The legal jargon surrounding startups is expansive: LLC agreement, S-corp, nonqualified incentive stock options, flow-through taxation, liquidation preference, Regulation D, shareholder derivative lawsuit, and the list goes on.
The reality is that legal issues for entrepreneurs can range from engaging, to confusing, to a significant business hurdle if things go wrong. This article aims to highlight six best practices that will help you avoid common pitfalls encountered by startup entrepreneurs.
1. Use written contracts. Contracts can be boring and difficult to read, but you should learn the basics of contract review if you plan on building a successful business. Written contracts protect you and your business partners (and can also impose significant obligations).
Memorialize agreements between yourself, other founders, investors, employees, customers and suppliers in writing. All too often one person’s recollection of an oral agreement will differ materially from another person’s recollection of the same arrangement.
Having a memorialized writing that clearly lays out the terms of any business arrangement avoids potential “he-said / she-said situations” and allows the parties to focus on growing the business.
2. Clarify founder arrangements upfront. Founders coming together to form new startups have several issues they should address. Who is contributing money? Who is contributing intellectual property? What percentage of the company is everyone getting? Are shares subject to vesting or buyback rights? What about restrictions on transfers of shares? Does the founder/developer own the intellectual property the business will utilize? What happens to a founder’s share of the company if the founder decides to leave (or is forced out)?
The details surrounding the “deal” between founders can quickly become overwhelming and easy to push to the side when everyone is keen on pushing the business forward. However, it is important to avoid distracting misunderstandings by hashing out the business arrangement between all founders as early as possible and in as much detail as possible. While having an agreement among the founders is ideal, discussing these issues and coming to an understanding is essential.
3. Protect IP from the outset. You may be developing the latest medical device or starting a boutique media consulting firm, either way your intellectual property (“IP”) will be an important part of your business that needs to be protected from the outset. IP can range from a patent, to a trademarked business name or slogan, to a copyrighted business logo, or even a trade secret.
Protect your IP from the outset by requiring all founders contributing IP to the startup to execute agreements assigning the IP to the company and including IP assignment provisions in all employee/independent contractor agreements. Additionally, you should perform due diligence on any IP being contributed to the company to confirm that the person contributing IP actually owns it.
4. Plan ahead for employee equity. As your business grows you may consider issuing equity to key employees as incentive compensation. Employee incentive equity allows you to attract, retain, and motivate employees to make important contributions to your company. While it may be a cashless incentive, you must keep in mind that granting incentive equity is not free.
Incentive equity will affect your cap table and will result in dilution of your interest in your company when the securities granted vest and are exercised. Plan ahead by allocating a set pool of equity for key employees with vesting and other restrictions that align with the company’s interests.
5. Take the smart money. If you are building a successful business, you may have the opportunity to bring in outside investors. Outside capital can provide funding to help you take your business to the next level. However, you should make sure you take on the right kind of outside investors. The best outside investors can offer not only capital but can be partners and mentors in growing your business by serving on your governing board, offering guidance and advice, and making business connections on behalf of the company.
Before taking on outside investors you should carefully consider whether a potential investor’s goals are aligned with the success of your company and whether the investor can (and is willing to) offer value-added contributions other than money. You may find that the non-money contributions are more valuable than the funding itself.
6. Be prepared for legal complexity. As your business grows, the legal issues you face will evolve. You may decide to hire employees, raise additional capital, acquire a competitor, or be acquired. As your company undertakes these major events, you will face increasingly complex legal issues.
For example, raising additional capital may trigger certain obligations under state and federal securities laws, and participating in an acquisition (either as the acquirer or the target) will give rise to complex contractual issues. You should be aware of these potential complexities so that you can better assess the appropriate time to involve your legal and other advisers.
John Goodlander and Matt Benson are corporate attorneys with Cook, Little, Rosenblatt & Manson in Manchester. Goodlander has experience counseling businesses in connection with business formation and entity selection, mergers and acquisitions, equity and debt offerings, and corporate governance.
Benson represents entrepreneurs of all types and at all stages of their businesses, from startup to exit.