Legal Due Diligence Prep for Founders: Employment, Equity, and Operational Hygiene

Legal Due Diligence Prep: Preparing Employment and Equity Documents for Investors

When an investor’s term sheet arrives, the celebration is quickly followed by the diligence request list. This is where a startup’s operational hygiene is tested, and nowhere is the scrutiny more intense than on your people and equity. For founders at pre-seed to Series B stages, who often manage this process without a dedicated CFO, disorganized documentation can create significant friction, delay funding, or even kill a deal. Investors need to answer a few fundamental questions before they wire funds, and your ability to provide clear, correct answers is crucial. Learning how to prepare employment and equity documents for investor due diligence is not just a legal exercise; it is a demonstration of your command over the business. This process reveals whether your company’s foundation is solid or built on risky assumptions that will need to be cleaned up at a high cost. For broader expectations, see the investor due diligence hub.

The Three Pillars of People Diligence

Investor diligence on your team and ownership structure can be distilled into three core questions. These form the pillars of what we can call “people diligence,” and your primary goal is to answer them decisively.

1. Team Composition: Who is on your team, and what is their precise legal relationship to the company?
2. IP Ownership: How have you systematically secured the intellectual property (IP) created by every person who has contributed?
3. Equity Allocation: Who owns what percentage of the company, and is every fraction of a percent fully supported by a clear, legal paper trail?

Weakness in any of these areas can introduce unacceptable risk for an investor, undermining valuation and threatening the entire deal. Let's examine how to fortify each pillar.

Pillar 1: Who Works For You? Mastering Worker Classification

One of the most common red flags for investors is the misclassification of workers. The distinction between an independent contractor and an employee is critical for US labor law compliance, impacting tax, liability, and IP ownership. The core of this distinction in the US hinges on the degree of control the company exercises over the worker. If you dictate how, when, and where the work is done, you are likely dealing with an employee, regardless of what their contract says.

Understanding Contractor vs. Employee Rules

A scenario we repeatedly see is a startup engaging a key, long-term contributor, like a “Head of Marketing,” as a 1099 contractor to save on payroll taxes and benefits. This individual works full-time, has a company email, and is integral to daily operations. To an investor, this is not a contractor; it is a misclassified employee. This classification error represents a significant liability for back taxes, penalties, and potential benefits claims.

Contrast this with hiring a design agency for a discrete, three-month logo and website project. This is a legitimate contractor relationship, as the work is project-based, and the agency retains control over its own process and personnel. The key difference lies in behavioral control, financial control, and the nature of the relationship.

The practical consequence of misclassification can be severe. An investor may require you to reclassify workers and pay all associated back taxes and penalties from the financing proceeds, reducing your available runway before you even start building. To avoid this, remember that “Worker classification tests include the IRS 20-factor test and the ABC test used in states like California.” For US companies with remote teams, state-specific rules, especially California’s stringent ABC test, add another layer of complexity that demands careful attention. You can find general guidance on how regulators view this issue in the DOL Small Entity Compliance Guide.

Pillar 2: Is Your IP Secure? Nailing Startup Equity Paperwork

For nearly every SaaS, Biotech, or Deeptech startup, intellectual property is the most valuable asset. Investors must verify that the company, not the individuals who created it, unequivocally owns this IP. This is accomplished through tightly drafted legal agreements. Every single person who has ever contributed to your product, code, or research must have signed an agreement that assigns their created IP to the company. This includes co-founders, full-time employees, part-time interns, and external consultants.

The Critical Role of the PIIA

The key document for this is the Proprietary Information and Inventions Assignment (PIIA) agreement. It serves two vital functions: protecting confidential company information and ensuring any inventions, code, or processes developed within the scope of work belong to the company. Without a complete set of signed PIIAs, the ownership of your core technology is in doubt.

Imagine a deeptech startup where an early collaborator contributes to a foundational algorithm but leaves before signing a PIIA. Years later, as the company approaches a Series A, that missing signature creates an ownership cloud that can derail the entire funding round. The former collaborator now has significant leverage and may demand equity or cash to sign the assignment, a costly and completely avoidable problem.

When drafting these agreements, be aware of state-specific provisions. For instance, “California Labor Code Section 2870 carves out inventions created on an individual's own time without using company resources from IP assignment agreements.” This protects employees but also requires that your PIIA is correctly worded to comply with state law while still protecting company assets. The paper trail is non-negotiable.

Pillar 3: Who Owns What? Perfecting Cap Table Preparation

An investor needs to know exactly what they are buying into. The capitalization (cap) table is the system of record for your company's ownership, detailing every shareholder, option holder, and warrant holder. A disorganized, inaccurate, or incomplete cap table is one of the most serious diligence failures because it directly impacts valuation and the investor’s final ownership stake.

From Spreadsheet to Single Source of Truth

Every entry on the cap table must be supported by a corresponding legal document: a signed stock purchase agreement and 83(b) election for founders, board consents and grant agreements for employee stock options, or signed SAFEs and convertible notes for early investors. A verbal promise of equity is not an issuance. Founders must formalize every grant through proper board approval and signed paperwork.

The reality for most pre-seed startups is more pragmatic: they start with a spreadsheet. This is generally acceptable for the first few founders and a handful of initial grants. However, as the company grows, spreadsheets become prone to version control errors and formula mistakes. In practice, we see that “A common tipping point to migrate from a spreadsheet to a cap table platform (e.g., Carta, Pulley) is having 15-20 stakeholders or after a Seed round.”

These platforms not only manage the cap table but also serve as a repository for the underlying legal documents, creating a single source of truth that dramatically simplifies the due diligence process. For an e-commerce startup raising its first priced round after issuing a few SAFEs and early employee options, having this organized on a platform ahead of time can turn weeks of frantic document searching into a simple, shareable report. Remember to keep your 409A valuation current as you approach a priced round, as it is essential for granting stock options at a compliant strike price.

A Practical Triage Framework for Founders

Preparing your employment and equity documents for investor due diligence does not have to be overwhelming. What founders find actually works is a triage approach focused on mitigating the highest-risk items first. This isn't about achieving legal perfection overnight, but about demonstrating operational hygiene and control.

Step 1: Conduct a Pre-Diligence Audit

Before the diligence list arrives, perform your own internal review. This audit should focus on the three pillars and identify any potential gaps or red flags.

• Worker Classification Review: Create a list of all independent contractors. For each, assess their role against the IRS and state-level control tests. Does their role function like an employee's? Be honest in your assessment.
• IP Assignment Inventory: Make a list of every person who has ever contributed code, design, or other IP. Confirm that a signed PIIA or consulting agreement with IP assignment is on file for every single one.
• Cap Table Reconciliation: Go through your cap table line by line. Match every grant, issuance, and transfer to its corresponding signed legal document. Confirm that all option grants were approved by the board and that the number of shares issued matches the documentation.

Step 2: Remediate High-Risk Gaps Immediately

Your audit will likely uncover issues. Address the most critical ones first. The goal is to resolve problems that could be deal-killers.

• Fix Missing IP Assignments: If a core engineer or an early, critical contributor is missing a signed PIIA, this is an urgent problem. Contact them and get the agreement signed. You may need to offer a small payment for their cooperation, but it is far less costly than a deal falling through.
• Correct Misclassifications: If a key team member is misclassified, consult with legal counsel immediately. The solution may involve transitioning them to employee status and addressing any potential back tax liabilities proactively.
• Clean Up the Cap Table: If you find discrepancies, work with your lawyer to correct them. This might involve board resolutions to ratify past errors or gathering missing signatures. If you have crossed the 15 to 20 stakeholder threshold, begin the process of migrating from a spreadsheet to a dedicated cap table platform.

Step 3: Establish Long-Term Operational Hygiene

Once the immediate fires are out, implement systems to prevent these problems from recurring. This demonstrates to investors that you run a well-managed company.

• Standardize Onboarding: Create a formal onboarding process. Every new employee and contractor should sign their respective agreements as a condition of starting work. No exceptions.
• Maintain a Virtual Data Room: Use a secure digital folder, or a data room, to store all executed agreements. Organize it logically with folders for corporate records, equity, employment, IP, and commercial contracts.
• Centralize Equity Management: Use your cap table platform as the central hub for all equity-related activity. Issue new grants through the platform to ensure documentation and board approvals are handled correctly from the start.

This proactive organization transforms due diligence from a frantic scramble into a routine process, allowing you to focus on what matters most: closing your round and building your business. For more on this topic, see the investor due diligence hub.

Frequently Asked Questions

Q: What is the most common equity mistake early-stage founders make?
A: The most common mistake is making informal or verbal promises of equity without completing the required legal paperwork. A verbal promise is not an issuance. Every grant must be documented with board approval and a signed agreement to be valid, preventing future disputes and diligence issues.

Q: Can I fix a worker misclassification issue from years ago?
A: Yes, misclassification can often be corrected, but it is best handled proactively with legal counsel. The process may involve reclassifying the worker, paying back taxes and penalties to the IRS and state agencies, and potentially settling benefits claims. Addressing this before diligence shows good faith to investors.

Q: How does a messy cap table affect my company's valuation?
A: A messy cap table creates uncertainty about who owns what. This uncertainty is a major risk for investors. They may lower the valuation to compensate for the potential legal costs of cleaning it up, or they might require a portion of their investment be set aside to resolve ownership disputes, reducing your usable capital.