In this edition, our friends at Orrick, Michelle Dold, and Perry Teicher provide insights on legal due diligence for impact-oriented founders. They have also provided forms and tools to help you and your team on this journey. The tools are found in the "Highlighted Resource" section. Do not be overwhelmed, instead, let this help you plan and begin to ask questions to lawyers in your network.
What is Legal Due Diligence?
Legal due diligence is the process by which investors examine your company’s legal, corporate, and commercial documents to identify potential risks associated with an investment. These findings often inform the negotiation process and may affect how an investor engages with your company post-transaction.
Generally, impact investors, particularly those focused on early-stage investment, will conduct the same baseline legal diligence as non-impact investors - reviewing corporate, capitalization, employment, IP, and commercial documentation. The approach to legal diligence, however, may vary in certain key respects due to the goals of impact investors.
First, impact investors often request additional documentation related to environmental, social, and governance (ESG) policies and impact measurement, focused not just on diligence and compliance, but on positive outcomes and target changes. Second, impact investors that specialize in working with early-stage startups may approach diligence as an opportunity to build the company’s capacities, including those related to good corporate governance. Third, some impact investors may be comfortable accepting greater risks than non-impact investors, particularly when it comes to striking the balance between a company’s financial and impact performance.
In this newsletter, we’ll provide a high-level checklist of the legal documents that potential investors may expect your company to provide during legal due diligence. This list is not exhaustive but is intended to provide a sense of the broad categories on which investors and their counsel tend to focus. While this list is geared towards U.S. companies, it may also be relevant for non-U.S. companies seeking to raise money from U.S. impact investors.
Corporate Documents
Incorporation Documents - This includes your company’s Certificate of Incorporation and any amendments, Action of Incorporator, and Bylaws. Investors want to know that you followed the proper state law processes for creating your legal entity and have been operating in accordance with those laws and your company’s Bylaws, which are the basic rules by which a corporation is governed.
Minute Book - This includes all board and stockholder consents and board meeting minutes. The Minute Book tells the “story” of your company’s major decisions and transactions and is often an area of focus during legal diligence. It is crucial to obtain and document proper corporate approvals, particularly of debt or equity issuances, as not doing so can call into question the validity of corporate decisions. Missing approvals can become a sticking point in the diligence process, which can lead to delays in closing.
Qualification to Do Business - If your company is operating in a state other than your state of incorporation, you may need to register or “qualify to do business” in that other state. Investors will want to confirm that your company is complying with the local laws of any state or country in which you operate.
Capitalization Documents
Capitalization Table - A capitalization table, or “cap table,” is a spreadsheet that details the ownership of your company’s securities. Though the cap table is pivotal for financial diligence, it is also one of the key documents in legal diligence as it provides a guide for investors and their counsel to check that all equity and debt issuances have been properly documented and approved. Maintaining a complete and accurate cap table can help you understand your company’s ownership structure, while demonstrating to investors your company’s commitment to good record keeping. Cap table management platforms are excellent tools to help you keep your cap table up-to-date and avoid errors.
Equity - Investors want to assess their potential ownership stake post-investment in relation to all existing ownership stakes of the company. You should be prepared to provide the following equity documents, as applicable:
a. Founder Equity Issuances - Founders should formalize their ownership by signing a Common Stock Purchase Agreement or similar agreement. Additionally, founders paying U.S. federal income taxes generally submit an 83(b) tax election for stock that is subject to vesting. An 83(b) election is a letter to the IRS stating that the founder wants to be taxed on their stock on the date the stock is granted, rather than on the date it vests. Investors frequently request proof that 83(b) elections were filed within 30 days of the grant date, as failing to file can create tax liability for the individual and the company.
b. Equity Issuances to Service Providers - Investors will also want to see an documentation related to equity issuances to employees, consultants, and advisors. This may include the company’s Stock Plan, Option Agreements, Restricted Stock Purchase Agreements, and Restricted Stock Agreements.
c. Equity Issuances to Outside Investors - This includes any documentation related to issuances of preferred stock, SAFEs, convertible notes, or other equity instruments to outside investors, including any side letters that may give individual investors custom voting, information, or pro rata rights.
d. Securities Exemptions - To sell securities, companies must either register that sale with federal and/or state securities regulators or rely on an exemption from registration. Investors will want to see that your company made the required filings or has other evidence of exemption under applicable securities laws.
3. Debt - Investors will also want to review Loan Agreements and any related documents to understand repayment terms that could affect the company’s cash flow.
Employee and Other Service Provider Documents
Employee Confidential Information and Invention Assignment Agreements (CIIAAs) - CIIAAs have two primary functions: (a) to prohibit employees from using or disclosing the company’s confidential information except in the context of their employment and (b) to ensure the company owns any ideas or inventions related to the company’s business that are created by the employee during their employment. Investors often ask companies to confirm that each employee, including founders, has signed a CIIAA.
Consulting and Advisor Agreements - Consulting and Advisor Agreements serve a similar function for service providers that are not directly employed by the company. These agreements often contain confidentiality and invention assignment provisions, in addition to detailing services to be provided and compensation arrangements.
Intellectual Property (IP) Documents
Registered IP - Investors will want to review any registered IP your company owns to help determine the value of the company’s assets and to ensure that the company owns any IP needed to run its core business. Common forms of registered IP for early-stage companies include patents, trademarks, and domain names.
IP Assignment Agreements - As mentioned above, it’s crucial to ensure that any IP created by current or former service providers is properly assigned to the company through an IP Assignment Agreement. Additionally, assignments of registered IP may need to be recorded with the appropriate government entity, such as the Patent and Trademark Office.
Litigation Documents
Your company should be prepared to provide documentation relating to any pending or threatened claim, lawsuit, proceeding, or investigation in which the company is involved. It is important to be transparent about any such actions, without violating confidentiality or other obligations, to build trust with potential investors and allow them to properly assess the risks associated with the transaction.
Material Contracts
Providing your core customer and vendor contracts helps to substantiate the financial statements and forecasts your company provides during financial due diligence. Investors often focus on elements such as pricing, term and termination rights, indemnities, and regulatory issues, which can help investors assess risks and opportunities related to your company’s business model.
Impact Documents
Just as your material contracts help substantiate your company’s financial statements and projections, your impact-related documents help substantiate your company’s impact performance and progress towards your mission. Common documents that impact investors request are impact reports and ratings that include data on the company’s progress against its output, outcome, and impact KPIs and internal policies on corporate governance, sustainability, diversity, equity and inclusion (DEI), and fair labor practices.
Further, impact investors will be keen to assess compliance with any special impact structures or designations your company has. For instance, if your company is a Delaware public benefit corporation (PBC), investors may request copies of public benefit reports and consents or minutes documenting how the board is balancing shareholder and stakeholder interests. If your company has a B Corp Certification, investors may request copies of your B impact assessment and certification documents.
Cross-Border Flips
Some U.S.-based impact investors may prefer to invest in companies that are incorporated in the U.S. because they are more familiar with U.S. legal and tax systems. However, this does not necessarily preclude non-U.S. companies from seeking funding from U.S. impact investors.
If your company fits this profile, you may consider undertaking a “cross-border flip,” by which your existing non-U.S. entity becomes a subsidiary of a U.S. parent entity. Cross-border flips are often complex and tax-driven. Companies undertaking cross-border flips should partner with legal counsel knowledgeable in U.S. law and the law of the company’s jurisdiction of incorporation.
What Can I Do to Start Preparing for Legal Due Diligence?
Legal due diligence shouldn’t pose a major challenge during a transaction for companies that maintain good corporate records. You can set your company up for success by prioritizing documenting proper corporate approvals and maintaining clear, organized records of the documents described above.
For early-stage companies, putting in place these good governance and record-keeping structures may seem expensive or daunting. However, there are many publicly available resources that can help early-stage companies practice good governance and legal documentation without expending significant resources. Orrick Tech Studio offers free, downloadable templates for many of the documents discussed above, answers to questions frequently asked by early-stage founders, and other free resources.
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None of the above should be construed as legal advice. Companies and investors should consult qualified legal counsel before pursuing any financing or investment.
Highlighted Resource
Worth Listening to
Raising Money as an Impact-Oriented Company - OrrickLive! Conversations
Coming to the USA - Flip Transactions - OrrickLive! Conversations
Incorporation/Organization - OrrickLive! Conversations
End Notes
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