Prepare UK startups' employment contracts for investor due diligence before they're under a microscope

Legal Due Diligence Prep: UK Employment Contracts

An investor's legal due diligence process can feel like a final exam you did not know you had to study for. Suddenly, every document, from employment contracts to contractor agreements, is under a microscope. For UK startups, particularly those in R&D-heavy sectors like Biotech and Deeptech, or fast-scaling SaaS and E-commerce businesses, these details are not just administrative hurdles. They represent foundational risks that can stall funding or create significant liabilities down the line.

Getting your house in order is not about legal perfection; it is about demonstrating organisational maturity and mitigating risks before they become deal-breakers. This preparation is a crucial part of any employment contract checklist for UK startups, ensuring you are ready for investor legal checks when the time comes.

The Foundation: Your Employment Contract Checklist for UK Startups

When investors review your team, they start with the paperwork. Weak or non-compliant employment contracts are immediate red flags, suggesting potential future claims and a lack of operational discipline. The starting point for UK employment law for startups is not a generic online template but a solid, compliant document that protects the business and meets statutory minimums.

A key legal requirement is found in the Employment Rights Act 1996, which mandates that a 'Section 1 Statement' of key employment terms must be given to an employee by day one. This is non-negotiable. The required terms include names of employer and employee, start date, pay details, hours of work, holiday entitlement, job title, place of work, and notice periods. While this sounds basic, founders managing HR on spreadsheets often miss crucial details.

Beyond these statutory minimums, a due diligence-ready contract must contain three critical clauses. In practice, we see that investors scrutinise these areas to assess how well the company protects its core assets:

• Intellectual Property (IP) Assignment: For a Deeptech or SaaS startup, this clause ensures that all code, discoveries, and commercial ideas created by an employee belong unequivocally to the company.
• Restrictive Covenants: Clear and enforceable non-compete and non-solicitation clauses are needed to protect your client relationships and team. Generic, overly broad clauses are often unenforceable in the UK; they must be tailored to the employee’s role and be reasonable in scope and duration.
• Confidentiality: A well-drafted confidentiality clause is paramount to protect trade secrets and sensitive business information.

Failing to get these right proves costly during diligence, raising questions about the defensibility of your most valuable work. See our HR due diligence guide for more context.

Contractor Risk: Understanding IR35 Rules for Founders

The flexibility of using contractors is a major advantage for early-stage startups, allowing them to access specialist skills without the overhead of full-time employment. However, this flexibility comes with a significant compliance risk in the UK, governed by a set of tax rules known as IR35. This legislation is designed to identify contractors who function as employees, often termed 'disguised employees'. Misclassifying contractors is one of the most common and costly mistakes uncovered during investor legal checks.

If a contractor is deemed 'inside IR35', the company becomes liable for their income tax and National Insurance contributions, plus potential HMRC penalties. During due diligence, an investor’s legal team will probe the nature of your contractor relationships to assess this risk. They will look beyond the contract's label and examine the reality of the working arrangement. Key factors include Control (do you dictate how, when, and where they work?), Substitution (can they send someone else to do their job?), and Mutuality of Obligation (are you obliged to offer work, and are they obliged to accept it?).

A scenario we repeatedly see is a SaaS startup engaging a 'freelance developer' who works 40 hours a week, uses a company laptop, is managed by the CTO, and is listed on the internal org chart. Despite their invoice and 'consultant' title, their working reality screams 'employee'. This creates a significant, unrecorded financial liability. The UK government provides the CEST (Check Employment Status for Tax) tool as a guide for IR35 status, and documenting your assessment process for each contractor is a vital step. Understanding the IR35 rules for founders is not optional; it is a core part of de-risking your business for investment.

Share Option Scheme Compliance: Validating Your EMI Scheme

For pre-seed to Series B startups, share options are a critical tool for attracting and retaining top talent when cash is tight. In the UK, the most popular and tax-efficient way to do this is through an Enterprise Management Incentive (EMI) scheme. The Enterprise Management Incentive (EMI) scheme is a UK-specific, tax-advantaged share option scheme. It offers significant tax benefits to both the employee and the company, but its preferential status depends on strict adherence to HMRC rules, a frequent point of failure found during diligence.

Compliance issues can invalidate the options' tax advantages, creating a major problem for your team and a headache for investors. The most common pitfall is procedural. For EMI schemes, HMRC must be notified of each individual option grant within a 92-day deadline. Missing this window is an irreversible error that disqualifies the grant from EMI benefits. Founders, often running finance on Xero without a dedicated HR function, can easily overlook these administrative deadlines.

Another critical distinction arises for startups with US ties. A 409A valuation, common for US investors, is not a valid substitute for a pre-grant HMRC valuation agreement for a UK EMI scheme. An HMRC-agreed valuation provides certainty on the market value of the shares, securing the tax treatment. Relying on a 409A valuation is a frequent error that can undermine the entire scheme. An investor’s legal team will demand to see the HMRC scheme registration, the 92-day grant notifications, and the HMRC valuation agreement. Without this complete paper trail, the value of your incentive package is cast into doubt.

Practical Steps to Prepare for Investor Legal Checks

Preparing for investor scrutiny is not a one-time event but a continuous process of good corporate hygiene. For founders juggling product, sales, and fundraising, focusing on the highest-impact areas is key. Start by auditing your employment documentation against this checklist.

1. Review Your Standard Employee Contract. Does it contain a compliant Section 1 Statement, issued on time? Are your IP assignment, confidentiality, and restrictive covenant clauses specific and enforceable, not just copied from a generic template? This is the foundation of your legal protection.
2. Assess Your Contractor Relationships. For each one, ask honestly: who controls the work, can they provide a substitute, and is there a mutual obligation? Document your reasoning for their self-employed status, referencing the CEST tool where appropriate. This proactive analysis demonstrates you are managing the IR35 risk.
3. Check Your Share Option Scheme Compliance. Confirm that all EMI grants were notified to HMRC within the 92-day window and that you have a valid, up-to-date HMRC valuation agreement, not a US-style 409A. Collating this documentation now will prevent stressful, last-minute scrambles during a funding round.

Addressing these three areas will resolve the most common employment-related issues that arise during due diligence, helping to ensure a smoother, faster deal closure. See the Investor Due Diligence hub for broader guidance.

Frequently Asked Questions

Q: Can I use a standard employment contract template for my UK startup?
A: While templates can be a starting point, they often lack the robust IP, confidentiality, and restrictive covenant clauses investors scrutinise. A generic template may not meet the specific needs of a high-growth tech business, creating significant risks that can be uncovered during due diligence.

Q: How do I prove a contractor is genuinely self-employed for IR35?
A: Document your assessment for each contractor. Use the government's CEST tool as a guide and keep records showing they control their work, have the right to send a substitute, and are not in a relationship of mutual obligation. The contract alone is not enough; the working reality matters most.

Q: What happens if I miss the 92-day EMI notification deadline?
A: Missing the 92-day deadline to notify HMRC of an EMI option grant is an irreversible error. The options will lose their tax-advantaged status, creating a less favourable tax situation for the employee upon exercise. This can damage team morale and is a serious red flag for investors.