Raising venture capital can be a game-changer for startups, fueling growth, product development, and market expansion. But before you can secure that critical investment, you’ll need to pass the scrutiny of legal due diligence. Venture capitalists (VCs) want to ensure that your business is sound, compliant, and free of legal risks that could undermine their investment.
In this guide, we’ll break down what VCs look for during the legal due diligence process, from corporate structure to intellectual property (IP) protection, and share practical tips on how founders can prepare to pass with flying colors.
What Is Legal Due Diligence?
Legal due diligence is a comprehensive review of your startup’s legal standing, contracts, and obligations to ensure that there are no hidden risks or liabilities that could affect an investor’s decision to fund your company. It’s an essential part of the investment process, and being well-prepared for it can not only smooth the path to funding but also demonstrate that your startup is professionally managed and legally compliant.
Why Legal Due Diligence Matters to VCs
VCs are investing large sums of money in your business, and they need to know that their investment is protected. Legal due diligence gives them a clear picture of any potential risks that could impact your company’s operations, revenue, or long-term viability. If your legal house is not in order, it could raise red flags that might delay or derail the investment.
Passing due diligence with confidence not only improves your chances of securing funding but also strengthens trust between you and your investors.
Key Legal Areas VCs Scrutinize During Due Diligence
Let’s dive into the core areas of legal due diligence that VCs focus on when evaluating your startup:
1. Corporate Structure and Governance
What VCs Look For:
Investors want to ensure that your company’s legal structure is sound and that the rights and obligations of stakeholders are clearly defined. They’ll review your Certificate of Incorporation, Bylaws, Cap Table, and Board Minutes to ensure that the company is properly organized and that governance is well-documented.
How to Prepare:
• Ensure that your company is incorporated in a founder-friendly jurisdiction (such as Delaware for U.S. startups).
• Keep up-to-date Board Minutes and ensure that all key decisions are documented and approved by the board.
• Maintain a clean and accurate Cap Table showing current ownership, stock options, and equity allocations.
Pro Tip:
Work with an experienced corporate attorney to review your company’s formation documents and governance practices before entering the fundraising process.
2. Intellectual Property (IP) Protection
What VCs Look For:
For many startups, intellectual property is one of the most valuable assets. VCs will scrutinize your IP portfolio to ensure that all inventions, patents, trademarks, copyrights, and trade secrets are properly secured and owned by the company. They’ll also want to verify that any IP created by employees or contractors is fully assigned to the company.
How to Prepare:
• Ensure that all patents, trademarks, and copyrights are filed and assigned to the company, not individuals.
• Have IP Assignment Agreements in place with employees and contractors to confirm that any inventions or works created during their employment belong to the company.
• Implement Non-Disclosure Agreements (NDAs) to protect your trade secrets and proprietary information.
Pro Tip:
Consider conducting an internal IP audit to make sure that all IP is properly documented, registered, and protected before entering due diligence.
3. Contracts and Commercial Agreements
What VCs Look For:
VCs will examine your contracts with customers, suppliers, partners, and vendors to understand your company’s obligations, liabilities, and revenue streams. They want to ensure that your commercial relationships are legally sound and won’t pose any financial or operational risks.
How to Prepare:
• Organize and review all Customer Agreements, Vendor Contracts, Partnership Agreements, and Service Contracts to ensure they’re up to date and compliant with relevant laws.
• Clearly document all Terms of Service and Privacy Policies if you’re offering a customer-facing product or service.
• Address any contractual risks, such as provisions for termination, penalties, or potential breaches.
Pro Tip:
Maintain a contract repository where all important agreements are stored and easily accessible for review during due diligence.
4. Employee and Contractor Agreements
What VCs Look For:
Your investor will want to see that your employee and contractor agreements are properly structured and compliant with labor laws. VCs pay close attention to equity compensation, IP assignment, and non-compete agreements to ensure that your workforce is aligned with the company’s goals.
How to Prepare:
• Ensure that all employees and contractors have signed Employment Agreements or Contractor Agreements that include IP assignment, confidentiality, and non-compete provisions.
• Review your Stock Option Plan and ensure that equity grants are properly documented and align with the company’s cap table.
• Comply with all local labor laws, including those related to employment classification (employee vs. contractor).
Pro Tip:
Be transparent about your equity compensation structure, and make sure that all stock options and employee grants are clearly documented.
5. Financial and Tax Compliance
What VCs Look For:
Investors want to make sure that your company’s finances are accurate and that you’re in good standing with tax authorities. VCs will examine financial statements, tax filings, and any existing loan agreements to ensure your company is financially healthy and compliant with tax obligations.
How to Prepare:
• Ensure that all tax returns and financial statements are up to date and accurate.
• Keep clear records of any loan agreements, convertible notes, or debt obligations.
• Maintain clean accounting records and work with a reputable accountant to ensure financial compliance.
Pro Tip:
Work with an accountant who specializes in startups to ensure your financial records are in order and tax filings are accurate before entering due diligence.
6. Regulatory Compliance
What VCs Look For:
Depending on your industry, regulatory compliance can be a critical area of due diligence. Investors will want to see that you comply with all relevant laws and regulations, such as data privacy laws, environmental regulations, or industry-specific licensing requirements.
How to Prepare:
• Ensure that your company complies with data privacy regulations such as GDPR, CCPA, or HIPAA if applicable.
• Confirm that you hold any necessary licenses or permits required to operate in your industry.
• Stay up to date with regulatory changes and make sure that your business practices are compliant with local and international laws.
Pro Tip:
If your startup operates in a highly regulated industry (e.g., fintech, healthcare), work with legal counsel to conduct a regulatory compliance review before entering due diligence.
7. Litigation and Disputes
What VCs Look For:
Any past, pending, or potential litigation can be a red flag for investors. VCs will review your company’s history of legal disputes, lawsuits, or claims to assess any ongoing legal risks.
How to Prepare:
• Be transparent about any past or current litigation, and provide documentation on how the issue was resolved.
• Work with legal counsel to assess any potential legal risks and develop a strategy for addressing them.
Pro Tip:
If your startup is involved in any litigation, be upfront about it with investors and provide clear explanations and resolutions.
Tips for Passing Legal Due Diligence with Flying Colors
Now that you know what VCs will be looking for, here are some tips to ensure you’re well-prepared for legal due diligence:
1. Start Early: Begin organizing your legal documents as soon as you know you’ll be raising capital. This will save you time and stress during the due diligence process.
2. Keep Records Organized: Maintain a digital data room where you can securely store and share all relevant legal, financial, and corporate documents with investors.
3. Work with Legal Counsel: Engage an experienced startup attorney to review your contracts, IP protections, and corporate governance to ensure everything is in order before due diligence begins.
4. Be Transparent: Don’t try to hide any issues from investors. Being open about any potential legal risks and how you plan to address them will build trust with VCs.
Conclusion: Preparing for Success
Passing legal due diligence is one of the most critical steps in securing venture capital. By understanding what VCs are looking for and preparing your legal documents in advance, you can streamline the process, reduce stress, and ultimately increase your chances of closing the deal.
Being well-prepared not only makes you look professional and organized but also positions your startup as a solid investment opportunity for VCs.
Call to Action:
Need help preparing for legal due diligence? Explore our directory to connect with experienced legal experts who can guide you through the process and ensure your startup is ready for investment.
