Ten Common Startup Mistakes – Part 1

Today seems like a good day to tie together a number of subjects I’ve written about in the past, as a list of the Ten Biggest Legal Mistakes Startups Make. Here are the first five:

Number 1 – Choosing the Wrong Form of Entity

All too often, I encounter startup founders and would-be founders that reflexively think they need to set their company up as an LLC (a limited liability company). So I ask them, “are you thinking about getting venture capital funding?” If the answer is yes, then right away I tell them they need a C corporation, because venture capital investors will not invest their money in LLC’s. This isn’t some well-kept secret, either. A simple internet search on the subject will quickly show that VC’s require that the startups they invest in be set up as corporations, and preferably, Delaware corporations. So it is always frustrating to me when someone has wasted time and money setting up an LLC, when he or she really needs a corporation. Even more frustrating is when that founder had a lawyer set them up with an LLC; that’s sloppy lawyering, at best. Aside from the VC issue, I find that the corporate structure is generally simpler and easier to work with than LLCs, which are really jumped-up partnerships with complex tax issues. Many startups want to compensate employees with stock options, but options are a corporate concept. You can’t do stock options with an LLC. Finally, the dreaded “double taxation” you get with corporations is not really an issue for startups, because they generally don’t have profits and aren’t making dividends.

Number 2 – Failure to Split Founders’ Equity Properly

Following fast on the heels of picking the wrong entity is failing to properly split up the equity among founders. I’ve written a full post about this subject, so I’ll just write a brief summary here. Founders often just reflexively split the equity into equal shares. The truth is, different founders contribute differently to the startup. Some of those contributions are more valuable than others. It is an uncomfortable and difficult discussion, however, and while opting for equal shares seems like an attractive, less controversial alternative, the discussion is going to happen sooner or later. Better to have it happen sooner, before issuing founders shares.

Number 3 – No Vesting or Buyout Provisions

It is very common for startups to fail to include vesting and buyout provisions that apply to founders’ equity. This is particularly the case when the founders go cheap and use DIY services like LegalZoom to set up their corporation (or worse, their LLC). Everything might seem warm and fuzzy among the founders when starting out, but over time, frictions arise or someone gets burned out, and a founder leaves. What you don’t want is for that founder to leave with all her shares. By vesting those shares over time, and having the option to buy back vested shares at a nominal price, a startup protects itself against having an ex-founder out there with 40 or 50 percent of the ownership. You can read more about this subject here.

Number 4 – Forgetting the 83(b) Election

When you have founders’ stock or stock options that vest over time, you want to make sure that you do a timely 83(b) election. This is one of those wonky tax issues, and you can read more about it here, but I’ll give a brief rundown. When you receive stock that vests over time, you recognize taxable income as the stock vests, because in theory, that stock has increased in value since it was originally granted. The 83(b) election allows you to recognize income on the increase in value at the time you receive the stock, rather than when it vests. There should be minimal increase in value (if any) at that earlier point in time, so there should be almost no tax liability. You have to make the 83(b) election within 30 days of receiving the restricted stock or stock options, however. Not 31 days later. Not 50 days later but I can pay a penalty. Thirty days. Failing to do this can be a huge and costly mistake. Don’t make it.

Number 5 – Failing to Lock Up Intellectual Property

It is crucial for startups to lock up their intellectual property at every opportunity. When setting up the startup, one or more founders may have developed IP that is important to the enterprise. The startup should have the founder execute an IP assignment agreement in exchange for receiving her founders’ shares. By doing so, the startup now owns the IP, and if the founder leaves, she can’t take the IP with her. In addition, other employees may be developing IP for the company, and they should all execute contracts that specify that the IP belongs to the company, not the employee. Finally, if some of the founders are still working “day jobs” at other companies, it is important to review their employment agreements with those other companies. IP that they think they are developing for the startup may actually belong to the day job.

Those are the first five common startup mistakes. The next five will be in Part 2, which is here. Thank you for reading!

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Startup Checklist

In previous posts, I have provided a lot of information on various aspects of getting a startup company established. I thought it would be useful to put a lot of that information in one post, as a startup checklist. So here we go…

1. Review your employment agreement – before doing any substantial development work, founders who are maintaining their day jobs should review their employment agreements (and this could include employee handbooks, etc.) to ensure that there are no conflicts with the startup. In particular, a startup founder wants to make sure that any IP she develops will belong to her startup, and not to her day job. It’s a good idea to have a lawyer take a careful look at employment agreements and policy statements.

2. Decide how you will split the equity among the founders – while equal shares might seem easy and uncontroversial, it may not be the best, fairest way of splitting the equity.

3. Form a corporation – if you have any aspirations of seeking angel investments or venture capital funding, form a corporation, not an LLC. And form it in Delaware. You might think forming an LLC is cheaper or easier, and you will be wrong. You will end up needing a corporation anyway, and will waste time and money fixing things that should have been done right the first time.

4. Adopt bylaws – once you have filed your certificate of incorporation, you will need to adopt bylaws to govern the management of your new company.

5. Appoint a Board of Directors – You will need one or more directors to oversee management of your company. The directors can now approve various resolutions to get the company operating.

6. Enter into a shareholders agreement with vesting and buyout provisions, and issue stock – you will want to have vesting provisions in place from the start, in case any founders leave the startup. Otherwise, you will have an ex-founder wandering around outside the company with fully-vested shares. Also, make sure each founder receiving shares files an 83(b) election with the IRS at the time you issue shares. Let me repeat that in boldface, because it is really important: make sure each founder receiving shares files an 83(b) election at the time you issue shares.

7. Assign IP to the company – at the time of issuing shares, make sure that all founders assign to the startup any IP they are creating. This will be part or all of the payment for their shares, depending on the situation.

8. Qualify to do business – You will need to qualify to do business in whatever state your principal location is located in, unless you are located in Delaware (see number 3). This is fairly easy to do; you just file some paperwork and pay the state a fee.

9. Stock options – do not issue stock options until you have a proper stock option plan in place, approved by the board of directors, with a Section 409(A) valuation of the stock options. This doesn’t necessarily have to be done at the outset, but there are advantages to doing it before entering into negotiations with VC’s over a Series A round.

10. Employment/consulting agreements — if you are going to hire employees or use outside developers, make sure they sign agreements specifying that any work they do for the startup is the property of the startup.

11. Comply with securities laws – just because you are not a public company does not mean that you are exempt from the securities laws. This is a complex area, with many risks and pitfalls. Definitely consult a knowledgeable lawyer in advance, and preferably each step of the way. Only seek funding from accredited investors; it will make your life much easier. There are no friends-and-family exemptions from the securities laws.

All of the above items are essential to making sure that your startup has a smooth path to growth. If you omit any of the above items, you jeopardize the well-being of the startup, and create many headaches and costs downstream.

Follow me on Twitter @PaulHSpitz