Red flag 1: No signed contract for a contractor who built core product
This is the most damaging finding in any diligence process. A contractor who wrote significant portions of your codebase, designed your core UI, or built your data infrastructure has no signed agreement. There is no IP assignment. There is no work-for-hire clause. The contractor, technically, may own the work they created.
Why it slows the round: investor counsel will flag this as a potential IP ownership dispute. They will want the contractor to sign a retroactive IP assignment before closing. If the contractor has already left and is unresponsive, you have a material IP risk that may require a legal opinion letter or an indemnity provision in the investment documents. Both take time and legal fees.
How to fix it now: generate a contract with explicit IP assignment and have the contractor sign it immediately. If the contractor has left, reach out and offer a reasonable payment for a retroactive IP assignment agreement. Document everything. It is better to spend $1,000 on a retroactive assignment than to have a $2 million round delayed by 6 weeks.
Red flag 2: Contractors who look like employees
Investor counsel will review your top contractors and ask one question: does this person look like an employee? They look at hours worked (over 30 per week is a flag), exclusivity (working only for you), duration (over 12 months), integration (on your Slack, attending standups, using your email), and control (you manage their daily tasks).
Why it slows the round: misclassification creates retroactive liability. If 3 contractors should have been employees, the potential back-payment (taxes, social security, benefits, penalties) becomes a contingent liability that investors must price into the deal. Some investors will require you to reclassify or convert the contractors to employees before closing.
How to fix it now: run a misclassification assessment on every contractor. For those who score high risk, either restructure the engagement to restore genuine independence (reduce hours, ensure other clients, remove from internal tools) or convert them to employees through an EOR. Converting proactively demonstrates maturity. Being forced to convert during diligence demonstrates negligence.
Red flag 3: Expired or missing tax forms
A W-8BEN that expired 18 months ago, a W-9 that was never collected, or a contractor in India with no PAN on file. These are not catastrophic individually, but they signal sloppy compliance practices.
Why it slows the round: investor counsel will ask whether withholding obligations were met during the period without valid tax documentation. If you continued paying a foreign contractor after their W-8BEN expired, you may have been required to apply 30% backup withholding and did not. That is a quantifiable tax liability.
How to fix it now: audit every contractor’s tax form. Collect new forms where they have expired. For the period between expiry and renewal, consult your tax advisor on whether any retroactive withholding or filing is needed. Going forward, track expiry dates and collect renewals proactively.
Red flag 4: Payment records with no invoice linkage
A bank statement showing 12 monthly transfers to an individual in another country with no invoices, no contract reference, and payment descriptions like ‘services’ or ‘payment’. To an auditor, this looks like unexplained outflows. To investor counsel, it looks like undocumented contractor relationships.
Why it slows the round: counsel cannot verify that payments were for legitimate business services without documentation. They may require you to reconstruct the documentation retroactively or provide a management representation letter attesting to the nature of the payments. Both take time.
How to fix it now: retroactively link every payment to an invoice. If invoices were never generated, ask contractors to issue retrospective invoices for the services they provided. This is not ideal (prospective documentation is always better), but it closes the gap. Going forward, ensure every payment has an invoice before it processes.
Red flag 5: No Data Processing Agreement for contractors with system access
A contractor who has access to your production database, customer records, or analytics dashboards but has never signed a Data Processing Agreement. Under GDPR, CCPA, and other privacy frameworks, this is a compliance violation by the company, not the contractor.
Why it slows the round: data privacy violations are increasingly scrutinized in diligence, especially for companies that handle customer PII. An investor with European LPs is particularly sensitive to GDPR exposure. The counsel will want DPAs signed before closing.
How to fix it now: generate DPAs for every contractor who accesses personal data. Omnivoo’s document generator creates jurisdiction-specific DPAs for free. Have them signed within the week. Going forward, include a DPA in the standard onboarding package for any contractor who will access systems containing personal data.