4 Big Legal Mistakes That Startups Make
Legal stuff you need to know
Since starting LawTrades, and especially thinking about the point where we have worked with a few dozens startups to get their legal work done, I’ve reflected on some of the biggest legal mistakes that they’ve made and later regretted.
When you start a company—especially during the early days when you don’t think that it will amount to anything—legal is probably the last thing on your mind. But not buttoning-down on legal issues from the start can have crippling consequences when your startup starts succeeding. So here’s a few things to keep in mind and consult with a lawyer about:
Mistake #1: Forming the Wrong Corporate Structure
Incorporating your startup at the early stages can be thought of as the nuts and bolts to keep your business machinery running. But in order to pick the right entity, you need to first ask yourself whether you are raising outside capital or not. If that answer is yes, then you almost certainly should be a Delaware C-Corp. Investors prefer this because they are structured both for large entities and external investment.
LLC’s are not geared for startups for a number of reasons: (1) VC’s hate pass-through entities ( meaning that the taxable profits or losses for the business are passed through to the business owners, who record these as part of their personal tax filings); (2) the tax partnership rules are very complicated; (3) it doesn’t allow for stock option plans, convertible notes, etc., (4) it gets more costly and complicated down the road.
But why Delaware? Delaware has an efficient court system that favors businesses and corporate law. There’s also more administrative ease than other states and generally just establishes a level of credibility with investors and potential partners.
Mistake #2: Not Managing your Intellectual Property Ownership Appropriately
Be careful when working on your startup while you’re still employed by another company. Your employer may have rights to your intellectual property/invention if you’re using your facilities and resources to further your business.
Also, get used to using what’s called the Confidential Information and Invention Assignment Agreement. It basically ensures that any developer or co founder that worked on coding or designing the site, assigns their rights back to the company.
Think about it this way: if the Winklevoss twins made Zuckerberg sign this agreement before he started coding “HarvardConnection”, Facebook might look very different today.
Mistake #3: Not Doing Proper Research on Potential Investors
You are essentially married to your investors for a number of years once you accept their money — so you must do your due diligence on them and make sure they’re a right fit for your company. There’s no real science to it. Get references from other founders who have done deals with them, grab a beer with them, or simply just Google the firm and find out about their past investments.
Are they down to earth or total dicks? Do you see yourself counting on them? Will they be there in the trenches with you? Do they share the same vision as you? How did the treat their other portfolio companies.
Mistake #4: Not Creating a Vesting Schedule
Vesting schedules should be created in order to protect the other co-founders (VC’s often require it too). You don’t want one founder walking away with 25% of the company after he gets bored and wants to work on something else.
The typical vesting schedule is four years and set up on a monthly basis. A one-year cliff is appropriate if you don’t know your co-founder. Up-front vesting is also possible and you should talk to your startup lawyer about filing the 83(b) election — failing to make a timely 83(b) election with the IRS is something that could lead to disastrous tax consequences for a startup company founder or employee.
Questions? Say hi @r44d. If you’re thinking of starting a company or already started one, drop me a line at raad (at) lawtrades (dot) com. We’re a startup as well and love helping other startups navigate the legal process.
