Tuesday, August 28, 2012

Legal Due Diligence: Investor’s Perspective

In the perfect world, anyone making an investment should retain highly qualified and specialized legal counsel to assist with the transaction. Attorneys that work on financings every day will know exactly how to approach the legal due diligence process and will be invaluable guides, scouring the company’s legal documents to protect the investor’s rights and pointing out to the investor any red flags and fixes.

However, we do not live in the perfect world, and some angel investors out there will consider their investment amount too small to engage legal counsel, and will venture out on their own.

If you are in that boat, you should at least conduct your own due diligence. At a bare minimum, there are 3 things you should request from the company in which you are investing, before you sign on the dotted line and before you initiate the wire (or write that check):

  • Charter Documents. A company’s charter documents are, depending on its jurisdiction of incorporation, its articles or certificate of incorporation and its bylaws. It is important to see charter documents to make sure that you are investing in a real corporation, not a corporation that the founders are planning on forming, and not in a general partnership or a limited liability company.
  • Cap Table. The cap table that you request should contain, in addition to the obvious, founder vesting schedules and all other convertible notes (or other convertible securities) of the company. (I’ve written about cap tables more extensively in a prior post.) If you are not sure how your convertible note converts into shares of the company’s stock and what percent of the company you stand to own, I would urge you even more strongly to consult an attorney.
  • IP Assignment. There are two types of inventions assignment agreements to looks for: one for pre- and one for post- formation.
    • Most founders will begin generating intellectual property for their company before it is incorporated. Unless there is an agreement assigning all their inventions to the company, the inventions belong to the founders personally. Therefore, the first type of IP assignment agreement to look for is one assigning pre-formation IP to the company. Relatedly, if the company claims to have any patents and trademarks, check to see that they are registered in the name of the company. Many founders will forget to effectuate the transfer with the patent and trademark office, and this is something that should be done before your money goes in.
    • Once a corporation is formed, there should be in place an inventions assignment agreement with each founder which covers all inventions developed by such founder during the life of the company. Usually, this is an agreement that goes with a consulting agreement or an offer letter, but because many companies are unfunded at the time of incorporation and the founders do not enter into consulting agreements or offer letters with themselves, at the very least a free-standing inventions assignment agreement should be in place.

Beyond the documents mentioned above, if the amount that you are investing is upwards of $100,000, I would strongly recommend having your counsel conduct full legal diligence review.

Happy investing!

White Summers  Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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