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Investor Due Diligence Checklist for Web3 Founders

July 26, 2022

Introduction

Startup fundraising campaigns can be divided into three stages:

  1. Initial negotiations followed by the Term Sheet signing;
  2. Due Diligence (DD); and
  3. Signing of the investment documents followed by the investment transfer.

If the first negotiation stage covers mostly financial and economic questions on matters such as startup valuation, investment size, etc., then the next two stages will mainly consist of legal questions.

The volume of legal work that must be performed by a startup at the preparation stage for DD and the signing of investment documents will depend on the startup’s stage of development. In this article, we share a list of legal information that is often requested by Web3 investors at various stages of their Web3 startup’s development, and usually before they sign any investment documents.

When is it best to sign a Token Warrant with an investor? Which document is better, the SAFT or the Token Sale Agreement. Find answers to these questions in this article on choosing a fundraising document

Due diligence on the pre-revenue or pre-product stage

At the pre-product stage, a Web3 startup usually doesn’t have a product that is ready to put to market, or even ‘market-validated’, yet. Instead, the product has a Proof of Concept and still needs a White Paper that will describe the types of tokens, outline the tokenomics, and detail any plans for token distribution. As a result, the startup's team is the key factor for most early-stage investors when making an investment decision. The investors will be curious to know if the teams’ previous experience is relevant, what the founders’ mindset is, and how the team collectively organizes their work process.

For founders to be able to work on their project, even at this very early stage, they will need a team to help with product development and subsequently will need a company (a DevLab company, to be specific) to pay the teams’ salaries and handle any other team related operational needs, such as paying office rent and paying corporate subscriptions. Investors will usually want to see certain things in place to better understand whether the team and the project are operating well. The key information that is shared with investors includes:

  • captable data and the management structure of the DevLab company
  • incentives for the team (token & stock options for employees and advisors)
  • intellectual property information (all IP must be fully owned by the DevLab company)

In the process of this due diligence, the investors will ultimately want to understand whether the founders are sufficiently motivated and whether the team is ready to work on the project long-term.

Read more: The Ultimate legal structuring guide for founders of DApps.

Due diligence on the pre-token launch stage

At this stage, a Web3 startup will have launched a working product, developed their tokenomics, and described it all in a White Paper, however, the tokens themselves will not have been released. There should also be a registered company (or the team should be in the process of registering a company) called a Token Distribution Company, created specifically to issue tokens in a legally secure manner.

At this stage, in addition to the due diligence checklist described above in the pre-product stage, Web3 investors will also check:

  • the token cap table, token distribution plan, and tokenomics principles;
  • the token legal opinion;
  • any legal opinion regarding the token-issuing company (specifically any legal opinion regarding the country in which the Token Distribution Company is registered. Ideally, the legal opinion will note how favorable the regulatory climate is, along with the absence of any regulatory obstacles that may hinder the issuance of tokens; and
  • details on the governance of the token distribution process and the work of tokenomics, specifically, clarification on how exactly these processes will be controlled. Will governance be managed centrally by the founders, or do the founders plan to transform the project into a DAO and subsequently decentralize the governance?

At this stage, it is important for the investor to understand how the tokenomics will work, including whether it will be able to ensure stable growth of the value of the token and also whether there will be no restrictions (either technical or regulatory), that may impact the distribution of this token and the scaling of the tokenomics in the future.

Read more: Token cap table: why Web3 investors need one and how to use it.

Due diligence on the post-token launch stage

Due diligence in this stage will involve tokens that have already been issued. It also covers the process of their further distribution. At this stage, in addition to the due diligence questions from the two previous stages mentioned above, the following information must also be clarified:

  • where the tokens are already listed, for example, on which particular exchanges / wallets;
  • how the emission of tokens and the process of their distribution is controlled, for example, either centrally or through a DAO; and
  • how the compliance process is built, including which verification procedures are implemented and which AML mechanics are implemented, in particular, for the token sale.

The key objectives of the investors’ due diligence at this stage is to determine:

  1. how liquid the token is;
  2. how developed the ecosystem is for the use of this token; and
  3. how the KYC/AML processes for the token distribution are organized.

Due diligence at the DAO launch stage

This stage is not mandatory for Web3 startups; however, if the Web3 founders have decided to completely decentralize the project management and transfer it to the "ownership of the DAO" (in other words, make the project management ownerless), then any investor due diligence will be addressed to the DAO management. Investors’ questions, in this case, will include:

  • how is the DAO legal wrapper structured?
  • how is the DAO Constitution designed?
  • how is DAO governance organized?
  • what are the requirements for DAO members? 
  • how is the compliance procedure organized for the processes of filing and spending undertaken by the DAO Treasury?;
  • what is the structure of the DAO management bodies?
  • how can an investor organize his participation in DAO governance?

At this stage of due diligence, investors are also interested in the question of company control, in addition to tokenomics. In classic Web2 startups, this issue is dealt with by checking the Shareholders Agreement (SHA) and Articles of Association / Bylaws, which state both the decision-making procedure and the investor’s right to participate in the board of directors and the investor’s right of veto, etc. In the case of DAO (whose governance is decentralized), investors will look for answers to these questions in the DAO Constitution and the constitutional documents of the DAO legal wrapper.

Read more: How to choose a crypto-friendly country for DAO legal structuring.

Web3 founders can prepare for investor due diligence at any stage of project development 

It is important for Web3 founders to be ready for the investor due diligence in two key aspects:

  1. the economical terms of the deal – starting from the Dev Lab Company cap table and ending with the token cap table, token economics, and principles of DAO formation–all of which help the investor understand what amount of shares/tokens they are entitled to receive and how the investor will be able to make an exit; and,
  2. how the company is controlled – starting with the board of directors of the Dev Lab Company, continuing with the issue of control over the token distribution process and ending with the DAO governance-a model.

If you’re preparing for due diligence or planning one soon, Legal Nodes can help you. We’re a legal platform that helps Web3 founders solve their legal tasks in one place. You start from a discovery session, where our Head of Web3 Legal helps you better understand the regulations that might affect your project and which countries are the most crypto-friendly for legal structuring. From there, we’ll build a legal roadmap for you that will include the most important legal tasks to achieve your business goals and assign you a dedicated Virtual Legal Officer who will manage the implementation of those tasks and ensure you’re staying on budget and the deadlines are met.

Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.

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Nestor is a Co-founder & COO of Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups, helping them scale on global markets.

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