Legal Due Diligence for Startups
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What is due diligence?
Due diligence is a “complete and appropriate” investigation or audit of a startup’s documentation and facts before an investor purchases/invests in the startup business.
Why is due diligence important to startups?
If a startup desires to receive investments from angel investors or venture capitalists, investors likely will trigger the due diligence review of the startup’s business operation, financial situation, and legal documentation to ensure that their investment is worth the money. A startup that does not prepare adequately for due diligence review may decrease investors’ interests in the company.
Why is legal due diligence important?
Investing in an early-stage startup with no certainty of commercial success is a risky move. Furthermore, early-stage technology startups can encounter legal issues even before they thrive, as their services and products heavily depend on the ownership of intellectual property as well as the several key individuals to make their dream come true. Investors would certainly want to protect their investments from additional legal and regulatory risks.
Due to their early-stage nature, legal problems are generally confined to these major areas:
Company’s Intellectual Property
Corporate and Capital Structures
Third-Party Contracts
Employee and Independent Contractor Agreements
Tax obligations
1- Company’s Intellectual Property
Intellectual Property is one of the critical assets of a technology startup in its early stage. This is because early-stage companies do not have a lot of valuable assets, and most startups develop their product in association with their IP. It is important for startups to identify their IP and protect their IP accordingly. You can read this article for more information about IP due diligence.
IP Ownership
From the investor’s perspective, they want to see clean ownership of IP, or at least a transparent chain of ownership showing that the startup owns or has substantial IP rights. In the context that a company is utilizing IP from a third party, the startup would want to make sure that it has sufficient rights for an adequate duration of time to execute its business plans.
IP Protection
Another essential aspect to consider is IP protection. Startups can easily fall into the trap of accidental public disclosure, which significantly hurts a startup’s right to a patent. Furthermore, trade secrets need to be protected with proper legal documentation to prevent unauthorized disclosure. Otherwise, an unveiled trade secret loses its value as intellectual property. Trademarks can be problematic, too, when startups do not register their marks. For example, an unregistered Canadian trademark has limited protection under the law compared to a registered trademark that grants the company an exclusive right to that mark across the nation. Investors would be happy to see more sophisticated forms of IP protection.
IP Licensing
The investor will also be interested in how the startup exploits its IP, and thus all arrangements around the IP should be documented.
2- Corporate and Capital Structures
Investors will want to know that the startup company has the right legal structure and is up to date with all registration requirements. Most startups will incorporate a company to limit its liability and allow security (share) investments. Investors will be interested in reviewing articles of incorporation, Board meeting minutes, and good standing letter from the federal or provincial registry. The investors verify the company’s registration to avoid potential fines and liability issues.
Therefore, startup companies need to prepare their corporate record in a timely manner to document all important and major decisions and changes of shareholders, directors, or officers. Investors want to understand the history of the company as well as the capital structure. For example, they do not wish to deal with a company that cannot identify all previous and current shareholders or who owns what type of share. Furthermore, startups should record Board of Directors and Shareholder meetings or put the resolution in writing to know what happens in the past to make their investment decisions. A capitalization table and ledgers containing shareholders and director/officer information can be handy too.
3- Third-Party Contracts and Licenses
Startups sign contracts with outside parties for various purposes, and investors would want to examine all of them to make sure the startup did not do anything detrimental to itself. A poorly drafted contract can expose the startup to various legal issues, such as liabilities, early termination, and unenforceable clauses/agreements. Contracts at law require several essential elements. Therefore, startups should be aware of taking online templates without thinking about the template’s applicability in a particular context. Many legal terms have special meanings, and a bad template can render the entire contract unenforceable.
Besides the technical difficulty of not knowing the legal language, startups may make business mistakes that can hurt their viability and potential.
Third-party contracts and licenses may trigger additional IP concerns, especially when the startup relies on the third party’s product or services to develop its invention or other forms of IP. Watch out for the licensing terms to protect the startup’s IP rights.
A company should consider whether it is worthy of sacrificing long term business potential from short term viability before signing a contract. Common errors are:
Granting exclusive access to the startup’s technology,
Stripping the startup’s rights around a particular area of interest, and
Unnecessary non-compete clauses creating barriers for future business opportunities.
4- Employee and Independent Contractor Agreements
People are considered as critical assets of a startup. Several issues related to the startup’s personnel can arise in the context of labour law and intellectual property. An important rule to remember is not to “blur the line between employee and contractor”. You may want to read this blog for common employee/contractor-related legal issues in a startup.
Labour Law Standards
Employees are subject to the Labour Standard legislation/regulation in the startup’s jurisdiction, which sets out the minimum wage, CPP/EI contribution and other labour law requirements that the startup must abide by. On the other hand, independent contractors are not employees and will file their own tax returns and pay for their own CPP/EI contributions. Investors would like to examine these agreements and ensure that the classification is appropriate as the startup bears additional burdens to employees.
Employee and Independent Contractor Agreements
A well-written employment contract is vital to protect the rights of the company. The contract should lay out the terms and conditions of the employer-employee relationship and clearly states the compensation, working hours, expected working timeslots, vacation policy, holiday pay, termination clauses, procedures for applying for a leave, and many other things. For an independent contractor, the agreement should clearly state that the parties intend to be independent contractors and should not contain clauses to suggest an employer-employee relationship.
Intellectual Property
By default, employees do not own any rights to the work that they have created in the course of their employment. However, any investor will almost certainly prefer that the employment contract can reiterate and clarify the ownership of work-related IP to prevent legal disputes. A startup should also consider appropriate non-disclosure, non-compete, and non-solicitation clauses for applicable personnel to reduce its intellectual property risk. On the other hand, independent contractors presumably own all IP developed through the term of the agreement. Therefore, a startup must use appropriate wording to protect their IP ownership rights in dealing with independent contractors.
4- Tax Obligations
Companies are separate legal entities from individuals. Investors would want to see the startup is up to date with all tax filings and payments. A startup should also register to collect HST as soon as possible so that it looks professional. The startup should keep all tax-related receipts for accounting purposes and not withdraw funds from the amount of HST collected. Additional tax obligations exist when a technology startup deals with transborder or international customers or transactions. In general, startups should consult with tax professionals to ensure compliance with relevant tax obligations.
Sources:
https://www.stimmel-law.com/en/articles/due-diligence-what-it-and-how-you-do-it
https://seraf-investor.com/compass/article/penalty-box-legal-issues-startups
https://learn.marsdd.com/article/what-your-technology-investors-look-for-with-respect-to-intellectual-property-assets-ip/
https://www.lexology.com/library/detail.aspx?g=560d2b98-9607-4da4-91db-128638f44c57
https://linkilaw.com/company-law/six-employment-law-tips-for-startups/