Securing Series A funding is a major milestone for any startup, but it’s not just about having a strong pitch deck and promising metrics. Founders often underestimate the importance of getting their legal house in order before investors come knocking. If you want to avoid last-minute surprises that could jeopardize your funding, here are five key legal tasks to address at least a month before receiving your term sheet.
1. Finalize Founder Equity and Stock Issuances
One of the most common oversights startups face is neglecting to properly issue stock to cofounders. If stock hasn’t been distributed yet, it could lead to significant tax complications. Issuing equity without proper planning might prevent founders from taking advantage of tax-free or tax-deferred treatments, especially if you miss the window for an 83(b) election (more on that below). Work with your legal team to finalize stock issuances and ensure everything is properly documented and compliant.
2. Ensure 83(b) Filings Are Correct and Timely
The 83(b) election is crucial for any founder or employee receiving restricted stock. It allows recipients to pay taxes on the value of the stock at the time of grant, which is usually minimal for early-stage companies. Missing this filing can result in a heavy tax burden when the stock appreciates. If you or any cofounders missed filing an 83(b), you may be able to fix it before the term sheet arrives, but options for correction are limited post-term sheet. Early action is key.
3. Finalize Employee Stock Grants
Many startups grant equity to employees before raising Series A funding, often in the form of restricted stock or stock grants. Once you close your Series A, you will typically need to switch to issuing stock options, which are generally less favorable for employees due to tax implications and valuation constraints. Granting equity now can help attract and retain key talent, while ensuring they receive the most beneficial terms.
4. Resolve Issues with Former Founders or Employees
Lingering conflicts with ex-cofounders or former employees can be a major red flag for investors. These individuals may have unaddressed claims to equity or intellectual property (IP) that could create legal complications during due diligence. If any former employees or cofounders contributed to technical development or other key areas of the business but did not properly assign their IP, they could hold leverage over your company at a critical moment. Resolve these issues and obtain necessary IP assignments before engaging with investors.
5. Expand Your Board of Directors
Control of the board is an important aspect of Series A negotiations. If you don’t already have three common (founder-appointed) board seats, now is the time to establish them. Investors will likely request board seats as part of the Series A deal, and having control before negotiations gives you leverage. Expanding your board early also demonstrates proactive governance, which can be a selling point during due diligence.
Bonus Tip: What Can Be Handled Post-Term Sheet?
While these five items are critical to address before receiving a term sheet, many other legal tasks can be managed afterward. For example, updating company bylaws, revising stock option plans, or amending employee agreements can typically be addressed during the closing process. However, the more you can prepare upfront, the smoother the process will be.
Final Thoughts
Legal preparation isn’t just about avoiding pitfalls—it’s about showing investors that you run a well-organized, risk-aware business. By addressing these key areas early, you’ll not only streamline the due diligence process but also position yourself as a savvy founder. Work closely with your legal advisors to identify any gaps and resolve them well before the Series A negotiations begin.