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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