I’ve written before about typical founder mistakes for startups here and here and here, and this is an update with some additional mistakes that I’ve been seeing frequently over the past year.
Forming your startup as an LLC, assuming you can convert to a corporation when you need to.
This happens less frequently today, as there is more information available online, and law firms that operate in the startup space get more sophisticated, but it still happens. In the past, I’ve noted that following this path adds several thousands of dollars in unnecessary cost to the formation process – you may spend $1000 or so to set up the LLC, and then have to spend another $3000 or more to convert it into a corporation. The bigger issue is that you delay the start of your 5-year holding period under Section 1202. The educated startup founder will learn that Section 1202 allows you to avoid capital gains tax on up to $10 million in gains on your “qualified small business stock” when you exit. This can be a massive tax benefit to you, but you have to hold that stock for at least 5 years, and LLC membership interests do not count. So, if you start as an LLC, and then convert after 2 years, you’ve just wasted two years of your Section 1202 holding period. The 5-year holding period doesn’t start to run until after the conversion to a corporation occurs. This has the practical effect of extending your holding period by the period of time during which you had an LLC, and can cost you a lot of money if you exit too soon.
Proposing that stock for advisors or new employees/contractors come from the shares held by the founders, rather than from unissued shares.
This is something that founder clients propose frequently enough that it deserves inclusion in this list. I always shoot down the idea, because of the problems it creates. First, there are potential tax consequences for founders, because they are essentially cashing out their stock. Second, they are reducing their stake in the company. In an exit, where each share of stock is entitled to a specific amount of proceeds from the exit, having fewer shares means you are leaving money on the table, or rather, putting that money in someone else’s pocket. Finally, there are securities law implications, because you are transferring stock that is unregistered. Finding a way to transfer such stock in compliance with federal and state securities laws is a difficult and expensive process.
Enter into negotiations with investors or acquirers, and then sign the term sheet, without involving legal until after term sheet is signed.
I’ve seen this at least 3 times during the past year, and it is not unique to tech startups. Conventional businesses do this too. Term sheets, even though they are “non-binding,” set the substantive boundaries for the terms in your transaction, whether it’s a financing or the sale of your company. By not involving legal in the early stage of negotiating the term sheet, you lose out on getting expert guidance on the terms that should or should not be included, or on how to modify the terms to favor you. Once the term sheet is signed, you have a steep uphill climb to change any of the terms prior to closing. If you’ve negotiated a half-dozen term sheets before, and are sophisticated as to what the various terms mean, then that’s great, but most founders and business owners don’t have that background. Get the help you need and avoid these typical founder mistakes for startups.
Download Y-Combinator SAFE (the post-money SAFE) and issue to investors without involving legal.
This happens frequently (I bet 10 founders did this just as I’m writing this post), and the reason is that Y-Combinator is aggressively pushing founders to do this, telling them that first, the SAFE is free, and second, you can trust Y-Combinator. Too many founders, however, are using the “post-money” SAFE without understanding how excessively dilutive it is for them compared to the original SAFE, and quite frankly, without understanding any other terms of the SAFE. And let’s be clear, “SAFE” is a misnomer – it is not a simple agreement by any means. Downloading and using a complex legal document without understanding its provisions is the business equivalent of playing with a gun, without checking to see if it is loaded. These founders also don’t understand the true role that Y-Combinator plays. It is not some founder-friendly accelerator with your best interests at heart. Y-Combinator is fundamentally an investor, that’s how it makes its money. Therefore, its interests are aligned with investors, not founders. The other problem with downloading the SAFE and issuing it to investors without involving your lawyer is that you are most likely violating securities laws on both state and federal levels. The SAFE is a security, like stock, and if you issue a SAFE to an investor, you must find federal and state exemptions for registering that SAFE. Failure to find a proper exemption jeopardizes your company, giving the investors the right to demand their money back, and possibly subjecting your company (and you) to civil and criminal penalties. Is that really worth it for that $5000 investment from that guy you used to work with?