Top Legal Mistakes Entrepreneurs Make When Launching Startups

18 Jun Top Legal Mistakes Entrepreneurs Make When Launching Startups

High-impact entrepreneurship is not for the faint of heart. Most venture-backed businesses don’t achieve the levels of success their founders and investors hoped for. Indeed, a significant number will fail.

Having worked as legal counsel for dozens of venture-backed startups over the years, what frustrates me most is the number of companies that fail not because of the inherent challenges of creating “the next big thing,” but rather because the founders made some early, simple mistakes that doomed their startup before they ever left the starting gate. Here’s a quick look at some of the common mistakes that entrepreneurs should avoid when launching a new company:

Company Structure Mistakes

Businesses can be organized in any number of ways. The two most common structures for startups are the Limited Liability Company (LLC) and the C Corporation. The LLC is often chosen because it offers certain tax advantages (often more in theory than in practice). Usually, though, going the LLC route is a mistake, at least for startups that expect to court venture capital investors. Professionally managed venture capital funds are generally prohibited from investing in LLCs. Finding this out after the fact is not always fatal; converting an LLC to a C Corp. is usually possible, but it can be expensive and complex if the company has been operating for some time.

Having avoided the LLC trap, many startups then step into a somewhat less dangerous, but still problematic, choice of entity trap: which state to organize their C Corporation in. The obvious choice for most inexperienced entrepreneurs is the state in which the business is physically located. A somewhat less obvious choice is some other jurisdiction that is perceived to offer cost and/or legal advantages. The right choice, though, is almost always Delaware.

There are several reasons for this, but the bottom line is that venture capital investors and the leading law firms that represent them are familiar and comfortable with Delaware corporate law. Most lawyers that regularly represent venture capital investors and their portfolio companies have done their share of “Delaware reincorporations.” I don’t know one that has reincorporated a company out of Delaware.

Bottom line on choosing a business structure? If venture capital is part of your vision, stick with the tried and true: set up a C Corporation in Delaware.

Securities Law Mistakes

It would take a lot more space than I have in this blog to explain the ins and outs of federal and state securities laws-–-that is, the laws that restrict the ways startups can sell ownership shares in their companies to venture capital and other investors (including friends and family). So, once again, I am going to focus on the most common issues that trip entrepreneurs up. Issues that, when mishandled, can result in extra expense, create a situation where investors can demand their money back, and can make it difficult or even impossible to raise capital in the future.

First, there are, broadly speaking, two types of investors in the world (at least for the purposes of securities laws): “accredited” investors (generally, institutional investors and people that earn several hundred thousand dollars a year and/or have a net worth of at least seven figures) and “unaccredited” investors (everyone else).

As far as the law is concerned, accredited investors are generally expected to look after themselves. So long as you don’t mislead them and you answer their questions truthfully, they are generally considered capable of protecting themselves when they invest in your company. On the other hand, the legal powers that be generally consider unaccredited investors incapable of protecting themselves. Therefore, selling shares of stock to unaccredited investors is generally more expensive (you will typically need a private placement memorandum, which is significantly longer and more expensive than the simpler business plan that typically suffices for venture capital investors and experienced angel investors), and ultimately riskier than selling to accredited investors.

Another issue with taking money from unaccredited investors: selling stock to them often makes it more difficult to sell shares to accredited investors in the future. That’s particularly true for professional venture capital investors, who don’t want to find themselves serving as the “deep pockets” behind the company should things go south and the unaccredited investors cry foul.

Thus, the general rule for entrepreneurs looking for venture or other “smart money” risk capital is to stay away from unaccredited investors whenever possible. If for some reason you do talk to unaccredited investors for capital, do it very carefully and with your eyes open to the likely added expense and risk.

Another securities law issue that often bites entrepreneurs is the use of third-party “finders” to assist with fundraising. Typically, their assistance is in exchange for some form of compensation (stock, money, services, etc.) that is tied to a successful capital raise. The fee could be fixed or calculated as a percentage of the amount of capital raised. Simple rule: Unless a “finder” is registered with the SEC, stay clear.

Founder Vesting Mistakes

High-impact startups often include multiple co-founders: two or more people who share ownership of the startup at its inception. While there are myriad ways co-founders can divide their ownership, the simple two co-founder, 50/50 split suffices for the illustration of the all-too-common founder-vesting mistake that often kills deals. Or, perhaps more accurately, let’s call it the founder lack-of-vesting mistake.

In simple terms, vesting is a concept based on the notion that ownership of the company among founders should be based not just on what they bring to the table on day one, but also what each founder is expected to contribute over some period of time. Shares are divided among founders based on initial contributions (capital, idea, etc.) and also as an incentive for each founder to stick around and deliver the goods as the company develops.

Alas, too many co-founding teams forget the “over time” or “sweat equity” part of founder stock. In our example, they each get their half-ownership stake “fully-vested.” That means if, say, 10 days later one of the founders finds a better opportunity, that person gets to seize that opportunity-–-and keep all of his or her founder stock.

The solution? Co-founders should, when they initially divvy up their ownership shares, include vesting of some of their shares in chunks over time, consistent with what they expect their future contributions to be. The details can vary considerably, but a typical situation might be that one quarter of each co-founder’s shares are immediately vested, with the other three quarters vesting in equal monthly portions over two to four years. Upon a co-founder’s premature departure, the unvested shares would be sold back to the company at cost (which is usually pennies per share at most).

Intellectual Property Mistakes

Most startups with venture capital-worthy growth objectives are “know-how” driven—they have a “secret sauce” that gives them a material, sustainable competitive advantage. The secret sauce might include patents, copyrights, trademarks, trade secrets, customer relationships, etc. Many entrepreneurs are neglectful of identifying and protecting critical intellectual property assets, and too many of them don’t figure this out until the damage has been done.

This is not the place for reviewing the finer points of patent, copyright, and other laws regarding intellectual property rights. Besides, most entrepreneurs are smart enough to engage with legal counsel when it comes to the finer points of these laws. The focus here is on some basic blocking and tackling mistakes that get made before entrepreneurs even know they have an issue.

—Assignment of Intellectual Property Rights: Often, the first time an entrepreneur thinks about ownership of his or her intellectual property rights, like the software code he or she has developed, is when a prospective investor asks whether those assets have been assigned to the new company. (No reasonably intelligent investor wants to invest in a company that doesn’t own the secret sauce.)

In the case where the founder owns all of the relevant IP, neglecting to sign it over to the startup is usually no big deal: it is more a loose end that can be tied up as part of the first round of capital investment. But when there are two or more founders involved—or when there are folks other than founders, perhaps people not even involved in the business going forward-–-things can get much more tricky. Persuading someone with no future role at the startup-–-say, a former roommate who helped with some of the early coding-–-can get expensive when the entrepreneur waits until there is serious money at the table, money that won’t stay at the table unless all of the IP has been assigned to the startup. Friends can be quite problematic in these circumstances. Just ask Mark Zuckerberg, the Facebook co-founder and CEO who spent several years mired in expensive legal battles with former Harvard classmates arguing over the origins of Facebook.

The lesson here is simple. If an entrepreneur is bringing any intellectual property to the startup that he or she doesn’t fully own-–-the classic example being software code or designs that some third party had a hand in developing-–-deal with getting that IP assigned to the startup before there is much at stake, and certainly before an investor is willing to write a big check on the assumption that all of the necessary IP has been assigned.

—“Work for Hire” Rules: When you buy a car from your local car dealer, you don’t expect that the car dealer will share ownership with you. Alas, in the case of property subject to copyright law (including software), when you pay someone to write code for you, what you get when the code is delivered is not exclusive ownership but, rather, shared ownership with the coder. Unless, that is, you get the coder to specifically assign his or her ownership interest to you as part of the contract.

The so-called “work for hire” trap has bitten too many entrepreneurs, who only find out after the fact-–-often when an investor asks the entrepreneur who wrote the startup’s software code, and whether the same specifically agreed to grant his or her “creator’s” interest in the software to the entrepreneur-–-that he or she doesn’t have exclusive ownership of the software. Unfortunately, “we both knew what we meant” strategies about ownership seldom work. So be careful when you pay someone to develop software or any copyrightable property for you, and be sure and get the developer to assign his or her rights to the product to you at the front end of the deal. And get the agreement in writing. If you don’t, you will likely find yourself having to pay for the property twice.

Conclusion

This short (well, perhaps “not too long” would be a better description) blog hardly does justice to the numerous legal traps that can trip up entrepreneurs before they even get their startup off the ground. It should, however, give an entrepreneur thinking about starting a company some important boxes to check before proceeding too far down the startup path.