Common Legal Mistakes Founders Make and How to Avoid Them

Startup lawyers Josh Rottner and Pat Mitchell share 5 legal mistakes founders make and how to avoid them.

Source www.simpsonsworld.com

By: Josh Rottner & Pat Mitchell, Cooley LLP

This post is part of “A Rough Draft of the Legal Basics,” a series covering the legal basics every startup needs to cover.

As startup lawyers, we’re often asked about the most common legal mistakes that founders make. Now that our series has covered what founders can do right, let’s pause to discuss common things founders do wrong, so you can avoid making these mistakes yourself.

Mistake #1: Waiting to form your company and to formally issue equity to the founders.

Issuing equity can be taxable, particularly if the recipient pays less than fair market value for the equity. The longer you wait to issue the founders’ equity, the more the fair market value of equity may increase (presumably its value goes up as you work on the business). That means the tax burden may increase, too.

Avoid it by: Issuing equity as soon as possible

  • We recommend issuing equity as soon as possible when its value is lowest.
  • In certain circumstances, the tax laws have special rules that must be followed when determining what the “fair market value” of equity is.
  • Always talk to a tax adviser and your legal counsel when issuing equity.

Mistake #2: Hiring people to do work for your company without requiring them to sign inventions assignment agreements.

Inexperienced entrepreneurs often overlook Confidential Information and Inventions Assignment Agreements (CIIAA) because they either assume that their company owns the rights it needs just by hiring the employee or they’re simply pre-occupied with the startup grind.In many circumstances, that leaves individual inventors, not the companies that they work for, owning the intellectual property that they create.

This can create a whole host of problems which are likely to come up when an investor or buyer is conducting due diligence on a company. For example, investors and buyers will often require a company to go back and have all employees or consultants that haven’t previously signed a CIIAA or other inventions assignment agreement sign a new one as a condition of the investment or acquisition, whether or not that employee or consultant still works with the company. If a team member who didn’t sign a CIIAA has since left the company, that former (and potentially hostile) team member could hold the company hostage by refusing to sign, making it difficult for the company to complete the investment or sale.

Avoid it by: Requiring CIIAAs

  • Cover your ground by requiring that all employees sign CIIAAs at the very beginning of their employment. At minimum, these agreements should include language expressly assigning the company all of the employee’s rights in the intellectual property that the employee creates during his or her employment, and a confidentiality provision requiring the employee to keep the company’s proprietary information secret.

Mistake #3: Starting a company or hiring a person to work for your company without first checking for conflicts with current or prior employers.

Since CIIAAs contain provisions assigning intellectual property to the employer, a potential new hire’s current or prior employer may have a claim to intellectual property or ideas that your business wants the new hire to use. Technology and life sciences companies often also require their employees to sign non-competition and non-solicitation agreements.

This is particularly problematic for founders. If a founder comes up with the idea for their company while working at their former employer, the former employer may own the intellectual property rights to the invention, calling the very foundation of the company into question.

This is an area of particular risk: claims that an employee violated inventions assignment, non-competition, non-solicitation and non-disclosure obligations to former employers is a frequent subject of litigation among companies.

Avoid this by: Looking into CIIAAs, non-compete, and non-solicitation agreements

  • Protect your company by looking into all co-founders’ and new-hires’ existing employment agreements, including CIIAAs, non-compete, and non-solicitation agreements.

Mistake #4: Issuing equity to the founders without discussing the proper equity ownership and vesting schedule for each founder.

Sometimes in their haste to get started, founders don’t stop to think carefully enough about how to allocate equity among themselves or don’t want to have difficult conversations about equity allocation with their co-founders.

Re-allocating equity among the founders after initial equity issuances can involve tax considerations that may put founders in a worse position economically than they would have been had the equity been allocated in the desired manner from the beginning.

Founders also shouldn’t overlook vesting — how would you feel if you are foregoing a higher salary job to work on your startup and one of your co-founders leaves the company for a lucrative position and gets to keep all of her or his equity after leaving?

Avoid this by: Having Difficult Discussions about Ownership and Including Vesting

  • Avoid potential problems by taking a moment to think carefully about proper equity ownership before starting your company, and having the sometimes awkward conversations with your co-founders about the right ownership percentage for each team member based on their relative contributions to the company, both historically and going forward.
  • If there is more than one founder, we strongly recommend vesting for everyone.

Mistake #5: Not taking the time to put all agreements in writing and/or glossing over corporate formalities.

A common claim is an uninvolved party stepping forward asserting that the company “promised” them a certain percentage of the company, and has emails or other correspondence to prove it. This can be costly to the company and the founders, and derail a potential investment sale.

Investors and acquirers will do extensive legal due diligence before a significant investment or acquisition. If a paperwork error or omission is important enough, then the investor or buyer may walk away from the transaction. Even if the error or omission doesn’t rise to that level of importance, they will often require that the company cleanup the issue before the transaction closes. Ensuring that your company has the proper documentation can increase transaction certainty and avoid very costly cleanup in connection with an investment or sale.

Avoid this by: Always documenting your agreements in a written contract

  • Do not promise anyone equity, except in a legal agreement that clearly sets out the rights and obligations of the company and the recipient, including vesting.
  • Be sure to involve your corporate lawyers each time the company issues, or a stockholder transfers, equity. There are corporate formalities that must be observed and if they are not followed in the proper order, then the intended issuance or transfer may not be deemed to have been completed, which could result in tax issues similar to those discussed in mistake 1 above.
  • Use clearly drafted, written agreements for all important understandings with your co-founders, employees, and other business partners.

Background on the series “A Rough Draft of the Legal Basics”:

As start-up lawyers, we spend our days working with talented, passionate and courageous entrepreneurs creating cool things. Our clients are on the cutting edge of software, social media, energy, ecommerce, robotics and space exploration. As companies mature, they face a variety of legal issues depending on their industry, strategy and stage of development. But at the very beginning, almost all start-up clients have similar legal needs and tend to ask the same questions.

We have advised many companies (including some in the Rough Draft program) on these basic legal questions, and will be sharing our answers with the Rough Draft community in a series of posts on this site, of which this is post number 5. Click below for previous installments of this series:

Part 1: Forming a Legal Entity

Part 2: Issuing Equity to the Founders — Initial Concepts

Part 3: Issuing Equity to the Founders — Important Tax and Intellectual Property Considerations

Part 4: Building Your Team