Legal and tax due diligence carried out ahead of a financing round for a start-up differs in several respects from due diligence for an M&A transaction.
While M&A due diligence primarily aims to identify risks affecting ongoing business operations, the focus for start-ups is more on typical risks in a company’s founding and early growth phases. Below is an overview of topics that – based on sometimes hard-earned experience – require particular attention from a legal and tax perspective. We also provide pointers and tips on how to avoid and address these issues.
I. Legal aspects
1. Formation: Not every start-up starts with the immediate formation of, for example, a German limited liability company (GmbH). Often, a start-up’s life begins with (sometimes informal) collaboration between one or more individuals. When a GmbH is subsequently formed, it is essential that all assets (IP, equipment, initial contractual relationships, etc.) are transferred into the newly formed company. This often does not happen at all or only in a rudimentary way. Especially where external third parties were involved during the founding phase, there is a risk that, if the start-up succeeds, those third parties will assert equity claims or other claims against the company.
2. Transfer of shares: Even though transfers of GmbH shares under German law are generally formalized (notarial certification is typically required), there are scenarios where shares are transferred or redeemed without a notary’s involvement. Common shareholders’ agreements provide, for example, for transfers of founders’ shares subject to conditions precedent under “vesting” arrangements, allowing the company to claw back departing founders’ equity. A correct shareholders’ list is therefore not a given; a review of all share transfers is essential. Tax aspects of share transfers, particularly between founders, must also be considered (see below).
3. FTO search: Freedom-to-operate (FTO) checks are increasingly important, particularly in deep tech. If the business idea is based on an invention or a specific (technical) process, it must be assessed whether third-party patents or utility models block the start-up’s implementation. In such cases, third parties may assert cease-and-desist and royalty claims, which, in extreme cases, can force a shutdown or insolvency.
4. Open source: If self-developed software is a key asset, verifying the open-source components used is essential. Open source is made available under various, partly standardized licenses. Some licenses permit commercial use only under certain conditions – some may “infect” entire programs or components, turning them into open source as well. In the worst case, this can devalue key assets or products of the start-up; if identified in time, remedial adjustments can prevent or cure this.
5. Founder leaver events: Even though founders’ active roles are indispensable for most start-ups for a long time, many start-ups face situations where separation from a founder is required – or a founder chooses to leave. It should be clearly regulated what happens to the departing founder’s equity. It is also advisable to agree on (legally permissible and enforceable) non-compete covenants to mitigate the risk of unwanted competition. Investors should also review the conditions for company-initiated founder separation and the extent to which their contemplated stake allows them to influence this process.
6. Large and opaque cap tables: Especially in the early stages, many start-ups and founders accept numerous small or “angel” investments. While many such investors take a passive role, others become (sometimes overly) active in governance. German GmbH law grants relatively strong rights even to holders of minimal stakes. Future financing rounds often require all shareholders’ participation. Shareholders’ agreements should therefore include market-standard pooling provisions under which small shareholders are represented by a common spokesperson with broad power of representation. Without such provisions, there is a risk that shareholders can demand a high price to sell their stakes or to stop obstructing the company.
7. Convertible loans: Before any investment (whether via capital increase or convertible loans), existing convertibles should be carefully reviewed, particularly their conversion mechanics. Only then can one determine which convertible lenders will also convert in the round and on what terms. Early investors often have different valuation caps, resulting in disproportionately large equity stakes for comparatively small investments. This can be crucial in commercial negotiations.
8. Exit provisions: Start-ups that have already received investments often entered into comprehensive shareholders’ agreements. These typically contain detailed provisions on which shareholders may initiate and possibly control a sale of the company and under what conditions. Existing shareholders’ agreements are often (at least in part) assumed going forward. In such cases, it must be carefully reviewed whether and how a company sale can be pushed through against a minority’s will and, if so, which shareholders can decide this and with what majority.
9. IP does not belong to the company: In tech (broadly defined), IP is a key asset. Founders do not always ensure proper documentation that IP they create belongs to the company. Besides source code, this also includes registrable IP (e.g., trademarks or internet domains). While issues with active founders can often be solved via later assignments (see tax implications below), this is not always possible with employees, particularly former ones. Start-ups increasingly engage freelancers, often in other jurisdictions, with work that is not or insufficiently documented. The state-of-the-art is a clause clarifying that any IP created in the course of work for the start-up belongs exclusively to the start-up. Absent this, there is a risk – especially after successful, high-profile exits—that third parties assert rights to the company’s IP to force a (second) payout.
II. Tax aspects
1. Share transfers at nominal value: Especially in early stages, shares are often transferred at nominal value. If the actual value exceeds nominal value, there is a risk of recharacterization as hidden wage, triggering payroll tax and social security obligations for the company, plus liability risks in case of non-withholding. Investors should check provisions for accruals and contractual recourse against legacy founders. Clean documentation of valuation bases and a consistent compensation concept can mitigate risk.
2. Convertible loans: Upon conversion, the loan’s value at the conversion date must be substantiated. If conversion occurs before verifiable capital inflow and/or in the absence of valuation indicators, a taxable gain may arise. Market practice is therefore to convert only after the financing round’s closing. Clean documentation (term sheet, cap table, valuation basis) is also essential. In due diligence, conversion agreements, accounting entries and tax classification should be tracked.
3. Foreign activity and permanent establishment risk: Remote work and relocations of founders/CEOs (e.g., to Spain) can create permanent establishments and even shift the place of effective management. This can trigger foreign registration, filing and taxation obligations; potentially coupled with cross-border double taxation risks and possible exit taxation (taxation of all hidden reserves). Note that, under certain conditions, a home office can constitute a permanent establishment. In tax due diligence, investors therefore typically review governance compliance, place of management, travel routines, dependent agent arrangements, and any home office/workation policies.
4. VSOP and hidden profit distribution (vGA) risk: VSOP (virtual stock option plan) payouts on exit are often made by the company. Without a clear nexus to the company’s performance, the tax authorities may view them as a hidden profit distribution (verdeckte Gewinnausschüttung), with adverse tax consequences for the company and shareholders. VSOP agreements should therefore clearly emphasize the link to company success. Recourse clauses in favor of the company against shareholders can mitigate risk. For investors, legally and tax-aligned VSOP documentation is often critical.
5. IP does not belong to the company: IP developed early often initially remains with founders. If it is only assigned in the context of a financing, valuation at the round value may result—creating a tax burden for the founders. Early, form-compliant IP assignment (including open-source compliance, employee inventions, trademark/domain ownership) prevents later roadblocks. For investors, uncertainties do not usually create an immediate tax risk for the company, but they may impose potential tax burdens on founders.
