Emerging Company Basics: Legal Mistakes Founders Should Avoid
When I meet with founders looking to get their new startup off the ground, I am frequently asked about mistakes others have made and lessons learned. I always start this conversation by making a distinction between mistakes where I can help the founder fix the situation and mistakes where I cannot. In other words, there are a number of mistakes founders make at the beginning that can be fixed, such as:
- Setting up the business in the wrong form of entity (e.g., LLC v. corporation);
- Not issuing enough shares to set the company up for a customary capitalization (e.g., dividing 100 shares between the founding team);
- Failing to properly document board approval of corporate actions (e.g., no board minutes); or
- Not implementing vesting schedules on founder equity.
While these mistakes may cost you time and money that could have been avoided, they are all fixable from a startup perspective. They are frustrating for sure, but with a little extra work we can get things back on track.
On the other hand, there are two mistakes in particular that are more difficult to address, to which you should pay particular attention to avoid:
1. Casual or Ambiguous Promises of Equity
Whenever you are considering giving someone equity in your company, think twice (and probably call your lawyer). When cash is limited, founders often resort to promising equity as payment for helping them out. These promises are sometimes made casually via email or text without any binding agreement or further discussion.
For any number of reasons (e.g., the proposed recipient disappears and does not do the work expected, the parties forget about memorializing the arrangement, or the work that seemed so important at the time the promise was made turned out to be not so important), the promised equity never gets issued. Fast forward a couple of years: your startup is growing like crazy and on the fast track to financing, acquisition, or IPO—the individual who received the promise pulls out the email or text and says, "Where is my stock?"
Resolving these types of disputes can be contentious and costly. For this reason, be very careful about when you offer to give someone stock in your company, and make sure you have a binding agreement in place to memorialize the arrangement.
As a related note, sometimes the promise is for a set percentage of the company. Ten percent of the shares just after a startup is founded can equate to a much different number of shares than 10 percent of the shares after a financing or two. Similarly, how should the 10 percent be calculated? For example, would you include the shares reserved for an option plan in the total number of shares? Given the ambiguity that can arise from percentages, we always recommend committing to a fixed number of shares and avoiding commitments in terms of a percentage.
2. Failing to Get Intellectual Property Properly Assigned
In order to ensure that your startup owns its intellectual property, you must be certain that it has been validly assigned to the company in writing from the individual who helped create it. This is not limited to employees—it includes founders, consultants, advisors or any other person who has contributed to the business. If you fail to get a valid assignment when the services are being provided, you can only imagine how hard it is to go get an assignment after the fact when your startup is trying to complete a financing (usually when these issues are discovered) and the person who contributed the IP is no longer around!Some founders mistakenly think this not an issue for them because "intellectual property is only for tech companies." This is a big mistake. A recipe or formula is intellectual property for a food and beverage company. A design for a new office chair is intellectual property for your furniture store. Your business plan is intellectual property. You should always think about intellectual property in the broadest sense of the term when thinking about this issue.
At the end of the day, why are these mistakes so important? First, it will be next to impossible to find any investor who will be willing to invest money into a startup where there is uncertainty as to who owns the company or where there is not clear chain of title to the intellectual property.
Second, if a dispute arises with a third party with respect to these matters, the only way out is to settle. If the mistake is caught early, the cost of settlement may be less punitive, but these claims tend to come out of the woodwork once the startup has established some success. Generally speaking, the more successful the company, the bigger the settlement—sometimes regardless of the validity of the claim.
While these mistakes may seem obvious and avoidable for some, you would be surprised how often they are made. Silicon Valley is littered with stories of well-known startups that have had to pay out enormous sums to resolve these situations. I have personally been involved in attempting to address these issues for multiple startups in the past year.