Best Practices for Conducting Legal Due Diligence
Legal due diligence is a critical part of the investment process for startups, especially in Switzerland and Europe, where regulatory environments can be complex. Investors conduct legal due diligence to assess the company’s compliance with local laws, identify potential liabilities, and ensure the startup’s legal standing is solid. For startups, preparing for legal due diligence involves organizing contracts, intellectual property rights, and regulatory compliance documents. In this article, we’ll explore best practices for conducting legal due diligence to ensure a smooth process and favorable outcomes for both startups and investors.
Why Legal Due Diligence Matters
1. Identifying Legal Risks
Investors conduct legal due diligence to identify any legal risks that could affect the startup’s operations or financial health. These risks may include pending litigation, intellectual property disputes, or non-compliance with local regulations. Understanding these risks helps investors make informed decisions and negotiate better terms if necessary.
Example: A Swiss tech startup facing unresolved intellectual property (IP) disputes may be seen as a higher-risk investment, affecting investor confidence and valuation.
2. Ensuring Regulatory Compliance
Legal due diligence ensures that the startup is compliant with all applicable local and international regulations. In highly regulated industries like fintech or healthcare, compliance is crucial to avoid penalties, legal actions, and reputational damage. Investors need to verify that the company adheres to these regulations, especially as it expands into new markets.
Example: A Swiss fintech startup must comply with anti-money laundering (AML) regulations, which require extensive documentation and procedures to avoid potential legal and financial risks.
Key Areas of Focus in Legal Due Diligence
1. Corporate Structure and Governance
Investors will examine the startup’s corporate structure to ensure that it is legally sound and well-organized. This includes reviewing the incorporation documents, shareholder agreements, and governance structure. Any inconsistencies or unclear ownership stakes can lead to legal complications down the line.
Key Documents to Review:
- Incorporation documents
- Shareholder agreements
- Board meeting minutes
- Bylaws or articles of association
Example: A Swiss SaaS startup should have clear incorporation documents that outline the roles and responsibilities of its founders and shareholders, ensuring legal clarity on decision-making and profit-sharing.
2. Intellectual Property (IP) Rights
Intellectual property is one of the most valuable assets for many startups, especially those in technology, biotechnology, or creative industries. Investors want to ensure that the startup owns or has rights to all relevant IP, and that there are no ongoing or potential disputes over ownership.
Key Documents to Review:
- Patents and patent applications
- Trademarks and copyrights
- IP licensing agreements
- IP litigation history
Example: A Swiss biotech startup with patented gene-editing technology must provide investors with documentation proving ownership of the patent and freedom from infringement disputes.
3. Contracts and Agreements
Investors will scrutinize the startup’s customer contracts, vendor agreements, partnership deals, and employment contracts. They will look for red flags such as unfavorable terms, missing contracts, or clauses that could create future liabilities. Startups must ensure that all contracts are well-documented, up-to-date, and enforceable under local laws.
Key Contracts to Review:
- Customer and supplier contracts
- Employment contracts
- Lease or real estate agreements
- Non-disclosure and non-compete agreements
Example: A Swiss retail startup should have formalized vendor agreements with clear terms for pricing, delivery, and dispute resolution to protect the business from future disagreements.
4. Litigation and Legal Claims
Any ongoing or past litigation involving the startup will be closely examined during due diligence. Investors want to know if there are any pending legal claims, judgments, or settlements that could affect the company’s financial standing or reputation. Startups should disclose any legal issues and provide relevant documentation.
Key Documents to Review:
- Pending or past litigation records
- Settlement agreements
- Legal correspondence related to claims
Example: A Swiss AI startup facing a patent infringement lawsuit will need to disclose all details of the case, including the potential financial impact and likelihood of a resolution.
5. Regulatory Compliance
For startups operating in heavily regulated sectors, compliance with local, national, and international regulations is critical. Investors will assess whether the company adheres to industry-specific regulations, such as data protection laws, environmental standards, and financial reporting obligations. Non-compliance can lead to fines, legal action, and business interruptions.
Key Areas to Focus On:
- GDPR compliance for data privacy
- Industry-specific regulations (e.g., healthcare, finance, environmental)
- Licensing and certification
Example: A Swiss medtech startup must comply with the Medical Device Regulation (MDR) in the EU and provide proof of certification and regulatory approval to investors.
Red Flags in Legal Due Diligence
1. Unresolved Legal Disputes
Unresolved legal disputes, particularly those involving intellectual property or key contracts, are major red flags for investors. These disputes can create uncertainty about the company’s future, delay potential growth, or result in financial penalties.
What to Watch For:
- Pending IP litigation or ownership disputes
- Legal claims from customers or suppliers
- Disputes with founders or shareholders
Example: A Swiss startup involved in a legal dispute over its core technology patent will face difficulty securing investment until the matter is resolved.
2. Inconsistent Corporate Documents
Inconsistent or missing corporate documents raise concerns about the startup’s legal standing and governance. Investors expect to see well-organized and up-to-date documentation, particularly regarding ownership, shareholder agreements, and corporate governance.
What to Watch For:
- Missing or outdated shareholder agreements
- Inconsistent board meeting minutes
- Lack of formal governance policies
Example: A Swiss tech startup that cannot provide a clear shareholder agreement or board minutes could face delays or rejection during the due diligence process.
3. Non-Compliance with Key Regulations
Startups that fail to comply with critical regulations—such as data protection laws, licensing requirements, or industry-specific standards—pose significant risks to investors. Non-compliance can lead to fines, regulatory action, or loss of business licenses.
What to Watch For:
- Lack of GDPR compliance for handling personal data
- Non-compliance with environmental regulations
- Missing industry certifications
Example: A Swiss fintech startup not adhering to AML regulations risks significant fines and legal action, making it less attractive to investors.
Best Practices for Startups to Prepare for Legal Due Diligence
1. Organize Legal Documents in Advance
Startups should organize all legal documents in a structured format before the due diligence process begins. This includes corporate documents, contracts, IP filings, and compliance records. Having these documents readily available demonstrates professionalism and preparedness, making the due diligence process smoother.
Tip: Use a virtual data room to store and share all legal documents securely with potential investors.
2. Conduct a Preemptive Legal Audit
Before entering due diligence, startups can conduct a legal audit to identify any gaps or issues that need to be addressed. This audit helps the company correct potential problems, such as missing contracts, unfiled IP applications, or unresolved legal disputes, before they become concerns for investors.
Tip: Work with legal counsel to perform the audit and address any risks or outstanding issues.
3. Ensure Compliance with Local and International Regulations
Startups operating in regulated industries or across multiple jurisdictions must ensure compliance with all relevant laws. This includes adhering to local employment laws, data protection regulations, and industry-specific standards. Keeping up with regulatory requirements is key to avoiding penalties and legal risks.
Tip: Assign a compliance officer or use compliance software to ensure the startup remains up-to-date with evolving regulations.
4. Maintain Proper Corporate Governance
Strong corporate governance is essential for building investor trust. Startups should ensure that their board of directors is active, that board meetings are documented, and that key corporate decisions are recorded. Governance structures should also include policies for managing conflicts of interest and shareholder rights.
Tip: Regularly review governance policies and update them as the company grows.
Case Study: Legal Due Diligence in a Swiss Tech Startup
A Swiss-based software startup was preparing for its Series A funding round. During the legal due diligence process, investors discovered that the company had not properly documented several key customer contracts and had a pending lawsuit over a licensing agreement. The startup worked quickly with legal counsel to resolve the dispute, formalize its contracts, and implement a more robust contract management system. These actions reassured investors, and the startup successfully secured its funding.
Key Takeaway: By addressing legal risks and organizing documentation early, startups can improve their chances of passing due diligence and securing investment.
Conclusion: Best Practices for Legal Due Diligence
Legal due diligence is a crucial step in the investment process, as it helps investors assess the legal risks and complianceof a startup. For Swiss startups, preparing for legal due diligence involves organizing all corporate, IP, and regulatory documents, resolving any pending legal disputes, and ensuring compliance with local and international laws. By following best practices, such as conducting a preemptive legal audit and maintaining strong corporate governance, startups can improve their chances of passing due diligence and attracting investors.