What a lawyer's due diligence covers on a startup investment, and what it misses

What a lawyer's due diligence covers

Legal due diligence on a startup investment checks that the company is properly formed, that its shares and past financings were validly issued, that it owns its intellectual property, and that its contracts, employees and regulatory position carry no hidden legal liability. It tells you whether the deal is legally sound. Whether it's a good investment is a separate question.

A typical request list, like Cooley's sample venture diligence list, covers nine areas: board actions and minutes, charter documents, capital stock, legal and regulatory matters, intellectual property, management and employees, debt, other material agreements, and miscellaneous items. Then the lawyer negotiates the documents, usually starting from the NVCA model forms: the stock purchase agreement with the company's representations and warranties, the charter, and the investors' rights agreement.

What it does not cover

Legal diligence doesn't test whether the technology works, whether customers exist and pay, whether the market is big, whether the price fits the stage, or whether the founders are who they say they are beyond what the documents show. Those are business questions, and lawyers are rarely hired, or paid, to answer them.

Even the legal opinion company counsel sometimes gives investors is narrow. As Cooley puts it, such opinions aren't a substitute for due diligence and don't cover every aspect of the company and its business.

Representations are not verification

The purchase agreement's representations and warranties (that the company owns its IP, has no undisclosed litigation, has issued its shares properly) give you a claim if they turn out to be false. They don't make them true. At seed, a claim against a company that's run out of money is worth little, so the reps are only a backstop to checking.

That's also why the disclosure schedule matters. It lists the exceptions to the representations, and it's where a careful reader finds the things the company has told you in the least prominent way it could.

Where the gaps are dangerous

Most seed losses start in the space between a legal review and a business review. The documents can be clean while the IP, the technology, the price, the founder's history or a foreign structure carries the real risk. These are the gaps that come up most:

• IP that's assigned on paper but built somewhere else. The assignment agreement is signed. The code was written at a previous employer.
• Technology claims. The documents say nothing about whether the product is a thin layer over someone else's API.
• Round pricing. The documents are standard. The valuation isn't.
• Founder history. Clean corporate records, and a difficult story at the last company.
• Foreign structure. An Israeli subsidiary with grant obligations, reviewed by US counsel who flags it for local counsel and moves on.

Who should do what

Use the lawyer for what only a lawyer can do: the documents, the negotiation, and legal opinions on regulatory, tax and foreign-structure questions. Use a business diligence process, your own or an outside one, for the technology, the people, the customers and the price. The two should talk. Business diligence finds the questions, and counsel answers the legal ones.

When to bring in an outside read

If your lawyer has the documents covered and nobody has the rest, Olivent Diligence is the business half: an independent read of the technology, the team, the terms and the structure, ending in a written verdict and flagging the questions for your counsel. A Pre-Wire Screen is $2,500 in 48 hours. A Full Diligence is $8,500 in five business days. Only the investor pays, and it doesn't give legal opinions.