Beyond the Balance Sheet: The Investor’s Guide to Legal Due Diligence

Are complex legal hurdles draining your energy and diverting your focus from scaling your investments? Navigating intricate legal landscapes can be a major time sink, yet it’s crucial for protecting an investor’s stakes and driving the growth of your portfolio.

Legal due diligence (the systematic review of a target company’s legal affairs) is a critical step in the investment process that helps identify potential risks and liabilities before committing capital. A thorough legal review can uncover deal-breakers or negotiation leverage points that might otherwise remain hidden.

With time as your most valuable asset, you need a clear, concise guide to the most critical legal factors that will sharpen your investment acumen and boost your portfolio’s performance. Here’s your roadmap to the essential legal considerations investors should focus on during due diligence.

Corporate Structure and Governance

Internal conflicts can critically undermine a promising startup. Strong corporate governance structures are crucial for preventing and resolving internal disputes and ensuring long-term stability.

When evaluating a startup’s governance:

• Verify proper incorporation and good standing
• Examine board composition and voting rights
• Check bylaws, operating agreements, and board minutes
• Review shareholder agreements to identify unusual voting rights or control provisions and review transfer restrictions and rights of first refusal
• Scrutinize equity grant documentation for potential issues such as missing board approvals, grants exceeding authorized option pools or promised equity without formal documentation

Capitalization Table

A clear understanding of a company’s capitalization structure is essential for making informed investment decisions:

• Review the complete capitalization table to understand ownership distribution among founders, employees, and existing investors
• Assess the size and allocation of employee option pools and their impact on future dilution
• Identify any outstanding convertible notes, SAFEs, or other instruments that will convert in future rounds

Intellectual Property

In sectors like technology, life sciences, and creative industries, intellectual property isn’t just an asset; it’s the core of the startup’s valuation potential.

Key IP considerations include:

• Confirm proper ownership and assignment of all IP assets
• Verify that all founders, employees and contractors have signed IP assignment agreements
• Review trademark and copyright registrations
• Check for potential infringement issues

Material Contracts

A startup’s contractual relationships define its operational foundation and can significantly impact valuation, creating both opportunities and constraints that may not be immediately apparent on the balance sheet. Key areas to examine include:

• Review key customer and supplier agreements
• Evaluate exclusivity clauses, termination rights and indemnity provisions
• Check for change of control clauses that might be triggered by investment

Regulatory Compliance

In fields like fintech and biotech, where regulatory landscapes are constantly evolving, a startup’s ability to anticipate and adapt to these changes is critical. Investors should look deeper into the startup’s regulatory strategy and assess whether it goes beyond mere compliance to actively anticipate future legislation.

• Verify necessary licenses and permits
• Assess compliance with data privacy laws
• Review the company’s regulatory monitoring systems and processes
• Assess the leadership team’s awareness of pending legislation in their industry

Conclusion

Due diligence reveals the true foundation upon which your investment will be built. Beyond identifying risks, a strategic legal review uncovers competitive advantages in strong governance structures, defensible IP portfolios, and favorable contractual positions. The most successful investors leverage these insights not just to protect capital, but to structure deals that align incentives and position their portfolio companies for sustainable growth.

Our experienced team, which has guided numerous investors through their VC transactions, has developed a comprehensive and efficient approach to identifying the red flags that can sink deals. Our team spots problems and we provide practical solutions that keep deals moving forward while protecting your interests.

Reach out to discuss your investments and due diligence needs.

Disclaimer: This article is for informational purposes only and does not constitute legal advice or establish an attorney-client relationship. This article should not be used as a substitute for obtaining legal advice from an attorney. For personalized legal guidance, consult a qualified attorney.