In this post, I wrote about the first five out of ten common startup mistakes. Now I will continue with the next five common startup mistakes.
Number 6 – Ignoring Securities Laws
When a startup raises money, it has to comply with the securities laws. The Securities Act of 1933 specifies that a company cannot issue stock without registering that stock with the SEC, unless there is an applicable exemption. There are exemptions for private sales of securities, but these exemptions have various requirements that must be satisfied. When seeking investment from an angel investor or a VC fund, it’s crucial that the startup work with an experienced, knowledgeable lawyer, who can guide the startup through the process. It’s also a good idea to work only with “accredited investors,” who are more likely to understand the kind of investment they are making, and better able to withstand losing their entire investment. Failing to comply with securities laws can give investors the right to get their money back, and can create serious civil and criminal liability on the part of the startup and its executives.
Number 7 – Failing to Protect Against Angel Investors and VCs
Angel investors and venture capital firms are in the business of investing in startups. It is something they do every day, while startups engage in financings only occasionally. Consequently, investors bring a much higher level of experience and sophistication to the process (no insult to startups intended). Startups that fail to understand this imbalance risk getting taken to the cleaners, but there are things startups can do to protect themselves. First, you need to investigate your potential investors, to make sure there is a good fit between the investors and the startup. Second, create a competitive environment, where the investors have to compete with other investors for the opportunity to become part of your startup. You will get more favorable terms that way, although you have to recognize that mishandling the competition could result in all the investors walking away. Third, you have to be willing to walk away, too. If the terms aren’t right, if the investor isn’t a good fit, walk away from the deal. The consequences of a bad deal can be worse than you imagine. Fourth, understand every aspect of the deal. The terms don’t just include the financial terms like pre-money valuation and conversion discount. There are numerous complex legal terms that may seem like boilerplate to you, but they can have a big impact on your company and your equity stake. Which leads to the fifth item, which is get your own lawyer to represent you and explain all these terms to you. Don’t rely on using the investor’s lawyer, or even a lawyer recommended by the investor. That lawyer will have a big conflict of interest, because he or she will not want to alienate the investor and future deal flow from the investor. You can read more about this subject here and here.
Number 8 – Putting Off Developing Proper Management Structure
Many startups have flat organization structures, by design and preference. This may be acceptable at the early stages, but as the business grows and the headcount increases, so does the need for more structure and process. An employee handbook may seem unnecessary for a startup when there are only 3 or 4 employees, but when the hiring rate increases, a handbook is an important tool for communicating the desired culture and for setting expectations. It is also important to develop and communicate policies on harassment and discrimination, including processes for raising complaints. Clear policies in this area will help foster a productive work environment, and will help protect the company from liability. Another consideration in the HR area is creating a bring-your-own-device policy. If employees are doing company work on their own laptops, tablets, and smartphones, does the startup have procedures and policies in place to ensure data security and protection of its intellectual property? I work out of a co-work space where there are lots of startups, and I would guess that every one of them has employees and founders that use personally-owned devices. I would also guess that none of them have policies or technology in place to manage these devices (hint hint). You can read more about BYOD here.
Number 9 – Issuing Stock Options Without a Formal Stock Option Plan
Stock options can be an important compensation and recruitment tool for cash-poor startups. Stock options are securities, however, and failure to observe the formalities when issuing stock options can violate the securities laws. A company will need to reserve an option pool and create a formal stock option plan. Options will need a Section 409A valuation. Shareholder and board of director approval will be needed for all of this. There are legal and tax complexities, and a startup should consult an attorney before moving forward with stock options.
Number 10 – Failing to Consider Privacy Issues
Thank you for reading, and I hope you found it informative. If you are running a startup (or thinking about it), I hope this post gives you food for thought.
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