“Look, I don’t think we have any significant legal issues with our business,” the founder of a fintech startup told me as he and his team prepared to go to market. “If there was anything seriously wrong with it, then the lawyers would have flagged when they ran diligence during our last round.”
I’ve heard this assumption more than a few times in my venture career and, as a lawyer who is aware of what happens in legal diligence, it is deeply troubling. As you might imagine, being less than 100 percent sure that your business model is legal exposes you to potentially business-ending action from regulators.
Analysis vs. Diligence
You may have noticed that the title of this article focuses on “legal analysis” and not “legal diligence.” That was intentional. Legal diligence is often thought of as an omniscient process where a lawyer goes through every word of all your documents and gives a legal blessing on both the business model and the transaction, which is not actually what happens. Legal diligence is just a process that ensures all the right forms are in place and the business is ready to take on funding. A legal analysis of the business model almost never occurs in this process. A legal analysis would entail determining whether or not the business model is legal or has any significant regulatory hurdles.
Why is this important? As entrepreneurship progresses and startups continue to innovate in areas that are ripe for disruption, they may run into a number of different laws, rules, or regulations that were likely put in place long before the potential for disruption in that space was ever thought of. You may also notice that some of the rules in place have a strong public policy reason for remaining and therefore are unlikely to change.
While the CEO or founder usually leads this process, if you want that opinion to be from a legal professional, you’ll have to hire a lawyer to research and issue an opinion on the business model. But a lawyer isn’t strictly necessary to get your bearings on a business; often, any venture associate or analyst can handle significant preliminary work and at least get to the point where they can suggest if there is a certain issue that would benefit from a lawyer’s professional opinion. Starting a legal analysis is not as hard as one might think. The best way to begin is by checking with the regulatory body that the business will have to deal with the most.
Example 1: Disrupting the Restaurant Industry
Let’s imagine that you are presented with a startup that is looking to disrupt the restaurant industry, and they are based in Florida. Their idea is to make everyone’s home kitchen a restaurant and to make everyday people chefs. They have a lot of initial traction, and people are loving their product.
Assuming their business metrics were promising, the legal analysis should start with checking which regulatory bodies govern the serving of food in Florida. In this case, there are a few: the Florida Department of Health, the Department of Agriculture and Consumer Services and the Department of Business and Professional Regulations.
Since this company’s initial plans don’t include selling products that could go interstate, it is probably best to start by looking for state or local ordinances involving the sale of food from your home. (However, in the future, you’ll also want to check ordinances from other states since you are likely hoping that this company will expand to the entire nation.)
What you will find is that almost all the states in the United States, including Florida, have major restrictions regarding the sale of food from an unlicensed kitchen sold by unlicensed food handlers — the exception being California, which just passed a new law legalizing sale of food from the home, (but individual counties bear the burden of opting in). These restrictions are in place to uphold public safety and will likely not be altered in the foreseeable future. This means that the startup will probably have a hard time growing, or even operating, in the very near future.
Example 2: Flying Under the Regulatory Radar
Another example that is especially useful is how to conduct this analysis when analyzing a startup in the legal tech field. Legal tech is fraught with rules that are very important but not overtly obvious, like the Unauthorized Practice of Law (UAPL), fee-splitting rules, unethical solicitation of clients and other ethical standards that govern conflicts of interest. As legal tech startups push the capabilities of the tech available to them, they often run into one of these roadblocks.
So let’s imagine you are looking into a revolutionary startup that gives legal advice so that people never have to hire a lawyer. The first place to look here might be the ethics rules governing lawyers in a particular region, since they do vary from state to state. You will find that software that gives legal advice would probably trigger a UAPL violation in most states.
You may be wondering how it’s even possible for a startup like the ones I described above to operate at all if they did not figure out a way to legally operate. Unfortunately, it is not unheard of for startups to fly under the radar of regulators as they grow — even while having business models that are illegal. For example, WeFunder, a crowdfunding investment startup, raised $3 million in 2012 despite it being known that its business model was illegal when it raised those funds.
Implementing a legal analysis is an important part of the diligence process that will become increasingly essential as startups look to disrupt areas that have more regulations. For the most part, startups will have figured out the legal confines in which they operate, but making sure that this box is checked off can save you from investing in a business that might face serious regulatory or legal hurdles in the future.
Fortunately, checking that box off can be done in-house, and it’s as easy as looking first to the agencies that govern the industry the company is operating in. But above all, never assume that the business model legally checks out just because that company has gone through legal diligence previously — it could end up costing you everything.