Critical Considerations In Early Stage Diligence Of Technology Companies
Paying attention to online privacy and data protection, labor and employment, and CFIUS rules are now important diligence matters for any early stage venture transaction.
Because of the growing legal complexity in early stage venture deals, investor counsel must have a sophisticated grasp not just of corporate governance and economic terms of the investment (which themselves have become more sophisticated and nuanced). In addition, counsel must also have a keen understanding of online and data privacy, labor and employment issues, and strengthened regulations related to oversight of foreign investment.
Below are some of the more critical considerations of early stage diligence which investor counsel must keep in mind, and tips for investor counsel in navigating a modern tech deal.
Term Sheet Review
Key takeaway: The term sheet remains an important deal mechanism in setting expectations and should not be rushed.
The first stage of any transaction is the term sheet, which is the document that outlines material points regarding the transaction—things like valuation, governance of the company, and conditions of future sales.
The term sheet is typically non-binding, but the general expectation should be that it captures the essentials of the deal without material deviation. It remains an important step in any early stage venture transaction, and it should be negotiated in good faith with the general expectation that the negotiated terms will not be materially amended pending completion of business and legal diligence.
Investors should negotiate a binding no-shop and confidentiality clause when signing a term sheet to capture a period of exclusivity and to prevent the company from shopping the specific term sheet with other investors. The growing popularity of SPACs and direct listings has also prompted these terms to be captured in a term sheet (for example, in the definition of a “liquidation event,” alongside an IPO or an M&A). Other yellow- or red-flags that may have already been captured in early business diligence can also be memorialized in the term sheet to preview the issue and to give company counsel the opportunity to propose language to remedy them.
Capitalization
Key takeaway: Capitalization remains an essential issue for startups, and should be closely vetted. Major concerns with respect to capitalization can be potentially addressed through a company opinion of counsel.
Capitalization is typically a major area of clean-up for startups, particularly with founders who have not yet developed the important habit of documenting the relationship amongst themselves or other early stage service providers and advisors.
It is not surprising for investor counsel to discover that a capitalization table is not really an accurate reflection of promises and side deals made to some of the founders or other early stage service providers about “who owns what” in the company. Transaction documents typically ask for a company representation that disclosure has been made with respect to such side arrangements or undocumented understandings, and investor counsel should closely review those disclosures. Electronic platforms such as Carta are now commonly used to administer capitalization, and investor counsel should ask for access to these platforms and review entries and documentation. Gaps in capitalization are also frequently revealed in service provider documents, which may have promises of equity that are not captured in the capitalization table.
After an initial review, investor counsel needs to frankly assess the situation with capitalization and determine the risk of the investment if capitalization has not been properly documented.
In the event of serious concerns or doubts about capitalization, investor counsel can also seek an opinion of counsel that the represented capitalization in the transaction documents is true and accurate. A properly conducted legal opinion will require company counsel to assess literally every single grant of stock and ensure the existence of adequate documentation for each grant.
Opinions are expensive, however, and in transactions at the earliest stage at lower valuations (such as a Series Seed), the expense of seeking a company opinion may be a significant burden on the company. An investor may need to seriously weigh the risks of an investment where the investor learns of serious defects in capitalization, but capitalization cannot be buttressed by an opinion of counsel.
Intellectual Property
Key takeaway: Core intellectual property should belong to the company.
At the earliest stages, investors should satisfy themselves that the company is the perfected owner of the core intellectual property used by the venture to conduct its business. At a high level, this means confirming that (i) all founders have assigned over intellectual property to the business; (ii) any exclusions of intellectual property that a founder may disclaim from company ownership are not being used by the business.
Confirming ownership and prosecution of patents and trademarks is also important, but the federal registration process can take years in many cases, and infringement of registered intellectual property rights is an ongoing—and never ending—compliance point for successful companies. Investors should also confirm that the company has a good practice in securing intellectual property assignment agreements from employees and contractors.
Online Privacy and Data
Key takeaway: Counsel should not overlook a company’s compliance with online privacy and data regulations. Gaps in such compliance should be flagged and addressed.
The emergence of the General Data Protection Regulation (GDPR) GDPR in the European Union and the California Consumer Protection Act (CCPA) means that online privacy and data management must now be a central part of the online infrastructure for an early stage venture. A venture that targets the European Union for its goods and services will almost certainly be subject to GDPR. Similarly, the CCPA applies numerous provisions that permit consumers the right to “opt out” of certain data practices that may not be on the radar of early stage companies.
Investor counsel should have its eyes open about online privacy and data protection and familiarize itself with gaps in a target company’s data practices. The first or second round of investment is a good time to put in place better practices with respect to online privacy and data protection, when users of the venture remain relatively low, and the company is still building its infrastructure for exponential growth. The resources provided by early stage investment can thus be used to build out the necessary infrastructure to comply with applicable law.
Nonetheless, investor counsel should have a keen understanding of the company’s processes to date, and also understand how the company has assessed the risk of data mismanagement. A major diligence flag might be the company’s failure to grasp the importance of online privacy entirely, for example, if a core component of its business is the gathering of personal data.
Management Rights and Other Side Letters
Key takeaway: Ask for side letters with other investors, particularly if the investment is significant or is a lead investment.
Investor counsel should consider inquiring as to all “side rights” or “management rights” that the company may have provided to previous investors prior to the transaction in question. Many venture funds require “management rights” in order to qualify for the venture capital operating company exemption under the Employee Retirement Income Security Act of 1974, which may provide that venture fund with certain benefits. Other side letter rights may contain preferential treatment for a specific investor such as beneficial rights to information, pro rata offerings of future securities, an observer representative on the Board of Directors, or additional representations and warranties made in connection with the financing.
Depending on the size of the potential investment, an investor may wish to understand the extent of these letters and potential side rights and should consider reviewing such letters. Because investors need to represent in the transaction documents that they have made all sufficient inquiries and satisfied themselves with any material terms and conditions of the offering, seeking greater information and access to such side letter rights is never inappropriate. In addition, irrespective of the securities exemption being relied upon to sell the securities in a private placement, the general anti-fraud provision of Rule 10b-5 will apply, meaning that the failure to disclose material information could constitute securities fraud in certain circumstances.
Founder Terminations and Separations
Key takeaway: Check that departing founders have released the company from future claims and there is no uncertainty about equity holdings.
Departure by founders in the early stages of a venture is not uncommon, and a capitalization table may reflect a sizable grant of the company’s common stock to an individual who is no longer a service provider to the company at the time of the financing. In these circumstances, investor counsel should check that the departing founder executed a separation agreement in which the founder’s equity is expressly described (in number of shares, not percentages of the company) and which also released the company from any claims of litigation.
High level technical employees who contributed heavily to the development of key early stage technologies should also be generally subject to a separation agreement and release of claims upon their departure. The lack of a separation agreement for an important founder may not be fatal in certain circumstances, but counsel should diligence the issue and have an understanding of the risks associated with future demands for equity, breach of contract, or workplace misconduct.
Counsel should also consider whether early stage employees have been properly classified. It is not unusual for founders to have misclassified themselves or other early stage service providers as independent contractors, leading to noncompliance with state rules related to overtime, minimum wage, and withholding on wages. This issue should be examined to determine the expense of remedying the issue after the transaction is complete.
Section 83(b) Filings
Key takeaway: Check that anyone receiving vesting common stock has made a section 83(b) election.
Missed section 83(b) filings do not just pose potentially devastating tax consequences for the founder who missed the election; they can also impose harsh consequences on companies that have failed to properly account for the increased valuation of vesting stock grants. Many early stage companies with limited administrative support oftentimes fail to keep track of which of their founders or early stage common stock recipients have made section 83(b) elections. To the extent that a founder did not make an election, then a company needs to book the vesting common stock at fair market value, and make applicable withholdings. Companies that fail to do this may face withholding penalties. Founders—who may be surprised at their potential tax liability if the valuation on the common stock has increased dramatically—may also demand coverage to newly revealed tax liability that was not on their radar up until discovery of the issue.
While the Internet is littered with warnings to founders to timely file a section 83(b) election if they receive vesting stock, the lack of such filings remains a common occurrence. Some transaction documents, particularly at the seed stage, may not request deep diligence on Section 83(b) filings. Investor counsel should nonetheless inquire as to the status of all section 83(b) filings for any recipient of vesting common stock, or for any other grant of equity in which a section 83(b) is advisable.
Applicability of CFIUS Regulations
Key takeaway: Check whether the company is subject to CFIUS regulations and whether a declaration must be (or should be) filed with the CFIUS committee.
A full examination of the rules now imposed by the Committee on Foreign Investment in the United States (CFIUS) on early stage transactions is beyond the scope of this article, but at a very high level, it is now critical to keep in mind that any foreign investment in a U.S. technology company may be subject to optional or mandatory requirements to disclose the investment to the CFIUS committee in Washington D.C.
If the venture is involved in “critical technology” (as defined by CFIUS regulations) or is engaged in large-scale collecting of personal data over U.S. persons, CFIUS will almost certainly be implicated, and a mandatory declaration may be required. Counsel for the company and the investor should work in good faith to assess the need for additional compliance over CFIUS and to discuss whether a declaration should be made.
Even if a declaration is not mandatory, it may make sense to make a voluntary declaration to the committee in order to take advantage of a safe harbor that restricts the committee from reviewing the transaction except in certain limited circumstances. If investor counsel represents a foreign investor, the issue should without question be discussed with the company prior to the signing of the term sheet, and it may be appropriate to propose the manner in which CFIUS will be addressed in the term sheet as well.