Common Diligence Issues for Startup and Emerging Technology Companies

20 October 2022 Innovative Technology Insights Blog
Author(s): Paige M. Moscow

As an emerging or startup technology company seeking funding, your focus is likely on your product - it is the core of your business. That being said, how you protect your technology and set up the company that owns it can be just as critical as the technology itself.

This article will walk through some of the key areas of diligence that investors will focus on in evaluating startup and emerging technology companies. It will also serve as a checklist for your company to make sure it is prepared to enter the investor diligence phase of funding.

Corporate Matters

An investor will want to be certain that the entity which owns the underlying technology has been formed properly, and will need to understand who actually owns the entity.

a)  Formation of Entity: Investors typically prefer that your entity is set up as a Delaware corporation and often require that your entity is converted to a Delaware corporation as a condition to funding if it was initially set up as a different type of entity. Delaware has a relatively settled body of corporate law, which provides predictability and stability to both investors and companies alike. Additionally, C-Corporations can provide the benefit of 1202 tax treatment, as detailed in this article offering an in-depth discussion of the qualified small business exclusion. You should discuss with your accountant the benefits of a corporation versus another entity, such as a limited liability company (which has its own tax benefits). However, you should expect that an investor in a financing round will want to be investing in a Delaware C-Corporation. Thus, the remainder of this article assumes that you have set up a C-Corporation- but the principles are generally applicable to other forms.

b)  Capitalization: Be sure that you are properly papering and tracking all equity issuances. Issuances, including options, the vesting terms of such options, and the strike prices underlying any options, should be clearly approved by the board of directors and appropriately documented in written board minutes or board resolutions.

i.  Restricted Stock: If your company is granting restricted stock, consider using a vesting schedule to ensure that executives and employees are properly incentivized. Many investors will expect that restricted stock for key executives has vesting, and will oftentimes require vesting to be imposed as a condition of financing. All employees receiving restricted stock should also ensure that they have filed a timely 83(b) election. 83(b) elections essentially ask the IRS to tax you as of the date of grant of your restricted stock (when the fair market value is presumably much lower) instead of the date of vesting.

ii.  Options: Before promising or providing options to your key executives or employees, you should speak with an attorney about putting in place an equity incentive plan. The grant of company options should then be governed by the terms of the equity incentive plan. Each option will have an exercise price, meaning the price per share that the holder of the options must pay in order to exercise the option and turn it into actual equity in the company. All options must be granted at the fair market value of a share of common stock of your company as of the date of grant. This does not mean the date that you promise the option to your executive in an offer letter, but the date that the option is actually papered and granted to the employee.

iii.  409A Valuations: In order to determine the fair market value of a share of common stock, you should obtain a 409A valuation. 409A refers to a section of the Internal Revenue Code, which requires that options be granted at fair market value as of the date they are granted. While the Internal Revenue Code does not technically require that you obtain a 409A valuation, granting options at below fair market value can expose the grantee of the option (and in turn the company through a potential indemnity claim) to potential penalties and exposure for the spread between the actual fair market value of a share of common stock and the lower value actually used as the exercise price. Obtaining a 409A valuation provides a safe harbor if the per share value is used as the option exercise price. In most circumstances, you can use the 409A valuation as the basis for your company’s option exercise price for one year from the date of the valuation. You will need to obtain new valuations after each one-year period to ensure that you are within the safe harbor. Note, however, that 409A valuations can become stale even within the one year period if there is a material event that could impact the valuation of the business- for example, you sign a term sheet for a Series A financing or a large, long-term contract with a significant customer. We recommend obtaining a 409A valuation from a capitalization table management service. Investors will typically ask for 409A valuations as part of corporate diligence to ensure that you are obtaining a new valuation every 12 months and complying with 409A.

iv.  Capitalization Table: In addition to tracking issuances of equity through board minutes or resolutions, you should be keeping an accurate capitalization table that reflects the grants documented in such minutes or resolutions. The capitalization table should include authorized and issued shares of common stock (including vesting schedule for restricted stock), options (including exercise price and vesting schedule), and any other form of convertible equity, including convertible notes or warrants. It is highly encouraged, and looked upon very favorably by investors, to sign up for a capitalization table management service to track all of your equity issuances. Understanding the ownership of your company is one of the most critical items that investors will look at, and having a disorganized capitalization table can A) cause serious delays in the diligence process as investors will want to fully cross-check your capitalization table to ensure that all issuances are properly documented or B) cause liability down the road if there is a question about whether someone is truly an equity-holder in the company or what the terms of their equity actually are.

Technology and Intellectual Property-Related Diligence

Even if your company does not have any registered intellectual property (as is common for many early-stage or emerging companies), investors will want to be certain that your company owns any intellectual property and related proprietary materials, ideas, or information that is used in or necessary for the operation or development of the business. Investors will also want to have a strong grasp on which third-parties may have access to or the ability to use your intellectual property or other proprietary methods.

c)  Confidentiality and Assignment of Inventions Agreements.

i.  Employees. It is critical that each founder and employee of your company sign a confidentiality and assignment of inventions agreement. This agreement serves a number of purposes, but most significantly, it: (i) defines the scope of confidential information as it relates to the company and requires the signatory to agree to keep all such information confidential except for certain standard carve outs (e.g. the information becomes public); and (ii) requires the signatory to assign all inventions and intellectual property developed in the course of the signatory’s employment or services to the company, rather than be owned by the individual. This agreement may also include a non-solicitation and/or non-competition provision; however, non-competition provisions are becoming less common due to state-by-state enforceability issues as discussed further below. In the diligence process during a financing round, the investor will ensure that you have properly signed confidentiality and assignment of invention agreements for your key employees, and those individuals who have contributed to or developed intellectual property for the company in any way. Getting these agreements signed provides the investor with confidence that the company actually owns the technology that supports its valuation. Every company should provide this agreement as part its standard HR package for new hires. Note that if these agreements are not signed as part of the employment hiring process, getting them signed later will often require some additional form of consideration to make the agreement fully enforceable.

ii.  Contractors: You should also ensure that all of your company’s agreements with independent contractors contain provisions protecting your confidential information and assigning all proprietary work product and intellectual property that such contractor is developing for the company to the company. These provisions should mirror the confidentiality and assignment of invention provisions in the agreement described above.

d)  Commercial and Licensing Agreements: Investors will also pay specific attention to which third-parties have access to or the ability to use your technology or proprietary information, and what type of access. If you are entering into commercial agreements with customers that involve the licensing of your technology or proprietary methods, make sure that you understand what kind of license is being granted, who owns any intellectual property developed during the course of the arrangement, and whether the arrangement places any restrictions on your company’s ability to further develop, enhance, and use your proprietary technology. If you are providing a third-party with the right to use your technology, you should ensure that you have proper indemnification provisions for any claims of infringement resulting from such third party’s use of your technology. Additionally, any arrangements should ensure that third-parties are complying with applicable laws as it relates to the use and distribution of your technology (e.g. privacy laws related to the collection of personally identifiable information or international trade compliance).

On the other hand, you should ensure that you are in compliance with the terms of any licensing or other arrangements you are using for the development of your technology. For example, if you have any open source code incorporated into your product, you should ensure that you are properly complying with the terms of the applicable open source license. Investors will want to understand the full scope of inbound and outbound licensing agreements that you are party to in order to get a full understanding of what goes into your technology and where it is distributed.

Employment-Related Diligence

e)  Employee v. Independent Contractor Misclassification: A common area of concern for investors is the potential for misclassification of employees as independent contractors. In an attempt to save money, startups will often attempt to classify individuals who are performing core services for the company as contractors. However, in many states including Massachusetts, it is extremely difficult to classify someone as an independent contractor. The analysis is fact intensive, but even if your contract specifically states that the individual is a contractor, the nature of the actual relationship determines the classification, not the language of the contract.

f)  Payment of Employees with Equity/Payment of Founders: Another issue that arises when startups are strapped for cash is that they will propose equity as a form of compensation for employees. This type of arrangement does not comply with employment law, as all employees are required to be paid minimum wage. Similarly, because founders are technically employees, the company is required to pay all founders minimum wage. Paying employees in the form of equity or not paying minimum wage to your founders can open the company up to substantial liability and significant diligence issues in a financing round.

g)  Enforceability of Non-Competes: For years, non-competition clauses were consistently included in employee confidentiality and assignment of invention agreements along with non-solicitation clauses. However, in recent years states have become increasingly stringent in the requirements surrounding non-competition clauses- making it extremely difficult to enforce such clauses with some states even requiring specific statutory notice periods. If you have a key executive that should be tied to a non-compete, check with an attorney to ensure that the clause is actually enforceable in the state where the employee resides.

Other Specialty Diligence Areas

Investors will often identify certain red flag issues during diligence based on the nature of the company. For example:

h)  International Compliance Matters/Sanctioned Country Exposure

i.  Does the company do business with parties located in: Cuba, Iran, Syria, North Korea, or Russian-occupied regions of Ukraine?

ii.  If the company is providing a downloadable technology product, or its services are available via the internet, how does it track who can download and use the product, and what countries these individuals are downloading/purchasing from?

i)  Company Data Collection

i.  If your technology requires the collection of personally identifiable information, does the company have the appropriate compliance and protective measures in place?

j)  Ownership of Registered Intellectual Property

i.  Investors will likely run intellectual property searches with the United States Patent and Trademark Office.

k)  Government Contracting

i.  Government contracts can have a significant impact on the ownership of intellectual property, and often contain strict compliance requirements with certain federal programs and guidelines.

Conclusion

Even if your company does not have the compliance environment to address all of these issues as an early-stage company, it is crucial to understand and be prepared for the key diligence issues that investors will raise when you get to a funding round. Part of the balance of growing a successful startup is understanding what can be handled internally (and putting successful procedures and designated individuals in place to do that) and when it is necessary to reach out to counsel to ensure that the value of your technology and business is protected. Striking that balance can be extremely difficult, but this list should provide at least a start on some of the key issues that can directly impact your ability to receive funding as an emerging technology company, and what your valuation will be.

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