The Legal Red Flags That Kill Deals
1.Unclear IP Ownership
Intellectual property must be 100% owned by the company, not individual founders or contractors. When investors discover that critical code, designs, or technologies belong to freelancers or early employees without proper assignment agreements, financing immediately halts.
How to Fix It: Implement comprehensive IP assignment clauses in all founders, employee, and contractor agreements from day one. Conduct an IP audit before fundraising to identify gaps, then secure retroactive assignments where necessary. File patents for unique technologies and use NDAs before external discussions. For more guidance on protecting your startup’s intellectual property, visit The Startup Zone’s legal resources.
2.Missing Founder Agreements
Skipping formal founder agreements creates disputes about ownership, responsibilities, and decision-making that investors won’t touch. The infamous Facebook-Winklevoss case demonstrates how founder disputes can explode into costly litigation.
How to Fix It: Draft founder agreements immediately that specify equity splits, vesting schedules (typically 4 years with a 1-year cliff), roles, responsibilities, and exit provisions. Include clear terms for what happens if a founder leaves or underperforms.
3.Dead Equity on the Cap Table
Large chunks of equity sitting with former co-founders, ex-advisors, or inactive early team members signal poor judgment. This “dead equity” acts as a hidden tax on growth, new hires, and exit returns, prompting investors to reprice deals or walk away entirely.
How to Fix It: Implement vesting schedules with clawback provisions for all equity grants. Clean up cap tables before fundraising by negotiating buyouts of inactive stakeholders or adjusting their holdings to reflect actual contributions. Discover cap table management best practices to avoid these pitfalls.
4.Bloated Advisor Grants
Advisors holding 5-10% equity with minimal accountability scream mismanagement. Standard advisor grants should be under 1% over 1-2 years, tied to specific milestones or deliverables.
How to Fix It: Limit advisor equity to 0.25-1% based on their strategic value and commitment. Structure grants with performance milestones rather than giving away equity upfront.
5.Improper Fundraising Documentation
Accepting investments from friends, family, or angels without proper legal agreements violates securities laws and creates nightmare scenarios for future rounds. Non-compliance can result in significant financial penalties and investor lawsuits.
How to Fix It: Use SAFE agreements or convertible notes for early-stage investments. Draft shareholder agreements clarifying investor rights and obligations and ensure compliance with securities regulations in your jurisdiction.
6.Convertible Chaos
Multiple SAFEs or convertible debentures with different valuation caps, discount rates, and conflicting terms make it impossible for investors to calculate post-conversion ownership. If investors must guess who owns what post-close, you’re not getting a term sheet.
How to Fix It: Model conversion outcomes before your next round. Consolidate convertible debentures where possible and maintain clear documentation of all terms. Create a detailed cap table that shows fully diluted ownership under various scenarios.
7.Missing or Inadequate ESOP Pool
Operating without an employee stock option pool forces creation of pre-money, directly diluting founders. Investors expect clean 10-15% ESOP pools allocated post-round with proper grant documentation.
How to Fix It: Establish an ESOP pool early (typically 10-15% of fully diluted equity). Maintain meticulous grant documentation and ensure all option agreements comply with local employment and tax laws. Learn about equity compensation strategies that attract top talent.
8.Messy Corporate Structure
Starting as a sole proprietorship or partnership instead of incorporating properly creates unlimited personal liability and complicates fundraising. Choosing the wrong jurisdiction can also create obstacles for international expansion and VC backing.
How to Fix It: Incorporate as a private limited company in India. File all incorporation documents correctly, obtain necessary business licenses, draft bylaws or operating agreements, and secure a PAN. Visit The Startup Zone’s incorporation guide for step-by-step instructions.
9.Employment Contract Gaps
Hiring employees or contractors without proper written agreements creates ambiguity around IP ownership, confidentiality, non-competes, and compensation. This lack of documentation raises major red flags during due diligence.
How to Fix It: Implement standardized employment contracts covering IP assignment, confidentiality, non-compete clauses (where enforceable), compensation, and termination procedures. For contractors, use clear statements of work with IP assignment provisions.
10.Regulatory Non-Compliance
Operating in regulated industries without demonstrating compliance with applicable law from data privacy (GDPR, DPDPA) to sector-specific licensing, represents existential risk investors won’t accept.
How to Fix It: Understand your industry’s regulatory landscape thoroughly and maintain documentation proving compliance. Secure all necessary licenses and permits before scaling. For data-heavy businesses, implement robust privacy policies and security measures aligned with relevant regulations. Find compliance checklists for Indian startups on The Startup Zone.
