The surge in artificial intelligence (AI) innovation has made the sector a magnet for venture capital (VC) investment, particularly in the UK's growing tech ecosystem.
While funding opportunities abound, early-stage AI companies often find themselves under-prepared for the legal scrutiny and structuring challenges that come with VC backing. In this article, we explore the most common legal risks that AI startups overlook and how to manage them to ensure a smooth investment process.
1. Ownership of AI intellectual property and algorithms
For AI startups, intellectual property (IP) is everything. However, founders frequently underestimate the complexity of proving clear ownership of algorithms, training data, and outputs. Common pitfalls:
- Using open-source software without understanding the licensing restrictions
- Failing to assign IP from freelance developers, consultants or early-stage collaborators
- Unclear IP rights in academic spin-outs or joint ventures.
Before approaching VCs, conduct a full IP audit. Ensure all IP is properly assigned to the company, licences are documented, and there is no infringement risk lurking in your code base.
2. Data protection and AI compliance
AI businesses often train or deploy models using large volumes of data, sometimes including personal or sensitive information. The UK GDPR and EU AI Act place strict obligations on how data is collected, processed, and retained. Companies must be able to answer the following:
- Where did your training data come from?
- Was consent obtained or is there a lawful basis for the use of this data?
- How is bias, explainability or algorithmic fairness being addressed?
Adopt and document a data governance framework. This can include data minimisation policies, clear consent records, and internal assessments of AI bias or discrimination risks.
3. Weak contractual foundations
Startups often focus on product before paperwork. But weak customer contracts or vague collaboration agreements can raise red flags for investors. Risk areas:
- No clear limitations of liability in pilot or beta trials
- Unclear rights to use customer feedback or co-developed data
- Failure to include IP ownership clauses in partnership and consultancy agreements
- No terms and conditions and privacy notices.
Review all commercial contracts to ensure they allocate IP rights clearly, limit liability appropriately, and protect the startup's proprietary tech.
4. Equity structure and founder risk
Investors will want to review the company's capitalisation table and any potential disputes around founder equity, share vesting, or previous informal investment. Red flags include:
- Unrecorded founder agreements or unclear IP assignments from co-founders
- Shares issued without proper board or shareholder approval
- Dilution from excessive advisor equity or advanced subscription agreements/SAFEs with ambiguous terms.
Clean up your cap table early. Use founder agreements, consider reverse vesting clauses in the event a founder leaves, and ensure Companies House filings are accurate and up to date.
5. Overpromising in investment pitching
In the competitive world of AI funding, it's easy for founders to oversell the capabilities of their tech, particularly with regard to automation, accuracy, or compliance. VCs are increasingly cautious about substantiating claims, especially in regulated sectors like health, finance or defence.
Make sure your pitch materials and commercial contracts are aligned with what your product can deliver. Avoid statements that could lead to misrepresentation claims down the line.
6. Not planning for regulation
AI regulations are ever-evolving. The UK, EU, and other jurisdictions are introducing frameworks that will govern everything from high-risk applications to transparency obligations and algorithmic accountability. Be proactive. Even if you're not in a regulated sector now, a compliance-aware culture gives confidence to investors and can increase your valuation.
Final thoughts
AI startups operate at the intersection of innovation and risk. While VC funding can fuel growth, it also brings legal due diligence and expectations that many early-stage businesses aren't prepared for. We support founders and growth-stage tech companies with investment readiness, term sheet negotiations, and risk mitigation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
