process), or it has to find an exemption from registration, as we discussed in Fundraising and Securities Law. In addition to those exemptions used to raise money from investors, there are a number of exemptions available to companies when it comes to giving stock or options to employees, but they each come with their own limitations and conditions.
exampleIf a company issues stock options to employees, it should comply with federal securities Rule 701 with respect to those option issuances. Rule 701 has mathematical limitations on how many options can be granted to services providers during any 12-month period. A company issuing options to employees also has to comply with state securities law requirements, and may have to make a filing with a state securities administrator (as is required in California, for example).
Ideally, the investor would learn in diligence that the company is not self-administering its stock option plan, but relying on competent legal counsel to administer the plan.
danger If a company has issued securities for which no exemption is available, the company may have to make a rescission offer to the recipient of the securities. This can be true even if the recipients of the securities didn’t pay anything to receive them (as is the case for optionees). This is a very expensive and time-consuming thing you never want to see one of your portfolio companies go through.
danger If a company has not been working with competent securities counsel, this is a red flag. The company may have issued securities to prior investors or service providers that might have to be rescinded, with the money you invest funding those repurchases.
One of the ways startups conserve cash and attract talent is to pay employees lower cash salaries but reward the risk they’re taking on the startup by promising them a portion of ownership in the company—equity. Typically, employees are not given ownership directly, but the option to purchase stock in the company, an option that can be exercised not right away but over time, referred to as vesting.
Equity can be awarded in different ways, most typically through stock options, but also through warrants and restricted stock awards.*
Compensatory equity awards are awards of stock, options, restricted stock units, and similar awards issued to service providers of a company. Under the securities laws, companies may issue compensatory equity to service providers without those service providers being accredited if they comply with another exemption, such as Rule 701.
founder You will want to make sure that if you are investing in a company that is granting compensatory equity awards, typically in the form of stock options to employees and contractors, that they are doing so correctly. All option grants must be approved by the Board, and priced at the time of board approval. To avoid adverse tax consequences to the optionee (in the case of options), the options must be priced at no less than fair market value as of the date of grant. Companies do not have to obtain independent third party valuations of their common stock, but if they do, the burden of proof is on the IRS to challenge a valuation. For this reason, many companies start obtaining third party valuations of their common stock for option grant purposes as soon as they have closed their first fixed price financing. As mentioned above, they should all be recorded in the stock or options ledger and included in the cap table.
Founder vesting refers to a legal mechanism whereby founders have to continue to provide services for some period of time or have their shares potentially repurchased by the company. Founder vesting may follow a similar pattern to employee vesting, where the founder gains permanent ownership of their stock over the course of typically three or four years, with potentially a one-year mark for 25% ownership and monthly increases thereafter.
founderSince founders have typically purchased their stock up front as part of the corporate formation, the mechanism for founder vesting is typically a repurchase right of the shares by the company for the lesser of the fair market value of the shares or the price they paid for them. Since founders usually acquire their shares for a very small purchase price (a tenth or hundredth of a penny per share), being at risk of having those shares repurchased at the price is effectively a forfeiture condition.
As an investor, you will want the founders as well as the employees to be on a vesting schedule.
In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it.*
Let’s run through an example of why this is important.
exampleSuppose a company has three founders. When the company was founded, each founder owned a third of the company, or 1M shares each. What happens if, after you invest your money, one of the founders leaves? Does that founder continue to own 1M shares? That might be painful for both you as an investor and the other co-founders, especially if that founder’s expertise is going to have to be replaced by another founder who is going to want to receive 1M shares (this will dilute the value of the shares you and the remaining co-founders hold, an issue we’ll discuss in detail).
How do you solve this problem? Make sure the company has a repurchase right to buy back unvested shares at the lower of the cost or fair market value of the shares, which will lapse over a service-based vesting period. In other words, make sure founders are on a vesting schedule.
You would prefer companies you invest in to have provisions in their founder stock repurchase agreements that cause unvested shares to be “automatically” repurchased unless the company takes an affirmative action to not repurchase them.
confusion If you are investing in a company and are insisting on founder vesting, be careful to give some thought as to who will enforce these provisions against the company when and if they come due. For example, suppose you are investing in a “solopreneur”—your founder vesting agreement may as a practical matter not be meaningful if it is the founder who has to enforce it against him or herself.
If you have founders whose shares were issued vested, or who have already vested, or have substantially vested, you can re-start their vesting schedule by having them execute a new vesting agreement.
exampleTwo founders set up a legal corporate entity early in their work and have been pursuing a startup idea for three years. They have finally made enough progress to go out and seek their first outside funding. If they had put themselves on a four-year vesting schedule, they would be 75% vested. As an investor in a very early-stage company with two key founders, you want to make sure that they are motivated to stick around going forward. If the vesting schedule is not addressed, one founder could leave the day after the investment with a substantial portion of the company.
founderInvestors may require that vesting on founders’ shares be reset at the time of the investment. The reason for this is that investors might not want founders who are fully vested or nearly fully vested to lose motivation for staying in the company long-term. This is accomplished by having the founders execute a new Founder Stock Vesting Agreement, which gives the company the right to repurchase the unvested shares at the lesser of fair market value or the founder’s cost, which less of FMV or at-cost repurchase right lapses over the vesting period. This is not problematic from a tax point of view for the founders involved. In fact, the Internal Revenue Service has issued guidance that in some circumstances it is not even necessary for founders in this situation to file Section 83(b) elections, since they will have already owned the shares when the vesting conditions were placed on them.*
founder Founders may resist having their vesting schedules reset. From their perspective, they have worked hard for those three years (in the above example), and in many cases have invested their own money or foregone salary. Founder vesting will then become a point of negotiation and will likely be incorporated in the term sheet.
Employee vesting refers to vesting on employee stock option grants. Sometimes investors will require that all employee option grants have to vest over a specified schedule (such as monthly over a 48-month period, but with a one-year cliff), unless approval is given by the investor’s designee on the board or a majority of the investors.
All employees should be on vesting agreements for the stock or stock options that are part of their compensation. The most typical vesting schedule is four years with 25% vested after the first year of employment, often referred to as the one-year cliff, with vesting monthly after the first year.
caution Sometimes companies provide in their documents that upon a sale of a company, holders of unvested shares or unvested options have their vesting accelerated. This is favorable for employees, but from an investor perspective you would want to make sure that such a program is well thought through.
exampleA startup wants to hire an experienced enterprise software sales executive. That executive is willing to take the significant risk of joining this early startup because she is being offered 5% of the equity. If the company gets acquired in a year, and she gets fired because the acquirer does not need another head of sales, she will have only 1.25% of the equity. Being a savvy salesperson, she negotiates an acceleration provision in her employee agreement, that if the company gets acquired, she vests 50% of her unvested stock, and if within three months she gets fired by the acquirer for no cause or is asked to move more than 100 miles away, she vests the rest immediately. Without these provisions, the sales executive may not be excited about an acquisition opportunity that is otherwise good for the startup and its investors.
caution You will want to look out for this in your due diligence. This makes a company more expensive for another company to buy, because the buyer company will have to re-up the equity incentive of the workers. This re-upping may result in the buyer reducing the amount of consideration paid to the target company stockholders.
There are two types of change of control vesting:
single trigger acceleration
double trigger acceleration
Single trigger acceleration is 100% vesting upon one event—the change of control transaction. Double trigger acceleration is acceleration of vesting upon the occurrence of two events:
a change of control, or
the termination of the founder without “cause,” and sometimes if the founder quits for “good reason” within a certain period of time (such as 12–18 months) after the change of control.
As an investor, you would prefer “double trigger” acceleration because this way the buyer of the company will not have to re-up the continuing employees on equity grants to the same degree it otherwise might if all of the continuing employees had their vesting equity fully vested on the sale.
The example above has both a single trigger and a double trigger provision. What should you do? You can try to negotiate aspects of that employee agreement as part of the investment. This is the “golden rule” at work. She who has the gold, rules.
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
Bylaws
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:
Section 83(b) elections. The founders should have given the company copies of their filed elections.
Federal tax returns. If a company forms a state law corporation, they have a federal tax return filing obligation that first year, regardless of whether they have any income. This is the same with a multi-member LLC. There are penalties for failure to file. Make sure you know: What is the tax status of the company? C corporation? S corporation? Limited liability company taxed as a partnership? Limited liability company taxed as an S corporation?
State income taxes. In what state(s) does the company pay income tax?
State sales taxes. With respect to which states does the company collect and remit sales tax? (Failure to collect and remit sales taxes can add up to a large liability in a short period of time, and it is not uncommon for companies to fall out of compliance with sales tax collect and remit requirements.)
Payroll taxes. Payroll taxes in general are worth digging into. Does the company use a payroll service so that you can feel assured that employment tax withholding has been taken care of? Payroll taxes are especially scary because directors and officers can be personally responsible for them in certain circumstances. If they are not doing so already, insist that the company use ADP or a similar service for payroll.
exampleA company did not hire a payroll service provider that would have refused to process payroll unless the company gave them sufficient cash to pay the income and employment tax withholding to the IRS. Instead, the company was trying to process its own payroll. The CEO did not remit to the IRS the amounts of the income and employment tax withholding the company was required to remit by law. The board had to fire the CEO, and the company ultimately failed from this financial setback.
Our goal with this book is not to make you a legal expert such that you don’t ever need to hire a lawyer. Our goal is to give you enough background and context such that your time with a lawyer is efficient.
We will discuss for which parts of the investment process you or your lead investor would engage legal counsel, and additional considerations if you are investing alone. If you or your group of investors engage legal counsel for the investment, it is typical that the same lawyer would review the term sheet, any legal due diligence issues that you choose to pass on to them, and that they would create and/or review the definitive documents to make sure that they are consistent with the term sheet terms and are otherwise in proper legal form.