Chapter 6 - Legal
IN THIS LESSON
Prioritize Thorough Documentation for Start-up Legal Matters
Start-up Legal: If There's One Thing You Must Get Right, It's the Paperwork
Dealing with paperwork can prove vexing, particularly during the early stages of launching a start-up. Just as you're beginning to take off, the sheer volume of work can seem obstructive. Nonetheless, ensuring accurate and prompt completion of paperwork is of paramount importance. While achieving absolute perfection is a rarity among start-ups, the goal is to come as close as possible.
This emphasis on meticulous paperwork stems from the necessity to avert complications at the final stages of deal closure. Whether you're finalizing investment rounds, partnerships, joint ventures, or exits, the initial negotiations typically focus on prominent aspects, often leaving legal matters as an afterthought. Regrettably, these legal oversights tend to resurface during the thorough examination of due diligence.
The due diligence phase unveils deficiencies in ownership records, employee shares, local and employee taxes, and numerous other seemingly trivial factors that can unexpectedly hinder a deal's progression. Facing roadblocks just before the finish line is immensely frustrating, and more often than not, these obstacles trace back to incomplete or inaccurate paperwork.
Navigating the "Data Room"
Envision receiving an enticing buyout offer only to realize that your data room is in disarray. What exactly is a data room? In the past, it was a literal room filled with critical documents; a secured, physical space dedicated solely to housing essential information. In contemporary times, virtual data rooms provide the same access through the internet. Downloaded and printed documents are marked with the identity of those who accessed or printed them, enabling the tracing of any leaks. These documents range from vital contracts to proprietary market research, encompassing even seemingly mundane items such as incorporation papers. For start-ups in their initial stages, platforms like Google Drive often suffice, sparing additional monthly subscription costs.
Consequences of Missing Components
Imagine a scenario where a buyout offer is on the table, and as the potential buyer delves into your documents, they discover inconsistencies. Perhaps your incorporation documents, which establish your Delaware LLC, lack a corresponding registration document validating your business operations in your primary state. Alternatively, they might unearth issues like you being registered as a C-Corp, yet your board is non-compliant, or worse still, a co-founder who left in the initial stages still retains a 33% ownership stake. These issues could potentially unravel the deal, or at the very least, significantly delay it. Resolving these matters is imperative before the deal can be concluded. Buyers are disinclined to assume any liabilities, regardless of how minor they may appear. They might even insist on immediate debt repayments, salary reductions, or changes to the company's financial structure. Failing to meet tax obligations is undoubtedly the worst course of action.
ALWAYS REMEMBER TO PAY YOUR TAXES ON TIME. FAILURE TO DO SO CAN LEAD TO PERSONAL LIABILITY.
Cultivating Awareness and Expertise
While there's no need to obsess over every single document, it's crucial to remain conscious of the documents you need to file and their respective deadlines. Seek expert advice or enlist the assistance of someone with experience, especially if you're grappling with confusion. A slapdash approach now could lead to future complications. Moreover, as your company grows, the volume of paperwork escalates, making it progressively harder to revisit and modify documents. Changing fundamental documents might necessitate revising multiple contracts to ensure their continued validity.
While start-ups can't achieve perfection in all facets, it's essential to diligently pursue accuracy in your paperwork. Although expecting 100% perfection in paperwork is unrealistic, aiming for minimal errors is a reasonable goal. Minor issues can often be rectified without severe consequences, but for those errors to remain inconsequential, investing considerable effort into impeccable paperwork is imperative.
A Proactive Approach
Many companies find themselves scrambling to create and rectify documents during the final stages of a deal, often requiring gruelling 18-hour days due to unforeseen investor demands. Establishing a comprehensive documentation trail from the outset can yield substantial long-term benefits. While some of the checklist's upper items might not appear immediately relevant, remember to pay particular attention to the technology due diligence, as this is valuable information to solicit from your developers and understand as a founder when engaging with investors.
By prioritizing thorough documentation from the outset, start-ups can navigate negotiations more seamlessly and secure better outcomes when deals are on the horizon.
Sample Due Diligence Checklist:
1. Certificate of good standing from Secretary of State where you are incorporated/partnered/licensed to do business
2. List of all companies assumed names and registrations of them
3. A list of required licenses and permits, the status of them, and required officers/who is filling those roles
4. A list of all states the company does business and is authorized to do business plus annual reports for the last 5 years
5. Schedule of all law firms, accounting firms, consulting firms, and other professionals engaged by the company during the last five years, as well as amount paid, the status of payments, and status of the relationship
6. All documents related to credit arrangements, or debt, including promissory notes, security agreements, lines of credit agreements
7. All documents related to federal, state, and foreign trademark or copyright registrations, domain names, and pending applications used in or associated with the business
8. All documents relating to pending domestic or foreign patent registrations and pending applications used in or associated with the business
9. Any licenses or agreements of any kind with respect to the company, its name, or others patents, software licensure, copyright trade secret or other proprietary rights, proprietary information or technology, other than licenses or agreements pertaining to “off the shelf” or standard products
10. Corporate bylaws/LLC operating agreements- including all amendments
11. Articles of incorporation and or charter including all amendments
12. Copies of all government licenses, permits, or consents
13. Capable with list of all stockholders, warrant holders- including issuance dates, issuance prices, number of shares, vesting schedules of all stock, warrants subject to vesting, including a summary of any acceleration provisions
14. Copies of agreements relating to options, voting, warrants, puts, calls, subscriptions, and convertible securities.
15. Copies of all stock option and stock purchase plans, and a schedule of grants thereunder
16. Documents generated with connection to any investments, convertible, or debt financings of the company
17. Copies of agreements relating to outstanding options, warrants, rights (including conversion or pre-emptive rights) or agreements for the purchase or acquisition of any of the Company’s securities, and agreements relating to the Company’s past stock issuances.
18. Companies board or partner meeting minutes book, including all minutes and resolutions of the shareholders and directors, executive committees, and other governing groups
19. “Current business plan and any financial projections, as well as most recent financial statements, tax returns, filings, and bank statements for the past 12 months
20. The Company’s standard terms of service/terms of use for its customers
21. Any agreements, understanding, instruments, contracts or proposed transactions to which the Company is a party or by which it is bound which involve obligations of, or payments to, the Company.
22. Any company property leases, past or present.
23. Any agreements concerning the purchase, lease, or sublease of real property.
24. Any documents evidencing indebtedness for money borrowed or any other liabilities incurred by the Company.
25. Any documents evidencing any mortgages, liens, loans, and encumbrances with respect to the Company’s property or assets.
26. Any documents evidencing any loans or pay advances made by the Company.
27. Any licenses or agreements of any kind with respect to the Company’s or others’ patent, copyright, trade secret or other proprietary rights, proprietary information or technology, including employee confidentiality and proprietary information agreements.
28. Any insurance policies held by the Company or of which the Company is a beneficiary and a summary of such policies, if available.
29. Any judgment, order, writ or decree by which the Company is bound or to which it is a party.
30. Any standard forms of agreements used by the Company.
31. Any joint venture and partnership agreements.
32. Any management, service and marketing agreements.
33. Any confidentiality and nondisclosure agreements
34. Any agreements requiring consents or approvals in connection with the financing.
35. Any other agreements material to the business of the Company, or outside the ordinary course of business.
36. A list of officers and directors. If any officers are not currently devoting 100 percent of their business time to the Company, please note them on this list.
37. List and description of anything else that we may be missing or that we are not asking for that may affect our decision on the transaction
38. Any correspondence or documents relating to any pending or threatened action, suit or proceeding or investigation, including, without limitation, (I) those involving the Company’s employees in connection with their prior or present employment or use of technology and (ii) those being conducted by or before any governmental entity or regulatory agency.
39. Any correspondence or documents relating to allegations of the Company’s infringement of the proprietary rights of others- including past employees, cofounders, etc
40. A list of the Company’s current and past employees and consultants, including title, base salary, target bonus (if applicable), commission plan (if applicable), classification (including, if an employee, whether the employee is exempt or non-exempt), contracts, and state of residence.
41. Termination and separation paperwork for all past employees, cofounders, and any person that contributed work even if they contributed work and were not compensated- we will be checking these agreements for intellectual property assignments to company, non-competes, confidentiality clauses, severances, and separation releases
42. The Company’s standard form of employment offer letter and contract templates
43. Any agreements, understandings or proposed transactions between the Company and any of its officers, directors, affiliates, or any affiliate thereof, including without limitation, employment agreements and offer letters with severance benefits or vesting acceleration provisions.
44. Any plans, agreements or arrangements that provide benefits contingent upon a change in control.
45. Any severance or deferred compensation plans (including any salary deferral agreements, whether written or oral, with employees or consultants).
46. Any employee benefit plans, including, without limitation, stock option plans, 401(k) plans, pension plans and insurance plans.
47. Any forms of agreements used in connection with any stock option plans (such as a form of option agreement, notice of exercise and restricted stock purchase agreement).
48. If the Company sponsors a 401(k) plan, any determination or opinion letter and Form 5500 filings for the last 3 years.
49. All documents or other information relating to any loans made by the Company to its employees, directors or consultants.
50. The Company’s employee handbook, HR policies, and employee education materials
51. If the Company has any foreign employees, separately list (by country) all benefits provided to foreign employees.
52. Product strategy outline with current, in progress, and future/planned features list
53. Company technology stack information, integration documentation, GitHub access, and technology “map” of how the systems are connected, how they operate, and their usage
54. What are the product strengths, weaknesses, opportunities, and threats (SWOT) to help validate a reasonable direction is possible?
55. How does the company determine the product roadmap and what will add the most business value?
56. Are there quality problems with the product, such as performance issues, that may be expensive to fix?
57. Does the product fulfil end user goals in a usable way or is an expensive UI revamp necessary?
58. Map of systems architecture, and access to all coding documentation and practices
59. Is there anything in the architecture that is an impediment to meeting growth objectives?
60. Are there legacy components in the software that require replacement? How much will this replacement cost?
61. Are there third party or open source components that may be problematic from the legal or technical view?
62. Is the code written in a maintainable way such that others can be productive in the code base quickly?
63. Are there current opportunities for efficiency gains and/or cost reduction?
64. Will the existing practices scale appropriately with company growth?
65. Are there existing skills gaps that inhibit efficient delivery?
66. Are the right people in the right roles to meet investment objectives (particularly leaders)?
67. Who are the people critical to the business and must be retained with the acquisition?
68. Are there significant gaps in the organization that must be filled to meet investment objectives?
69. Is the level of R&D spend appropriate for the company size? Are there opportunities for reduction?
70. Are there opportunities for cost reduction, such as a move from locally managed resources to the cloud?
71. What is the cost in doing so?
72. Is there a suitable business continuity plan in place, and if not, what risk is undertaken and what is required to implement one?
73. Are the expenditures reasonable given company size?
74. Are deployment practices efficient with minimal risk of human error?
75. What are the top support call generators that may be indicative of product problems?
76. How many escalations make their way to the development team?
77. Are implementation times long potentially indicating lack of configurability/customization in the product?
78. Are there opportunities for product enhancement to scale to a larger number of customers requiring less on the services side?