Imagine you’re an associate at a law firm. It’s 7pm on a Friday and you’re considering maybe leaving and enjoying the evening. Then you get an email from the partner—your boss—telling you that there’s a startup deal happening. A VC wants to give this startup $2 million. But they’ll only write the check if you do a legal due diligence first and email them a legal opinion. A legal opinion is basically the startup’s lawyer telling the investor that, legally speaking, everything’s okay with the startup. It’s up to you to make sure everything’s really okay. It’s up to you to do the diligence—you and you alone are holding up this deal. So, what do you do?Gathering Documents
If you’ve been organized so far (which you have been, because you’re a responsible lawyer), you have a neatly labeled folder with all of the startup’s documents that you’ve created. But the founders have also created relevant documents, so you have to get those from them directly. You have a cap table in your neat folders, but now you have to check with the founders to make sure they weren’t promising shares to other people while you weren’t looking. As luck would have it, they have been doing exactly that, making your cap table obsolete. Now you have to ask them for a more up-to-date version of the cap table.
Then—when you finally have the documents from your folders, the documents directly from the founders, and the founders’ most recent cap table—you can finally get to work. A legal opinion encompasses many things, and you decide to start with the cap table. What specifically are you working on?Verifying the Cap Table
You’re working on (1) reading the cap table’s first line—it says Bob has 10,000 shares—and then (2) digging through all of the paperwork to find the actual twelve page document (typically an RSA, ISO, or NQO) that grants Bob this stock. In some cases (horror!), after all that searching you’re pretty sure the document you’re looking for just doesn’t exist. That person doesn’t really have the shares the cap table says they have. You make a note—you’ll need to work with the company to fix this and create the missing document. And repeat, (1) read the cap table’s second line—it says Sue has 17,687 shares—and (2) dig to find the documentation that backs this up. Now, (1) read the cap table’s third line… you get the idea.Checking Everything Against the Stock Incentive Plan
After this painful exercise, you’ll then do a logic puzzle to see if the startup ever granted more shares than were allowed under the company’s Stock Incentive Plan. If x number of people own stock grants granted under the plan, and y number of people own shares granted outside of the plan, and z is the total number of shares available under the plan, the question becomes, did the startup ever mess up and break the rules of the plan? Or did it grant more shares than the number of authorized shares? Although the math is not too hard, it’s time consuming to go through this. This is because figuring out which people have stock grants UNDER the plan, and which people have share grants OUTSIDE of the plan, is a pain.Working Against a Ticking Clock
Are you falling asleep by this time? Yes you are! Has Friday night come and gone? Yes it has! It’s getting into the wee hours of Saturday morning and despite the fact that it was the venture capitalist who requested the opinion, you’re going to have to charge your startup for the time you’re spending. With every hour that goes by, the cost will be higher, and the client less happy about the bill. Every hour that goes by is yet another hour that you’ll be blamed for holding up this deal. You really are all that’s standing between this startup and their dream deal.Due Diligence, Then and Now
Fortunately, experiences like that are a thing of the past, the kind of thing lawyers went through in the early 2000s. It’s not 2007 anymore. Company lawyers still get requests from investors seeking a legal opinion. But now, Fidelity software can automate this.
Using Fidelity, everything I’ve just babbled on about for seven paragraphs would be automated.
In Fidelity, information is catalogued and accounted for, which saves you time. This can save the startup money on legal fees. The startup earns street cred with the investor because it looks good that they have their act together. Imagine a startup’s due diligence taking 1/10th of the time of the old-fashioned diligence! Associates’ lives are also much better in 2017. Due diligence costs less. Startups, thankfully, are not having to pay for all those huge legal bills in the end.
So, if you’re a law firm associate whipping through a due diligence in Fidelity, be thankful 2007 is behind us. And go enjoy your Friday evening!
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Sample scenarios are for illustrative purposes only.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.