What Investors Look for in HR During Startup Due Diligence
HR gaps are one of the most common deal-killers in early-stage funding rounds. Here is exactly what investors and their lawyers check, and how to prepare before they ask.
Most founders are surprised to discover that HR documentation is a standard part of investor due diligence. Gaps in worker classification, offer letters, handbook policies, and equity documentation can delay or derail a funding round. Here is what gets scrutinized and how to get ahead of it.
Why investors care about HR
HR liabilities are financial liabilities. When an investor's legal team reviews your company before writing a check, they are not just looking at your cap table and revenue. They are looking for anything that could turn into an unexpected cost, lawsuit, or regulatory action after they own a piece of the business.
The most common HR-related deal problems are not discovered during a pitch. They surface weeks into due diligence, when the deal already has momentum and the founder is emotionally committed. At that point, fixing the problems under deadline pressure is expensive, and the leverage shifts to the investor.
The good news: every item on this list is fixable. Getting your HR house in order before you begin fundraising is significantly cheaper and faster than doing it in response to a due diligence request.
Worker classification
This is the first thing experienced investors look at. They want to know whether the people doing work for your company are correctly classified as employees or independent contractors. Misclassification is one of the largest contingent liabilities a startup can carry.
Investors will look at your contractor agreements, the actual nature of the working relationships, and whether you have any 1099 workers who look, by IRS standards, like employees. The behavioral control test, the financial control test, and the type-of-relationship test are all in play.
A single reclassification finding, if the IRS determines it was willful, can generate penalties exceeding $25,000 per misclassified worker, plus back payroll taxes, interest, and potential benefits liability. In a company with five misclassified developers, that is a six-figure contingent liability that will show up in the representation and warranty negotiation.
Offer letters and employment agreements
Investors want to see signed offer letters for every employee. The offer letter establishes the at-will employment relationship, the compensation terms, and any equity grant promises. Missing or unsigned offer letters create ambiguity about what was actually promised to each employee.
For technical and executive hires, investors will also look for signed IP assignment agreements, also called Proprietary Information and Inventions Agreements or PIIAs. These documents ensure that the intellectual property created by your employees belongs to the company, not the individual. In a software startup, missing IP assignments are a serious red flag.
Equity grant documentation is reviewed carefully. Every stock option grant should have a board-approved grant date, a signed option agreement, and a clear vesting schedule. Undocumented or informal equity promises are a significant problem because they create uncertain obligations that are difficult to value.
Employee handbook and core policies
You do not need a 100-page handbook, but you need a document that establishes at minimum: at-will employment, anti-harassment and anti-discrimination policy, a process for reporting complaints, and the basic terms of employment including pay periods and PTO policy.
Investors are not looking for perfection. They are looking for evidence that the company has thought about its legal obligations and has documented the basics. A company with 20 employees and no handbook signals to an investor that founder time has not been applied to people risk management.
A harassment or discrimination complaint that was not properly documented and investigated is a specific red flag. If you have had a complaint of any kind, investors will want to see that it was handled with a documented process.
Payroll compliance
Investors will confirm that you have been running payroll through a registered payroll provider and filing payroll taxes correctly. Unfiled or late payroll tax deposits are a serious red flag because payroll tax liability can pierce the corporate veil and become the personal liability of company officers.
State payroll registration is also reviewed. If you have employees working in multiple states, you should be registered as an employer in each of those states. Missing state registrations create back tax liabilities and penalties that investors are required to account for.
PTO and accrued vacation liability matters in states where accrued PTO is treated as wages. California is the most well-known example, but several other states have similar rules. Investors will want to understand your accrued PTO liability as a balance sheet item.
What to do before you start fundraising
Six months before you expect to begin a fundraising process is the right time to do an HR audit. This gives you enough runway to fix issues without pressure and document the remediation for investors.
The items that most commonly create friction in due diligence are: unsigned offer letters, missing IP assignment agreements, contractor relationships that look like employment, missing state payroll registrations, and absence of a basic employee handbook. These are all resolvable within 30 to 60 days with the right support.
Working with a senior HR professional before your raise is not a luxury. The cost of a pre-raise HR audit is almost always a fraction of the legal fees and deal risk created by surfacing these issues after term sheets are signed.