When you were a kid, did you ever get so excited about a new toy that you rushed to put it together, tossing the instructions to the side? Then you realized you missed a few steps and it suddenly became infinitely less fun?
That’s what it is like for startup founders who forgo proper legal standards in the rush to get their product or service to market, only there is a lot more at stake. When correctly implemented, the law will help you protect your business and the people who helped build it. As a founder you will be making legal decisions as you build your startup and throughout its lifespan.
“As a whole, the startup operating philosophy that seems to prevail is do something first and ask for forgiveness later, if necessary,” said FlightCar co-founder Kevin Petrovic. While that can work, it’s better to do some reasearch and get to know the space. Just because you can survive a crash landing, doesn’t mean we should make it the model for modern aviation.
Getting ahead of legal issues early can help you avoid potential pitfalls down the road. Here are some best practices if you want to stay on the right side of the law as a startup founder.
Do a founder prenup
Often times, as a startup founder, you will be going into business with other people; and, sometimes, those people will be your friends. It’s impossible to know everyone’s motives before hand, and you probably don’t have a crystal ball that will tell you if someone’s attitude will change down the line.
One of the first things you need to address is often the hardest — the legal elephant in the room that is making sure the deal is crystallized among the founders. Peyton Worley, a partner at Cooley LLP who works with startups, calls this the “founder prenup.”
The founder prenup is, “Where all of the founders agree on the terms of their stock, their ownership, and vesting; and agree on what will happen if a founder is no longer pulling their weight in the company and needs to be let go,” Worley said. This also has to do with what percentage of their stock will vest, and whether their termination was with or without cause.
Founding teams like to believe that the startup journey is a rite of brotherhood and sisterhood and that, as long as they have each other, nothing else matter. It’s true that your team is the most important part of your startup, but you have to protect yourself and your teammates from unforeseen complications that can arise from shoddy equity agreements or an undeveloped vesting plan. Much like a relationship, it is best to get everything out in the open at the beginning. It is also important to decide how each team member will add value and how shares will vest. Andreas Stavropoulos, a managing director at Draper Fisher Jurvetson, recommends a vesting schedule.
“Issuing shares without vesting seems like it’s helping the founders but can actually hurt the business if (as it happens often), the founders decide to part ways. Having a vesting schedule avoids having to have a negotiation about what is fair equity compensation for the departing founder,” Stavropoulos said.
As you set out to build your brand, it may seem common sense to make sure the name of your business is available where you are located. But, you should also make sure that it hasn’t been targeted by any competitors and that it holds no connotation to something that already exists in the market. Knowing that you are starting with a clean slate, and are going into it with no contention, makes it easier when you go to build your brand.
“I would advise people to be careful when choosing a brand identity. The further along you’ve been, and the more progress you’ve made, the harder it is to change your trade dress and the easier it is to lose your brand value,” Petrovic said.
Choosing a name for your startup is not something that should be taken lightly. A bad name can end up costing you millions of dollars if it keeps people from adopting your product or service. While you want to make sure it is a name you love, you also want to make sure it tells your story and doesn’t sound too much like something else that is already out there.
Incorporating: Making the right choice
Each business will have different legal needs. This article is not intended as a catch-all for every business in every industry. Be sure to look into industry specific-legislation and regulations that may affect your business. With that being said, there are some general issues that can be considered by most startup companies.
When founders set out to establish their business, one of the most confusing questions can be whether to choose an LLC or corporation for your business structure. Josh Green is the Chairman of the National Venture Capital Association (NVCA) and a general partner at Mohr Davidow Ventures, and before that he was a startup lawyer in Silicon Valley for 25 years. Green asserts that, while many founders opt for LLC to better handle failure and get tax benefits, it might not be the best route.
“The LLC, on the surface, has attractive benefits, like being able to absorb the losses in the beginning. But, long term, as you go out and seek venture capital, it actually will work against you,” Green said. “The reason for this, is that Venture Capitalists are generally prohibited from investing in LLCs. As a result, you will have to convert the LLC to a c corp at the time of the venture capital investment. And the legal fees will likely exceed the benefit of being able to deduct the losses in the LLC.”
Incorporating as a C corp means that your business will exist as a taxable entity, meaning that your business will pay taxes. An S corp is a corporation that has taken an s-election that gives you tax benefits similar to an LLC, but also greatly restricts the type of investors you can have and places a restriction on your shareholders as well.
“I think if anyone wants to raise outside capital, incorporating as a Delaware-based C corp is the simplest solution and it will eliminate any possible issues down the line,” Petrovic said.
Consider intellectual property
When it comes to the idea that the business is built on, founder should make sure they are not in violation of any non-compete agreements or in violation of intellectual property (IP) rights. Much of this will be determined by where you are coming from as an entrepreneur. If you are leaving a company where you developed a software, or spinning out from another project, pay close attention to who can claim ownership of the IP.
Once you have determined that you own the IP, you need to cede ownership of it so that it can be owned by the company. Peyton Worley, partner at Cooley LLP said you must make sure you transfer it from a personal asset to a company asset.
“Make sure that any of the ideas or IP is conveyed into the company. Make sure it goes from the individual to the entity,” Worley said.
The issue this presents is that someone who owned the IP can leave and take it with them. So, if you have a disgruntled co-founder, they can leave the company and it wouldn’t legally be able to continue operating with that IP as the foundation of your business. Look into having a lawyer draw up a technology assignment agreement so the business is protected.
“Make sure it is something that is thought about for your product, your space, and your company. That is your contact with the public,” Worley said.
Choosing a startup lawyer
The majority of entrepreneurs are self-starters, so the decision to hire a startup lawyer is often a contested one. While the do-it-yourself attitude is admirably, the law is not something that should be taken lightly, and a good startup lawyer will free you up to focus on things like gaining traction and customer retention. So, put your ego aside and hire a lawyer.
You can’t get to a lawyer too early. You need to establish a relationship with a lawyer before you seek funding, maybe even as soon as you have an idea. When it comes to finding a startup lawyer, David Greenberg, the CEO of Updater, said that it’s all about who you know.
“It’s all about referrals. Speak with founders of other businesses that you trust, ask who they use, and don’t forget to ask if they are happy with their representation,” Greenberg said. “Your startup lawyer should primarily focus on early stage corporate and venture law. It’s never a good idea to hire a friend or someone that your investors recommend – conflicts of interest are possible in both of these situations.”
He went on to add, “You never want your lawyer learning something new while representing you. Your lawyer will not be efficient and cost-effective if they are learning as they go. Therefore, your startup lawyer should have experience representing other startups at a similar stage as yours.”
According to Hrach Simonian, a principal at Canaan Partners, “Go with a firm that understands startups and specifically Silicon Valley law. Nothing more annoying than dealing with off the beaten path firms that are clueless on standard silicon valley terms and delay your financing as they educate themselves, on your dime.”
Some startup experts will recommend partnering with a second lawyer to handle all of the financial law regarding funding, but it’s not always necessary because many startup lawyers are well-versed in the financial aspects of launching a company. Just remember to always involve your lawyer anytime money is on the table.
“Speak with a lawyer before you take investment money,” Worley said. “Because the terms under which you take that money may be much more onerous than it would be if you spoke with a lawyer first.”