Legal Due Diligence for Startups: Investor Checklist 

Investing in a startup business is exciting. It typically involves working with passionate people with entrepreneurial ambitions. The dream is often to be at the start of something that quickly scales upward and makes money. There are, however, risks alongside opportunities. This is why we’ve written this blog as a legal due diligence for startup investors checklist. It is designed to introduce readers to the subject and provide a structured approach to investor due diligence. It should, of course, not be considered formal legal advice. Your circumstances will be unique, and we’d always advise talking to our team once you’ve got a handle on the basics.  However, if you’re considering a startup investment, we trust it offers a useful framework for any due diligence discussion.  

What Does Legal Due Diligence for A Startup Look Like?  

When used in the context of startup legal risks, the term legal due diligence, for investors, refers to the systematic assessment of the target business.  At a basic level, it confirms the startup is operating in a way that is compliant with the law. Assuming all is legal with your startup’s operation, due diligence reviews the start-up business to identify potential risks moving forward and, if required, reshape one’s investment strategy. After a due diligence process, investors may put mitigating factors in place to manage any discovered risks, reducing them to a level deemed acceptable. On occasion, however, it can mean walking away from the investment opportunity altogether. A properly undertaken investor due diligence exercise needs to be thorough and detailed. It should examine the target business across areas such as corporate structure, intellectual property, existing and potential contractual obligations, regulatory adherence, and compliance with financial rules and best practices.  This process is essential in understanding a startup’s growth trajectory and protecting the money invested.    

Key Areas of Legal Due Diligence For Investors  

Any startup investor is asked to navigate a landscape of uncertainties.  Legal due diligences safeguards them to a degree, verifying the integrity of any startup in their sights. Through appropriate due diligence investors can identify potential issues that may impact the viability or success of their investment. Without this critical process, investors risk encountering unforeseen problems, costs, conflicts and disputes.  

To help, we have identified five key areas any angel investor or VC legal due diligence should cover. 

Checking A Startup’s Corporate Structure & Compliance  

It is vital investors understand the business they’re buying into. This means initially assessing its business registration documents and shareholder agreements or equivalents to ensure all is well. Further compliance checks may be required if a startup operates in a regulated industry such as financial services or pharmaceuticals.  

It’s equally important to understand how the company is governed and how decisions are made. An investor’s due diligence exercise should investigate the structure and capability of the startup’s leadership, for example. It should read board meeting minutes and other communication related to the formation and operation of the business.  

Confirming A Startup’s Intellectual Property Is Secure 

Bright ideas, novel thinking and creative products are often key assets for startups. Investors must, however, ensure that the company has protected the rights to any innovations it trades on. Any investor due diligence checklist, therefore, needs to include Intellectual Property. Does the start-up own any trademarks, patents, licence agreements, copyrights, etc. It is easy to overlook these issues, especially in the context of website domain names, social media handles, logos and other marketing materials. Any third-party collaborations need to be fully understood and contractually sound. Potential intellectual property disputes can undermine a startup company’s growth potential.  

Investigating Startup’s Contracts, Agreements & Liabilities  

Due diligence processes should include investigating a startup’s legal and contractual obligations, including its commitments to customers, suppliers, and strategic partners. Legal agreements must be scrutinised to ensure they are sound, reasonable and fairly protect the interests of all parties involved. Other agreements, such as convertible notes, and funding arrangements should also be evaluated to ensure transparency and fairness across the startup’s business activities.   

Assessing Startup Regulatory & Compliance Risks  

In many sectors, such as financial services, healthcare, defence, and technology, regulatory compliance is, of course, critical. Investor due diligence should, however, also confirm their target startup adheres to general business regulations such as data protection, health & safety, insurance, security, and employee well-being.  Any pending or past issues, regulatory investigations, or non-compliance notices should be identified and evaluated as potential risks. 

Establishing A Startup’s Financial & Tax Compliance  

An investor’s due diligence process must review a startups financial statements, tax filings, and audit reports to ensure accurate and transparent financial reporting. Any outstanding liabilities, debts, or undisclosed financial risks should be identified. In addition to day-to-day reporting, the structure of a startup’s funding and the rights of existing investors should be examined to avoid complications and conflict with any new investment and future funding rounds.  

A Legal Due Diligence Checklist for Investors 

Startup Due Diligence Red Flags Investors Should Watch Out For  

Your appetite for investing in startups is dependent on your attitude to risk. Some opportunities will feel comfortable and secure. They may come with low returns. Others may promise greater riches but feel on less firm ground, with more that could go wrong. In both cases, however, due diligence is essential to prevent issues, at best, limiting success or, or at worst, stopping any deal in its tracks.  

A major red flag, for example, is a lack of clarity around a startup’s organisational structure and governance. If it’s not clear who controls the company or how things work, it can be difficult to identify any return on investment. A lack of a formal shareholder agreement and a lax organisational structure could mean disrupted operations that prevent a startup from growing. A weak or non-existent leadership structure certainly counts as a major red flag for any investor undertaking a due diligence exercise.  

Regulatory non-compliance is another red flag. Of course, this is particularly true for startups subject to industry-specific legal requirements, such as finance, healthcare, and data protection. However, startups that fail to adhere to general business regulations typically face increased costs, operational restrictions, and reputational damage. Investors must assess whether the company is fully compliant with regulations and whether it has policies in place to manage evolving future requirements. 

Intellectual property disputes can also drain a startup’s resources.  If a startup doesn’t own its own ideas or freely use them, scaling can be challenging.  Any IP anomalies in financial records discovered during a due diligence exercise could suggest mismanagement or deliberate misrepresentation, which should also be considered red flags by investors. A legal due diligence process is the best way for any investor to avoid problems. By conducting a thorough, professional legal review, investors can mitigate potential liabilities, ensure regulatory compliance, and make informed decisions about a startup before proceeding with financial commitments. 

How to Conduct Effective Due Diligence Of Startups  

It’s tempting to consider undertaking investor checks without specialist help. However, without a suitably knowledgeable and experienced team, it is difficult to approach the task with sufficient accuracy and rigour, even if the startup is cooperative and transparent.  Utilising specialist support can also help you negotiate any protective clauses in investment agreements. It all adds up to a package of work designed specifically to safeguard your interests.  

Conclusion 

As an investor, a comprehensive review of a startup’s legal, financial, and regulatory performance enables you to make informed decisions about where you put your money. Due diligence will help you minimise the risk of loss. By undertaking the tasks outlined in our high-level checklist, investors can protect their investments and contribute to the sustainable growth of the startups they support. 

For those seeking expert guidance in legal due diligence, Jamieson Law offers professional advisory services for each stage of the startup investment process. You can read more about the subject in our blog What is Due Diligence and What’s Involved? or contact us about your requirements here.  

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