Introduction

Before entering into any type of relationship with a company, investors and other business partners prefer reviewing its legal, financial, and operational facts and figures to identify any underlying risks or challenges and address them appropriately before making any commitments. This process of examination and identification of hidden risks is called due diligence.  Anyone committing a substantial investment with the expectation of profit will naturally want to ensure that the transaction is based on informed analysis rather than being left to chance. Most commonly relevant in Startup investments and mergers & acquisitions, due diligence lays the foundation of such business relationships. As a startup, any entity will need to present itself at its best in this regard; however, can one achieve the title of Due Diligence-ready without knowing what it entails?

The process of legal due diligence is not codified; instead, it involves reviewing other relevant laws and regulations and ensuring they are followed without discrepancies. Due to the varying nature of industry-specific norms and regulations, the aspects of due diligence also vary, yet a few remain constant across industries.

Relevance for Startups

Approximately 18% of global startup failures can be attributed to poor legal compliance,1 meaning that one  in five startups is bound to fail due to issues with laws and regulations. In India, the  Legal issues are generally considered a major contributor to startup failure, having an extended problem of a complex nature, leaving the founders without a proper understanding.3 The question of legal compliance stands as a central pillar for building an organisation with a durable foundation, one that can last the tests of the market and authorities. The basic role it plays is to uplift the credibility of the company in the eyes of the investors by presenting as a legally sound, trustworthy entity, worthy of their investment.

Each relevant aspect of the company is examined, from annual reports to compliance with industry-specific regulations and general guidelines of the government. Therefore, knowing what one should be prepared with is an essential component of due diligence preparations.

The GoMechanic Case

Following the GoMechanic incident from 2023, venture capital firms have become increasingly stringent regarding the due diligence of their portfolio companies. In a funding round with a potential investor, the company’s financial misreporting came to light, and later, when co-founder Amit Bhasin confessed that indeed errors had crept into their reporting and disclosures.4 This event not only subjected the particular startup to regulatory scrutiny but also alerted the whole investor ecosystem to adopt a more rigorous and vigilant approach towards due diligence processes, involving methods ranging from detailed legal and financial checks to implementation of forensic audits to minimize the risk of overlooked discrepancies,5 all of which could be prevented had the company prepared for due diligence thoroughly.

Red Flags Investors Look for While Doing Due Diligence

Red flags refer to specific warning signs that demarcate the existence or potential of a legal issue associated with the target company. These issues can adversely influence the investor’s decision to enter the transaction. Identifying these indicators is an essential component of due diligence preparation. 

1. Governance

The governance of a company focuses on its operations and internal systems, policies, and the leadership’s ethical conduct. Investors closely examine these to determine if the company’s operations are smooth and reliable, or if any unnecessary hindrances may result in future problems. Generally, a strong attention is paid to the company’s Articles of Association, Certificates of Incorporation, By-laws, internal policies and procedures, and Board meeting minutes.6 Factors like an all-powerful CEO, a weak internal control regime, a non-existent code of ethics, and a focus on rapid and immediate growth are all considered red flags by investors during due diligence.7 In 2018, when Carillion, one of the UK’s leading construction companies, collapsed due to a massive debt of nearly a billion pounds, the board members were the ones holding the ultimate blame, owing to their reckless nature as described by the parliamentary committee.8

2. Disclosures

Disclosures are the reporting and information presented to either authorities or investors, to declare the facts and figures relating to various aspects of the company’s operations, including financial disclosures, environmental disclosures, and social disclosures. A 2022 study published in the Journal of Business Ethics found that VC-backed startups had a significantly better disclosure regime at the time of their IPO compared to those without venture capital backing.9 Based on the study, it can be inferred that investors place significant importance on the quality of disclosure, often assessing it even before engaging with a potential portfolio company.

3. Contractual Risks

Any investor would want to know before putting their money on the line what type of contractual obligations their potential portfolio company holds. Therefore, investors keenly observe every major contract, including customer agreements, service agreements, any employment agreements and supplier agreements. The key focus is given to the termination clause, unlimited liabilty and indemnity provisions, liquidated damages under the contract, dispute resolution methods mentioned, non-assignment provisions, third intellectual property right claims, representations and warranties.10 A recent study of 349 judicial cases related to construction contracts found that the majority of contract-related disputes arose due to issues like illegal subcontracting, qualification deficiencies, unclear/incomplete terms of the contract, etc11, though not directly relating to investing and due diligence, the underlying principle behind all contracts remains the same. Whether in the field of Engineering or SaaS, investors care about dispute-prone clauses.

4. Intellectual Property

Generally, for any company and especially for startups, intellectual property is an integral asset, often forming the basic foundation of the company. Therefore, the investors are vigilant about all the IP-related aspects of the target company, including patents, trademarks, copyrights and trade secrets, examining whether these assets are adequately protected and registered to avoid any future hassle.12

5. Litigation, Claims & Legal Disputes

No investor wants to land himself in a legal dispute, not without learning the nature of it at least and for the same reasons, investors tend to conduct a comprehensive study of any ongoing, past or threatened litigation, claim or legal dispute with a firm, with a focus on assessing their financial and operational implications. Another potential deal breaker can be a track record of frequent litigation. The fundamental problem with such situations is that they tend to drain cash and valuable time, and repeated issues point to a deeper problem within governance or compliance structure.

6. Regulatory & Compliance Red Flags

Various regulatory bodies have been instituted across different industries to regulate, monitor, and control the working as well as the product qualities of companies operating in those sectors. Therefore, to be assured that in future their portfolio company won’t be subjected to any regulatory obstacles, investors closely examine the company’s regulatory and compliance regime. The goal is to identify any discrepancies or loopholes in the company’s regulatory and compliance disclosure. In the year 2024, major startups including Paytm, Byju’s and Droneacharya faced trouble with the regulatory authorities. The result was not limited to financial effects only, but also affected the investor confidence at large13. Therefore, startups entering funding rounds need to put their best foot forward when presenting their compliance disclosure; otherwise, any room for errors can directly affect the investor’s confidence.

Conclusion

In conclusion, the process of legal due diligence acts as a filter for the investors to help them separate the good investment options from the ones that carry a greater risk.  From investor’s perspective, one can understand how the existence of red flags in contracts, intellectual properties, governance structure or any relevant aspect of the operations of the company will affect our judgment, as these issues directly highlight the existence of deeper systematic errors within the organisation. The goal of being due diligence ready is not only to come strong during investment proceedings, but also extends to building a foundation based on credibility and trust, helping them in the long run. Founders who give the requried importance to preparing their company for due diligence are more likely to attract investor attention and funding by keeping at bay from any hidden legal pitfalls and eventually tap into faster and more sustainable growth.

References:

  1. Revli, ‘50 Must-Know Startup Failure Statistics in 2024’ (Revli, 2025) accessed  September 17 2025.
  2. Muskaan Kapoor, ‘Startup Failure and Success Rates: Research Report’ (StartupTalky, 22 June 2023)  accessed September 17 2025.
  3. Kishore Dasaka, ‘10 Legal Mistakes Made by Startups’ (Times of India Readers’ Blog, 12 February 2023)  accessed 6 October 2025
  4. Sowmya M and Abhilasha S G, ‘The Impact of Financial Misreporting on Indian Startups’ (YourStory, 9 February 2023) accessed 18 September 2025.
  5. Debangana Ghosh and Nikhil Patwardhan, ‘GoMechanic crisis: Startup funding due diligence to get stricter and longer’ (Moneycontrol, 10 February 2023) accessed 18 September 2025
  6. ‘M&A Due Diligence Checklist’ (Bloomberg Law, undated)  accessed 19 September 2025.
  7. Hugh Grove and Tom Cook, ‘Fraudulent Financial Reporting Detection: Corporate Governance Red Flags’ (2007) 4 Corporate Ownership & Control 4, 254-61  accessed 6 October 2025.
  8. CCG, ‘Corporate Governance Failure and Examples’ (CCG, 18 October 2024)  accessed October 6 2025.
  9. Douglas J Cumming, Lars Helge Hass, Linda A Myers and Monika Tarsalewska, ‘Does Venture Capital Backing Improve Disclosure Controls and Procedures? Evidence from Management’s Post-IPO Disclosures’ (2022) 187 Journal of Business Ethics 539–563  accessed 6 October 2025.
  10. ‘Legal Due Diligence: What Investors Look for Before Funding?’ (Burgeon, 17 July 2024)  accessed 6 October 2025.
  11. Yongcheng Zhang, Ziyi Wu, Chaohua Xiong, Jianwei Wang and Maxwell Fordjour Antwi-Afari, ‘A Data-Driven Analysis of Engineering Contract Risk Characterization Based on Judicial Cases of Disputes’ (2025) 15 Buildings 2245  accessed 6 October 2025
  12. Ibid. 10
  13.  Swati Dayal ‘Compliance Hacks for Startups: Don’t be a Cautionary Tale! (TICE, 4 July 2024)  accessed 6 October 2025

Gaurav Gupta is the Founder and Managing Partner at Bridge Counsels & Fazal Hasan Ali Fahim is an alumni of Faculty of Law, Aligarh Muslim University.