When are the key issues lawyers explore when conducting due diligence on a potential investment?
Michelle Fernandes, Lead Counsel at Index Ventures US: Each potential investment is an important new partnership for a VC. So the investor counsel uses due diligence not as a roadblock to closing a financing round, but as a way to uncover any issues that need to be addressed. Obviously, early-stage startups grow quickly and can make mistakes, but lawyers use diligence to figure out what those mistakes are so that we can work with the company to fix them and complete the financing round.
It’s very important for due diligence purposes that the company formation has been handled correctly and any intellectual property issues have been identified and managed. For seed and series A investments, a top priority is making sure that the company’s formation was done correctly, along with ensuring the company used standard paperwork for everything from its bylaws to its equity plan. Lawyers also check that there were proper authorizations and approvals obtained for all corporate actions, like adopting bylaws, correctly granting equity, and complying with securities laws.
“Obviously, early-stage startups grow quickly and can make mistakes, but lawyers use diligence to figure out what those mistakes are so that we can work with the company to fix them.”
With intellectual property, the VC legal team wants to make sure there are no issues from the start, so they look carefully at the events and facts surrounding the company’s formation, and what the founders’ background was before they started. We want to see a separation of employment, and generally get comfortable with the way the company was founded. We have to make sure the company owns the intellectual property rights it claims to, since that goes to the value of the company.
It’s also important to make sure someone is managing the capitalization table correctly and obtaining the correct approvals for any option or stock grants. This is extremely important because the capitalization table is used by venture firms to determine how to price a financing round — and in an exit, to determine distribution of proceeds. Given the legal implications with granting options and stock grants, this is another area it is crucial to work with outside corporate counsel to get right from the beginning to make sure all tax and securities laws are followed.
- Due diligence isn’t about finding default — it’s about correcting mistakes early on
- Lawyers look to make sure the company founding documents are accurate
- They also want to see how the capitalization table has been set up, as well as IP rights
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