Legal diligence looks for obligations the accounts may not show: workers who may legally be employees, pending or threatened litigation, and regulatory licences or rules the business depends on.
10 min read · Level 3
I think the most useful question in this part of diligence is 'has anyone ever written to you saying you owe them something or broke a rule?'. It covers far more ground than 'are there any lawsuits', and founders usually answer it more completely.
Three areas where significant obligations can sit outside the accounts:
Employment
Contractors who work like employees - fixed hours, one client, company equipment - may be classified as employees under local law Missing employment contracts or IP clauses Unpaid overtime, holiday or benefits Share options promised but not formally granted
Litigation
Current lawsuits, arbitrations or regulatory investigations Threatened claims in letters or emails Disputes with former employees, co-founders or customers
Regulation
Licences needed to operate (for example, payments, lending, health, telecoms) Data protection obligations Consumer protection and advertising rules Sector-specific rules that may change
A contingent liability is an obligation that depends on a future event, such as losing a claim or a reclassification decision. It may not appear in the accounts but can still cost real money.
Because these liabilities can be large and sudden. Reclassification of workers can create back-pay, tax and benefit obligations; a regulatory licence problem can stop a business operating.
Representations and warranties in the investment documents help, but recovering money from a young company or its founders after the fact is rarely practical.
This is educational information, not legal advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: U.S. Department of Labor - Employee or independent contractor; UK GOV.UK - Employment status; U.S. SEC - Investor.gov
Contractor reclassification risk.
Contractors working full time for the company only 15 Average annual fee per contractor 40,000 Estimated additional employer costs if reclassified about 15% of pay Annual exposure 15 x 40,000 x 15% = 90,000 Look-back period assumed 3 years Potential liability (before penalties) about 270,000
The investor asks for legal advice on the classification, a plan to move appropriate workers to employment, and a specific disclosure and warranty covering the risk.
Asking only whether there is litigation, without checking worker classification, informal promises and the licences the business model depends on.
Compare contractors' working patterns with local employment tests.
Include letters and emails, not only filed cases.
List licences and rules the business depends on and confirm compliance.
Use disclosures, warranties or conditions to address specific risks.
During diligence on any company with staff, customers in regulated sectors, or known disputes.
Do not form a view on worker classification or regulatory compliance without qualified local legal advice.
Courts and regulators in several countries, including cases in the UK Supreme Court and actions in U.S. states, have examined whether platform workers classified as independent contractors should be treated as workers or employees, with significant cost implications for the companies involved.
Worker classification can change a company's cost base substantially. It deserves specific diligence.
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