FAQ

Entrepreneurs like you dream big. Whether you want to enhance the way businesses connect with their clients or increase the efficiency of ordering products online, entrepreneurs set out to change their communities and sometimes even the world with their big ideas. But running out of cash can squash these dreams before you even start – learning about financing a startup business is just as important as effectively running one.

In fact, about 38% of startups fail due to a lack of funding or failure to raise new capital—the number one cause of startup failure. Financing a startup business may seem straightforward, but it’s a convoluted process, not a do-it-yourself project. Businesses must follow federal and state securities laws and SEC guidelines when raising funds, which are often complex and confusing. Not following these guidelines can put you at risk of losing funding along with the business you’ve worked so hard to build.

That’s why it’s essential to enlist the guidance of a startup financing lawyer like Paul Spitz, founder of Kinetic Law, who helps entrepreneurs seal the deals they need to move forward. Paul Spitz has years of experience helping business owners raise the capital they need to leverage and scale their businesses. Therefore, working with an experienced startup financing lawyer will give you the support you need so you can focus your efforts on creating a scalable, viable enterprise.

Before Talking to Investors

The idea of financing a startup business with investors’ money may initially seem exhilarating. But unfortunately, excitement doesn’t change how risky a deal with an investor can be without the proper knowledge, guidance, or support. Because risks are hidden under the surface, business owners must do their due diligence before diving in. So, before seeking financing from investors, here are some key factors worth familiarizing yourself with to ensure the success of your fundraising endeavors.

Researching securities law. For starters, business financing efforts must comply with federal, state, and SEC laws and guidelines. Failure to comply with these laws can lead to civil and criminal penalties, and could kill your business. Because of the complexities of these laws, it’s wise to have a knowledgeable startup financing attorney by your side. This way, you can ensure you adhere to all financing guidelines and avoid future adverse consequences.

Choosing the appropriate investment vehicle/option. While there are plenty of methods to raise capital, it’s crucial to select the most appropriate option for your situation. Not selecting a suitable investment vehicle could cost you control of your company and a lot of money in legal fees. Here are several common investment options entrepreneurs use when fundraising.

• Convertible notes are excellent for business owners raising less than $1 million. They become equity through a future triggering event (typically an equity financing) and the legal fees to close a round are relatively low. Plus, you can postpone equity valuation, giving your business time to grow. The drawback is convertible notes are debt, with a maturity date by which you must either repay the invested amount plus interest, or negotiate an extension with your investors.
• Simple Agreement for Future Equity (also known as SAFEs) also typically finance endeavors under $1 million. They don’t have an interest rate, but they convert to equity through a future triggering event. Plus, they are affordable. There are several versions of SAFEs, and you should work with an attorney to choose which one is best for your company, rather than just downloading something from the internet. Post-money SAFEs can cause excessive dilution, a possible problem for founders. In other words, the founders risk losing control over their company if there is too much equity dilution. Fortunately, Kinetic law has a SAFE version that avoids this complication.
• Preferred stock can be a suitable investment vehicle for founders raising over $1 million. Preferred stock gives investors more rights than common stock. As such, it is attractive to investors but can incur expensive dividend payments. On top of that, it’s often highly complex and detailed. Because of the time and expertise required to formalize the deal, legal fees are typically much higher than for convertible notes and SAFEs.

Selecting suitable accredited investors. Lastly, talking to the right investors is vital. Ideally, you should work only with “accredited investors” – investors that have a net worth or annual income above a specified level. Because accredited investors have a special status under SEC regulations, you don’t have to jump through hoops to land the deal. For example, if you work with non-accredited investors, you must put additional disclosures in the financing agreement, which is time-consuming and can rack up your legal bill.

Negotiating a Term Sheet

A term sheet is a non-binding document that summarizes the terms and conditions of the deal between you and the investors. It irons out the agreement’s details before placing those terms into a legally binding contract.

Not understanding the provisions of the term sheet can result in a founder agreeing to terms that are unfair, or inappropriate for the size of the deal. By having an experienced, knowledgeable startup term sheet attorney on your side, you can ensure you get the most out of the agreement and don’t give away too much.

For example, let’s say the investors added a term suggesting your company pay up to $60,000 in legal fees to the investors’ attorney to complete the transaction. If this term sheet is your first rodeo, you might not know if this is excessively high (it is!). Partnering with a knowledgeable startup lawyer ensures you know what’s fair and what isn’t.

Additionally, many founders assume that because investors and business owners have the same objective when negotiating a term sheet, using the investor’s lawyer will be fine. However, investors are pros when it comes to making deals. They look at term sheets monthly and have seasoned attorneys who know their way around deal negotiations when financing a startup business.

In addition, the investor’s attorney has an inherent conflict of interest, and cannot truly represent both the startup and the investor (no matter what they tell you). These dynamic puts startup founders at a disadvantage right off the bat if they choose to use the investor’s attorney, or even an attorney recommended by the investor. Therefore, having an experienced startup attorney on your side of the table will ensure terms are favorable, and the deal benefits all parties.

A knowledgeable startup lawyer like Paul Spitz can help you determine favorable terms and avoid the financing pitfalls of the entrepreneurs before you. This way, you can focus on growing your business and achieving your dreams.

Drafting and Negotiating the Investment Documents

After the term sheet has been signed, your startup lawyer will begin drafting and formulating the legally binding contracts. While the term sheet provides a blueprint of the terms and conditions of the final agreement, the investment documents will go more in-depth and provide the detailed terms of the arrangement.

The type of transaction will determine the amount of paperwork involved. For example, convertible notes and SAFE financings usually only need one relatively short document – the convertible note or SAFE itself. On the other hand, preferred stock financings require numerous, complex investment agreements.

But, no matter which investment vehicle you use, the terms and conditions can make one’s head spin, even for an experienced founder. A practiced startup lawyer like Paul Spitz understands these complexities and can easily explain them to founders who may be encountering them for the first time. Startup attorneys can break down legalese into understandable language, so there are no surprises down the road.

After pouring everything into growing your company, the last thing you want is a financing endeavor gone wrong. Fortunately, having an experienced attorney in startup financing will give you peace of mind and the confidence necessary to bring your business vision to life.

Closing the Financing Transaction

Closing the deal is an exciting moment: it’s another step toward success and a way to move your business forward.

As the final phase in securing financing for a startup, closing is a crucial time to have a startup attorney guide you. Legal due diligence, including perusing contracts and confirming the accuracy of the information in each document, is vital to closing the deal. A startup lawyer can spot inconsistencies, correct errors, and ensure you get your money quickly.

If you’re like most entrepreneurs launching a business, you’ve probably worked without a paycheck for what seems like forever. But now, you can finally say, “Show me the money.” Your patience and perseverance have paid off. So, it’s full steam ahead, putting your plan into action and showing investors what a successful enterprise looks like.

Financing a Startup Business? Let Us Help Get the Deal Done

Entrepreneurs shouldn’t shy away from seeking investor funding. Those dollars are the lifeblood of many a startup and can fuel your efforts. However, negotiating favorable investments might be outside your wheelhouse, especially since you’re focused on the particulars of your industry. This dynamic is why an experienced startup attorney can make a world of difference. They can help you acquire the necessary capital with the most favorable terms so you can put your energy into your zone of genius.

At Kinetic Law, we have years of experience counseling entrepreneurs. We can help with business formation and structure, debt and equity financing, drafting, reviewing, and negotiating essential documents and contracts, and general counsel services.

Kinetic Law is based in Cincinnati but can help clients throughout Ohio and California via our virtual platform. So, whether you operate your business in Cleveland or Silicon Valley, Kinetic Law can serve your needs and give you the knowledge and confidence you need to grow your business.

Ready to start raising capital? Contact us today for more information.

One of the most useful tools for an early-stage startup is the founders agreement (or shareholders agreement). The founders agreement is not the agreement where the company issues stock to the founders; we call that a stock purchase agreement. Rather, it’s part roadmap and part accountability document.

Questions to Ask When Creating a Founders Agreement

Here are some of the key issues that founders should cover in a founders agreement:

How will founders split the equity?

The lazy approach is to divide up the equity equally among the founders, but that may not be fair based on what each founder is actually contributing in terms of money, time, expertise, etc. You can read more about splitting the founders equity here. 

What kind of vesting will apply to each founder’s stock?

The most common approach is “4-year vesting with a 1-year cliff”, which means that the stock vests over 4 years, with 25% vesting at the end of the first year, and the remainder vesting in equal monthly installments for 36 months. When this type of vesting is used, the stockholder owns his or her stock outright from Day 1, with voting and dividend rights, but the startup has the right to repurchase the unvested stock at the original cost if the stockholder leaves the company before the end of the vesting period. This protects the startup from having someone depart with a large chunk of unearned stock. Read more about the importance of vesting here.

What are the roles and responsibilities of the founders?

This is the accountability part of the founders agreement. What role will each founder take? Will each founder be working full-time? If a founder is working part-time, what will the minimum number of hours/week be, and will that founder be expected to go full-time at some point?

What money or other assets will each founder contribute?

If a founder has developed specific intellectual property, such as software or a patent, you can use the founders agreement to obligate that founder to contribute those assets to the company (but don’t forget to also document the actual transfer through an intellectual property assignment agreement). Similarly, if a founder is going to contribute a certain amount of cash, document that in the founders agreement.

How will founders be compensated?

It’s common for founders of early-stage startups to get no compensation other than their stock in the company, with the potential for its increase in value through their efforts. Indeed, founders should have enough in personal savings to live on for at least a year. Once the company has started generating revenue or has raised a significant round of financing, it’s reasonable for the founders to start taking a salary, but don’t expect it to be market-rate as if you were working for an established company.

How will important decisions be made?

Corporations have a very specific governance structure, unlike LLCs, but in the early years, it’s possible to introduce some flexibility on decision-making. If you want to specify that certain decisions require super-majority or unanimous approval, the founders agreement is a good vehicle for doing so. Otherwise, the default rule is that holders of a majority of outstanding stock decide matters put before the stockholders, a majority of the members of the board of directors decide board matters, and the CEO decides most lower-level day-to-day management decisions.

How do you remove a founder?

It’s quite common for there to be a falling out among founders, or for one founder to drastically reduce his or her contributions. So how do you remove that person? Typically this would be a decision for the board of directors, but in some cases, it might require a stockholder vote. Beyond just the process of removing someone, it’s useful to also spell out some criteria that would justify the removal of a founder.

What is the goal or vision of the business?

The founders agreement is also a good vehicle for defining what the goal and vision of the business will be. This can be the core of a set of principles and goals that will help the founders define and maintain company culture as the startup grows.

By taking the time to address these issues in a founders agreement, would-be founders can build a solid foundation for developing a strong and successful startup. As issues arise, startup founders can return to the founders agreement to determine whether everyone is living up to their responsibilities and whether the company is on track, consistent with the original vision. And often, the process of working out a founders agreement that addresses these topics will reveal whether all the founders are truly aligned and committed.

Depending on the nature of your startup, many potential legal issues could arise – like regulation compliance, leadership structure, non-compete agreements – the list goes on. Here is an overview of the legal issues every entrepreneur should consider before startup formation:

Regulatory Concerns

Depending on the startup and its industry, there are often specific regulations that may apply to your business. These must be adequately addressed to avoid serious legal and financial consequences. For example, financial services are a heavily regulated industry, with stringent federal and state regulations that all financial entities must comply with. Any startup operating a website marketing to children will also face strict regulations relating to privacy and collection of personal information. Subscription box startups need to comply with regulations in several states relating to how they notify subscribers about the renewal of their subscriptions.

While compliance may seem costly and daunting, a startup’s costs for failing to comply with applicable regulations adequately may cost much, much more. Startups that ignore their compliance obligations face regulatory action from state and federal government agencies, as well as class-action lawsuits.

Intellectual Property

Another common legal issue for many startups, especially tech startups or any other business involving intellectual property (IP), is failing to adequately protect that IP by not ensuring that it’s owned by the startup. Under US intellectual property law, the person actually creating the IP owns it, unless that person explicitly states otherwise in writing. When founding the company any founder who developed pre-existing intellectual property should transfer that IP to the startup in exchange for his or her stock, and sign an IP assignment agreement.

In addition, the startup should also require any employees or contractors developing intellectual property to sign contracts acknowledging that intellectual property will belong to the business rather than the individual. Failing to take these steps at your company’s formation could potentially jeopardize the startup’s overall future, particularly if disagreements arise between owners and IP creators.

Formalizing Roles

Successful startups that turn into thriving businesses often begin by carefully delineating and formalizing the founding team’s roles and responsibilities. These roles will drastically vary depending on what exactly your company will do.

One of the most common reasons that many startups fail is not having the right team in place. For instance, many startups may choose to delay hiring a chief financial officer, assuming that managing the startup’s finances can’t be that difficult, especially at the beginning. But the chief financial officer is also responsible for working with potential investors, as well as developing financial processes and reporting requirements as the startup continues to grow.

While not required, it’s often a good idea for the founders to put together a founders’ agreement that outlines the roles, time commitments, financial commitments, and other contributions each founder will make. This kind of agreement can be important for measuring accountability as the startup grows.

Raising Money from Investors

Of all the legal issues every entrepreneur should consider before startup formation, it is important to note that raising money from investors is engaging in a highly regulated area of law. Preferred stock, convertible notes, and SAFEs are all securities and therefore regulated by state and federal securities laws. Startups need to work with an attorney with experience in securities laws before talking to investors, to ensure that they talk only to the right investors, disclose information where necessary, and address other potential requirements. It’s important to put together a legal plan for raising money BEFORE actually starting to raise money, to avoid costly mistakes. There’s a tendency for some startups to just download free template documents like SAFEs, and then issue them to investors without ever talking to an attorney. This is dangerous, as issuing securities is not a DIY type of project. By not complying with these laws and regulations, the startup jeopardizes its existence, and the founders are at risk of civil and criminal penalties, including jail.

Noncompete Agreements

Entrepreneurs looking to launch their startup often leave their current job to launch their new endeavors. Unfortunately, many employment contracts include provisions that make it incredibly difficult for an employee to launch their own business. These agreements typically last for about a year after the employee leaves and apply if an employee attempts to launch a business in a similar industry, since it may target the same customer base while using similar technology and knowledge. These agreements are specifically designed to protect companies from losing intellectual property or enduring competition and solicitation from former employees. Failing to address these issues before you quit your job may make this process even more difficult. It’s important to review all your employment documents from your current job, before leaving to create a startup.

Beyond that, many companies reflexively include non-competes in their employment agreements. If the startup is located in California, these non-competes are simply illegal and unenforceable. In other states, the landscape is rapidly changing in ways that make it harder to impose non-compete obligations on employees. When using a non-compete, it’s increasingly important to identify what state law will apply, as well as to identify what employer interests need protection. Then the company needs to carefully tailor the non-compete to address those interests, without being overly broad in terms of the time period or geographical scope.

If you are trying to decide whether you should hire a startup lawyer, you should begin by considering that tech startups are fundamentally different from conventional types of businesses. The legal issues tech startups face, whether it’s choice of entity, issuing stock, or taking on investors, require very specific solutions. Failure to handle these issues properly can have severe consequences for you and your startup.

When you break your leg, you don’t go to a dermatologist. Lawyers, like doctors, have specialties. A lawyer that handles criminal defense, or civil litigation, or your will, most likely doesn’t have the knowledge and experience that tech startups need. Even a lawyer that primarily handles conventional businesses like medical practices, restaurants, consulting firms, and the like, may not have the right knowledge and experience needed to work with tech startups.

The mistakes the wrong kind of lawyer makes can cause far-reaching problems down the road, and can be expensive to fix. For example, setting up a tech startup as an LLC, rather than a corporation, will cost you more money later when you have to convert the LLC to a corporation. Moreover, any qualified startup lawyer knows that LLCs don’t qualify for the favorable capital gains tax treatment under Section 1202 for “qualified small business stock,” but lawyers that don’t routinely work with startups may not realize this. Or even be aware of the issue. So when a lawyer sets up a tech startup as an LLC, the founders are losing valuable time to apply to the Section 1202 holding period, and may ultimately never qualify for the favorable tax treatment.

When deciding whether to hire a lawyer, you should ask yourself whether you want someone who can help you understand your ideal organizational structure. Most importantly, you should ask yourself who will be your lawyer when you talk to investors that could be essential for your business to expand and thrive.

How A Startup Lawyer Can Help You

Formation

At the most fundamental level, your startup lawyer can help you choose the ideal type of business. For tech startups, this will usually be a Delaware corporation. That’s what your investors will expect, so you don’t want a general practitioner to reflexively set you up as an LLC, just because that’s what he or she always does. It will cost you more money to fix that mistake than you would have spent forming your startup property. Your startup lawyer can also advise you on using vesting with stock grants to founders, employees, and developers, to protect the company from someone leaving after a few months with a large chunk of company stock.

Risk Management

One of the most significant benefits of hiring a startup lawyer is risk management. A skilled startup lawyer will often have experience helping emerging businesses in various industries, providing experience that spans solving common mistakes to more complicated problems.

This experience may often include helping you draft more individualized employment contracts, leases, or intellectual property assignment agreements that avoid problematic “standard” or “boilerplate” language, like non-competes (which are illegal in California). Attempting to use templates or other standardized legal documents without a lawyer’s advice is a common mistake we genuinely want to help you avoid.

Your attorney may also help you better understand how to structure compensation and benefits for founders, officers, and employees, including granting company stock and stock options. Even though many entrepreneurs are risk-takers, a skilled startup attorney is meant to help you manage that risk so you can accomplish the goals you set out to complete.

Strategic Vision

Aside from assistance with formation and risk management, your startup lawyer may also help you develop your strategic vision for your new business. A skilled attorney will generally understand how your business may survive within the context of your chosen industry. Part of this understanding will include the current and future business environment that may impact your startup’s growth. In this sense, your startup business lawyer may often serve not only as your legal counsel but as an experienced mentor who can help you avoid common mistakes.

Contract Preparation and Review

Perhaps one of the most apparent and underestimated benefits of hiring an attorney is the ability to make sure your business avoids any potential legal disputes over contracts for services, supplies, or space. Your attorney can help you draft agreements with employees, partners, or investors so that your organization is adequately protected.

One of the most important things startup founders must understand what is an 83(b) election. Failing to make an 83(b) election at all, or filing it late, can have costly tax consequences for the individual founder. Section 83 of the Internal Revenue Code provides that a founder or employee recognizes taxable income on his or her stock as that stock vests. In other words, when your stock is subject to vesting over a period of time (which should be common for tech startups), you can be taxed on the difference between what you paid for the stock on Day 1, and what the stock is worth as it vests. This can lead to a significant tax liability for stockholders of fast-growing companies.

However, Section 83(b) allows the stockholder to make instead a voluntary election to recognize the taxable income upon purchase of the stock, as opposed to waiting until the stock vests. This allows you to accelerate that tax to Day 1, so that you pay tax on the difference between what you paid for the stock and what it is worth at that time – and in most cases there will be no difference, so you can essentially avoid tax on the stock as it vests.

83(b) Filing Considerations

There are a few essential considerations to bear in mind when you file your 83(b) election. First, and perhaps most importantly, you must file your 83(b) election with the IRS within 30 days after purchasing the stock. This 30-day period begins on the day you received the stock and includes weekends and holidays – so if you don’t make the election within this time frame, you will forever lose your chance to do so. If the stock is in a startup that increases dramatically in value in a short period of time, this can be a very expensive mistake. For example, let’s say you get 250,000 shares of stock, at a value of $0.0001, and fail to make your 83(b) election. If the stock vests after the first year, and the stock has increased to $1/share (maybe because the company did a Series A financing), the shares that just vested are now worth $250,000. Because you didn’t file an 83(b) election, you now owe tax on $250,000 minus the $25 that you paid for the stock originally, or $249,975.

We recommend that you file the election through certified mail, requesting a return receipt. This is important because the burden of proving that your election was filed promptly is placed on the person filing the election – you.

When you receive startup stock subject to vesting, it is always wise to consult your tax or financial adviser for assistance, particularly when considering an 83(b) election. Your startup lawyer will also be another resource to guide you through the process of launching your startup, including helping you understand the 83(b) election and the process of filing.

When putting together your new venture’s business plan, it’s crucial to decide what type of business entity will be best for your startup. Choosing the wrong type of business entity is one of the most common, and significant, legal mistakes that startups can make. Too often, many unprepared entrepreneurs may rush to launch their new business independently without first consulting an experienced startup attorney that can help guide them in the right direction. The right choice of business entity depends on the kind of venture and the organization’s primary goals.

Common Types Of Business Entities

LLC

The limited liability company (or LLC) is a popular choice for many new businesses. An LLC provides protection from personal liability, meaning you are generally not personally liable for any debts or liabilities associated with the LLC.

As an LLC, your new company will not be required to have a board of directors, hold annual meetings or deal with many of the corporate governance tasks that corporations have to handle. Many entrepreneurs appreciate the informal and flexible management structure, as it allows them to focus on running the business.

Ultimately, however, the LLC’s tax flexibility is often the primary reason many entrepreneurs choose this type of business entity. Most often, LLCs are taxed as “pass-through entities,” which means that the LLC’s profits and losses are passed through to the members, and taxed at the member level, rather than the LLC level. Single-member LLCs are no different than how you are taxed as a sole proprietor, and multi-member LLCs are taxed like partnerships. If the LLC has losses, those losses get passed through to the members, and can be used to offset other income and potentially lower members’ taxes.

LLCs are the most widely used type of business entity for most new businesses in the US – restaurants, dry cleaners, consulting firms, marketing firms, franchises, and other types of businesses that you encounter every day. However, if you are forming a tech startup that intends to raise venture capital investment, you will most likely need a C corporation.

C Corporation

A C corporation (a/k/a “corporation”) is usually the ideal type of business entity for tech startups, especially if you intend to pursue venture capital funding. Venture capital investors are generally only able to invest in corporations, particularly Delaware corporations, for a variety of reasons. Unlike LLCs, corporations require a more formal management structure, with a board of directors, officers, and the need to hold regular stockholder and director meetings.

Another attractive feature for tech startups is that, unlike LLCs, a corporation provides you with the ability to compensate your employees with stock options, so it offers more opportunities for your startup to create equity incentives for employees.

Corporations are not pass-through entities for tax purposes. A corporation must pay taxes on its profits, and then if the corporation pays dividends to shareholders, those shareholders will pay taxes on the dividends they receive. This is called double-taxation, and while it is often characterized as a reason why you should form an LLC, it is usually irrelevant for tech startups. Most tech startups won’t have any profits to tax in those early years, and it is common for tech companies not to pay any dividends for many years. For example, Microsoft was founded in 1975 but didn’t pay any dividends until 2003. Apple was founded in 1976, and paid its first dividend in 2012.

Professional Corporation

Another very specialized type of business entity is the professional corporation. For some professionals looking to set up a practice, such as veterinarians, lawyers, accountants, or doctors, this type of business entity may be required by the state in which they practice.

Professional corporations are governed and taxed like conventional corporations, and the only real difference is the restriction that all shareholders have to be licensed professionals.

Note also that some states provide for professional limited liability companies.

Launching your new business is always an exciting time, whether this is your first experience as a business owner or you’re an experienced entrepreneur. But if this decision is not approached carefully, many entrepreneurs may make significant legal mistakes that could impact the business’s future success or sustainability.

It is crucial that you properly split equity among all founders when beginning a startup. Many startups often split equity equally among the founding team – which sounds simple, fair, and easy, but can be a mistake.

Why Dividing Equity Equally is Usually a Mistake

Let’s say founders choose to split equity equally among themselves, either reflexively or in a misguided notion that this division will be fair and avoid controversy. Ask yourself, “does this account for the different contributions we each will make?” The answer is often a glaring ‘No.’ It’s essential to divide equity in a way that properly reflects each founder’s contributions and value to the startup. This can be a difficult conversation for the founders, but it’s always a better conversation to have before launch.

Important Factors to Consider When You Split Equity

What Did Each Founder Contribute to the Startup?

When dividing equity, it’s important to consider the unique contributions each founder has made and will continue to make moving forward. These could include cash, labor, or a combination of the two. For many new businesses, especially tech startups, it’s even common that founders often contribute their own intellectual property. The founder(s) who made these early contributions may demand a larger share of equity, for plausible reasons.

Is the Founder Working Full-Time or Part-Time Supporting the Startup?

In some cases, one or more co-founders may not contribute to the organization in a full-time capacity. They may stay at their day job, while other co-founders may be entirely focused on the organization’s mission, dedicating every dollar and second they can. It’s important to consider the various levels of involvement each founder is committing to when dividing equity.

Which Founder Created the Idea Behind the Startup?

Some startups may place too much focus on which founder created the money-making idea supporting their business, allocating the most considerable portion of equity to that person. However, a successful startup also considers what day-to-day operations and execution will look like – possibly causing the founders to allocate a smaller division of equity to the “idea generator” as a result. After all, ideas are cheap, but executing on the idea is what makes a startup successful.

Which Founders Will Have Greater Responsibility Moving Forward?

Too often, a startup may also place too heavy a focus on which founders contributed more to an organization’s launch, rather than which founders will be critical players in an organization’s success in years to come. For example, software development may be most important when the company is formed, while marketing and finance may become more important when dealing with investors or getting ready to launch the product. For a startup to grow and thrive, these future contributions are key – and must be factored into the division of equity.

Balancing These Factors and Deciding How You Split Equity

While these questions are complicated and may seem easier to avoid, it will significantly better your startup if you have these discussions now. Delaying could open the door to controversy among founders, which can kill a company, so it’s imperative to determine the framework you want to use to divide your organization’s equity – sooner rather than later.

This framework should attempt to value each of the various contributions that each founder has already made, and also examining the contributions that will be made over the next two or three years that are often critical for a startup’s success.

Five Keys To Working With Investors

Cincinnati Startup Lawyer

If you are a startup founder and you are looking for outside investment, here are five keys to working with angel investors and venture capital funds.

Investigate Your Investors

Potential investors are going to put a lot of money into your company, and they will investigate your company thoroughly. You should do the same with your investors. After all, you will be in a close relationship with these investors over a period of several years, and you will be giving up a great deal of equity and control to them. Consequently, you need to be comfortable with how they operate, and you need to know what they bring to the table. Talk to other startups that these investors have put money in. Are they easy to deal with? Do they respect the founders and employees? Are they accessible? Do they pepper the founders with 3 AM phone calls? What kind of business background do they have? Do they have good contacts?

Create a Competitive Environment

You will have greater leverage in negotiating favorable terms if investors have to compete with each other for a chance to invest in your company. If your startup is hot, if it has good buzz, there will usually be more than one angel or VC eager to invest. Creating a competitive environment, or even the appearance of a competitive environment, can be crucial to getting more favorable terms. You have to be careful with this, however, because if you go too far in playing one investor off against another, you could drive them all away and be left with nothing.

Be Cold-Blooded

Your startup is your baby, but to the investors, it is just another company they might invest in. They aren’t being emotional when dealing with you, and you need to avoid becoming emotional as well. Be prepared to walk away if the terms aren’t good. This is especially hard when you have already put a lot of time and effort into closing a deal. Establish reasonable deal-breakers in advance, and stick to them.

Understand the Deal

Even if this is your third startup and you have been through a couple of financings before, your investors do this for a living, and you don’t. As a result, they will always have a greater facility with the deal terms than you. I recall sitting in a meeting with a VC a few months back, and the guy was speaking at about 90 mph. He was rattling off numbers, terms, and formulas at far too rapid a clip for his audience to keep up with him. He may have been speaking total nonsense, but it was all going by so quickly who could tell? The point is, he was completely comfortable dealing with these complex terms and ideas, while many in the audience were hearing it for the first time. It is crucial, therefore, that founders put the time into understanding each and every part of the deal. Rely on advisors, rely on lawyers, but make sure you read every word and ask questions. That leads us to our fifth key…

Get Your Own Lawyer

An angel financing or Series A financing is no time to go it alone. You cannot rely on Legalzoom to help you here. And you absolutely should not use your investor’s lawyer, or even a lawyer recommended by your investor. Your investor’s lawyer cannot represent you and the investor at the same time; it is a honking big conflict of interest. If it comes down to you or the investor, guess which one of you will get screwed? The same applies to a lawyer recommended by the investor. He is going to rely on the investor to continue to recommend him to clients, so he isn’t going to push that hard on your behalf. The risk of cutting off those referrals is too great, compared to the small amount he will make from you on this one transaction. You need to get your own lawyer, and you need someone who understands these kinds of transactions. The guy who does your patent applications or your parents’ will generally is not going to have sufficient expertise and experience in this area. Remember, the investors do this every single day. You need an experienced, strong corporate lawyer who can explain the deal to you, and negotiate hard to make the terms and working with investors more favorable to you.

Follow me on Twitter @PaulHSpitz

“Why should I use you to set up my business, instead of Legalzoom or Clerky? You cost more money.”

I get that question occasionally from clients, and I usually answer by explaining that all those sites do is provide documents, which may or may not suit your needs. You may not know whether the documents are good quality, and nobody is available to explain every single sentence in the documents, much less make changes. I, on the other hand, provide legal services. And those legal services that I provide include advice on what is best for your business, as well as providing customized documentation to ensure that we are meeting your needs.

Well, last week a prospective client asked me that question, and as I started to formulate an answer, I went to the website of the document provider – incorporate.com, to see what it offered. In this case, we were talking about forming a multi-owner LLC. Incorporate.com didn’t specify as to whether the operating agreement was designed for a single-owner LLC or a multi-owner LLC. There’s a big difference in complexity, as well as in the kinds of issues you need to address, so it was a significant area of confusion on the website. Then I notice a convenient live chat function, so I decided to dig deeper. Here’s the transcript, and I think you’ll find it quite illuminating.

Thank you for choosing incorporate.com. A representative will be with you shortly. You are now chatting with ‘Jaron’

Jaron: ‪Hello, how are you?

you: fine, thanks. So I’d like to know, for your LLC formation package, is the operating agreement a single-member or multi-member operating agreement?

Jaron: ‪The operating agreement can go either way

you: Well, which is it?

Jaron: ‪Is this something you are looking to have set up today?

you: maybe

Jaron: ‪It is whatever you need it to be

you: and does it include transfer restrictions?

Jaron: ‪like heir to heir?

Jaron: ‪Or ownership?

you: like a right of first refusal if my co-owner wants to sell to an outside party

Jaron: ‪Yes, you can include that in the operating agreement. We also provide a guidebook with further instruction on that as well.

you: and all of this is the same price, regardless of what I want included? regardless of whether it’s a single-member or multi-member?

you: all for $385.95

Jaron: ‪YEs

you: How many drafts of it will you do for me, to ensure it’s the way I want it?

Jaron: ‪I can also provide priority handling at no extra charge.

Jaron: ‪Yes

you: how many?

Jaron: ‪Let me double check. Bare with me [spelling error his, not mine – another nice touch from the experts]

you: double check on all those questions, please

Jaron: ‪Sure… one moment [long delay]

Jaron: ‪You can supply the operating agreement after writing it out. We provide the template. You can update it at anytime with written consent. The only time there is a fee is if you have a third party update it

you: So you provide a basic template, and I have to make all the changes? You don’t write these in for me?

Jaron: ‪We do not. You will write them up, we will file them internally

you: So the transfer restrictions and all that aren’t in the agreement you provide. I have to write all that up for you?

Jaron: ‪Correct. We file it for you, you provide the structure that you want.

you: What do you mean, you file it? [note: you don’t file an operating agreement with anyone; it’s a contract between the business owners and the LLC]

Jaron: ‪You will supply us with the language and draft of the operating agreement. Once you notarize it and send it in, we can update it to your liking at anytime [another tip – you don’t have to notarize an operating agreement]

you: Well, if I have to write the operating agreement, why do I pay you?

Jaron: ‪We provide the template. If you want to submit it yourself without our template, than I can customize a package for you to save you money without the operating agreement

you: I want the operating agreement, but you told me you could customize it with whatever I want, and now you are saying that you can’t, that I have to provide the customized language. Is that correct?

Jaron: ‪Yes, meaning you can make the operating agreement anyway you want it. There is no structure that you are stuck to.

Jaron: ‪If you need to update or make changes, we can do that. No fee

you: But I provide the language

Jaron: ‪Yes

Jaron: ‪We provide a template. You can use it if you wish

Jaron: ‪Or provide your own language [kind of like going to a restaurant, but bringing your own ingredients and cooking them yourself]

you: One last question. On your website, you say the Ohio LLC filing fee is $125 plus a $5 document retrieval fee. But the LLC filing fee in Ohio is $99. Why the difference?

Jaron: ‪I will get you the breakdown, one moment [long delay]

Jaron: ‪Sorry for the delay

you: Yes?

Jaron: ‪$125 is the LLC filing fee of for Ohio anywhere

you: Not according to the Secretary of State’s website.

Jaron: ‪You will have to go to the Secretary of State yourself to retrieve the documents without the $5 fee in addition

Jaron: ‪Yes I see the $99

you: I’m not talking about that. I’m asking why you charge $125 for the basic filing fee, when according to the Ohio secretary of state website, the filing fee is $99 [note: the Ohio Secretary of State actually lowered the filing fee from $125 to $99 several months ago, something other states should consider doing. I’m talking about you, Illinois, Texas, and Massachusetts]

you: so please explain

Jaron: ‪I am really sorry about the confusion. I am not sure why the fee is more. All of the service companies charge the $125 rate… I honestly do not know why but I will happily discount it for you.

you: No, I’m just concerned that you wouldn’t know what the correct fee is. Aren’t you the experts?

Jaron: ‪Yes, most times there are things like “Walk in fees” that are built into the price. I think that may be the case here but for some reason it is not listed. Most of our state fees include the full breakdown. I am not sure why Ohio does not. I apologize

you: There’s no walk-in fee. Ohio lowered the filing fee several months ago, and you just don’t take the time to ensure that you are charging the correct amount.

So let’s note a few key things from the chat:

1. The representative wasn’t very knowledgeable. That’s always a troubling sign.
2. The representative started out by promising that I could get anything I wanted (at that low price), but quickly had to backtrack when I pressed him on the issue. By the time we were done, I was going to have to write the operating agreement myself!
3. The company’s website was out-of-date when it came to the Ohio filing fees, and when I asked about it, the representative basically made up an answer out of thin air (or pulled it out of his ###, if you prefer). If I hadn’t forced the issue, they would have overcharged me.
4. The representative was also completely wrong about the $5 document retrieval fee. Some state’s charge to download documents, but Ohio isn’t one of them. This is an unnecessary and dishonest fee, and you shouldn’t have to pay it.

I hope you have a better idea now of what you get with these document services, and why I charge more money.

Follow me on Twitter @PaulHSpitz

The answer is, sometimes, a letter of intent can be binding.

When companies are exploring a potential deal – whether it is an investment, a merger, or the sale of real estate or some other asset – they often put together a “letter of intent” prior to finalizing and signing a definitive contract. The purpose of the letter is to outline the key terms of the agreement, and to serve as a basis for negotiating all the details that will go into a definitive agreement.

Sometimes, however, the parties are unable to reach this definitive agreement. Some detail becomes a sticking point, or circumstances change, and one of the parties tries to walk away, thinking that the letter of intent won’t be binding. So what might make it binding, and force the parties to conclude a deal?

First, if it includes all the material terms in it, a court could decide that there is enough agreement between the parties to find an enforceable contract. This can be the case even if the letter of intent says that it is subject to reaching a comprehensive agreement satisfactory to both parties.

Second, if it contains a provision saying the parties will negotiate in good faith, a court might require the parties to continue to do just that. There have been cases where circumstances have changed for one party, so that it wants to walk away, but there was a “good faith” clause that prevented the party from getting out of the deal.

If you want to maintain maximum flexibility, therefore, leave out one or more material terms, deferring agreement on those terms to further negotiation. Also, ensure that there’s no obligation in the letter of intent to continue to negotiate in good faith.

On the flip side, however, companies often expend considerable resources putting deals together, and they want to ensure that a letter of intent will lead to a final deal. For companies in this situation, by all means get those material terms nailed down in the letter of intent, and put in a clause requiring the parties to negotiate in good faith. Another tactic to discourage walkaways is to include a break-up fee clause. That clause provides that if one party walks away from the deal, it will be obligated to pay a break-up fee to the other party, to compensate for the time and other resources invested to date. The problem with this approach, however, is that after making efforts to ensure the letter of intent is binding, you may discover that you no longer want to be bound.

Follow me on Twitter @PaulHSpitz

Be Careful When Choosing Investors

An episode of Shark Tank demonstrates why startup founders have to be careful when choosing investors i their company. I don’t watch the show, but I tuned in to this episode because it featured a local startup called Frameri (which has since then gone out of business). Frameri was working on a line of eyeglasses where you can easily pop out the lenses to put them in new frames. If any of my readers wear eyeglasses, you know how much this can save you. The last time I bought a new set of eyeglasses, the cost of the frames and lenses took me past $500 before I could blink.

Pretty much as soon as Frameri’s cofounders explained the product, the “sharks” hit them with abuse and condescension. One of them pointed out that Luxottica (also based in Cincinnati) is a huge player in the market as if that was an indictment of Frameri’s idea. Apparently the judge has never heard of IBM, which used to dominate the computer industry, or the concept of disruption. Luxottica’s market dominance allows them to inflate prices, creating an opening for innovative players like Frameri and Warby Parker. Pretty obvious, if you ask me.

Another judge called the Frameri guys “cockroaches.” I kid you not. My cousin was on Shark Tank pitching her company, and one of the judges called her a cockroach, too. Could have been the same guy, so maybe “cockroach” is his go-to word. In any case, any investor that is personally abusive like that should immediately be disqualified.

At one point in the show, one of the judges asked if they were on the show to get an investor, or if they were using the show for publicity. Well, doesn’t everyone who goes on a reality show or competition show do it for the publicity?

About 1 minute into Frameri’s segment on Shark Tank, I was rooting for Frameri to reject all of the investors. Most of them dropped out, leaving one left to make an absurd investment offer. To Frameri’s credit, they turned it down. Just because a rich person dangles money in front of you doesn’t mean you should take it. A bad deal is still a bad deal. And a bad investor is even worse. You want an investor who understands your company, your industry, and your environment. You want your investor to be a source of more than just money. The investor should be able to provide support, guidance, mentoring, and connections. Finally, you want an investor that you can have a good working relationship with over a long period of time. Someone who calls you a cockroach isn’t that kind of guy.

So that’s really the bottom line. Forget about the money. Money is the least part of choosing investors. Look at the person, and ask yourself if you can work closely with this investor over the long run. Do you want this person to sit on your board of directors? How is she going to respond to business ideas that she doesn’t like? Is he going to call you – the company founder, the CEO – a cockroach in front of your staff? If you wouldn’t want to spend a minute more than absolutely necessary with this person, then move along and find someone else.

Contact me or Follow me on Twitter @PaulHSpitz

I had an interesting lunch with some fellow lawyers the other day. I know, “interesting” and “lawyers” shouldn’t be used together in a sentence, but bear with me. We were discussing venture capital deal terms we had encountered with various startup financings we had worked on. One of the other lawyers mentioned that in two deals he had worked on recently involving local Midwestern startups and investors, the investors had insisted on a 3X participating liquidation preference. I was really taken aback by this. In a Series A financing I had worked on a couple of months ago, involving a startup and VC firm that are both in the San Francisco bay area, there was a 1X non-participating liquidation preference. The VC didn’t even try to get something more.

To understand why this is important to startups and to the health of a startup ecosystem, let me explain what a liquidation preference is, and how it works. A liquidation preference is money that the investors take off the top, when a startup they have invested in goes through an exit. For example, suppose a startup is being acquired by Facebook. If a VC that has invested $3 million in the startup has a 1X participating liquidation preference, that means that the VC takes the first $3 million off the top, leaving less money for everyone else. Since the liquidation preference is participating, the VC then gets to share in the remaining proceeds with the common stockholders, pro rata. Essentially, the VC gets to double-dip. In a small transaction, this could be devastating to the founders. For example, look at what happens if Facebook is paying only $5 million for the startup. The VC gets $3 million off the top, leaving only $2 million for everyone else. Because the liquidation preference is participating, the VC may also get a share of that remaining $2 million. And that’s just with a 1X liquidation preference.

Typically, the VC may only use the 1X liquidation preference in a smaller exit transaction, as it protects his downside. In a larger exit transaction, the economics may favor converting the preferred stock to common stock and sharing in the proceeds that way. A liquidation preference greater than 1X, however, may skew those decisions.

Now let’s look at how a 3X participating liquidation preference would impact the deal. Suppose the sale price of the startup is $10 million, and the VC invested $3 million. Now the VC gets $9 million off the top, leaving $1 million for everyone else. Because the liquidation preference is participating, the VC will get a share of that $1 million, too. The founders and any employees holding stock and/or stock options get screwed, to put it politely.

What are the implications of this for startups and a startup ecosystem?

When you have a vibrant ecosystem with lots of strong startups and many angel and VC investors, you have competition for deals. As a result, the deals tend to be fairer to the startups. A strong startup has some bargaining leverage when seeking financing, and investors are eager to invest in such companies. When the investors have to compete for deals, they offer more favorable terms to the startups, lest they miss out. FOMO is a powerful force.

You see this at work in Silicon Valley, which has a well-established startup ecosystem with many VC investors and some of the most promising startups. In the Fenwick & West Silicon Valley Venture Capital Survey for the first quarter of 2017, only 16% of the deals involved multiple liquidation preferences. This is actually a steady rise over the past year; in the first quarter of 2017, the number was about 7%. Of those multiple liquidation preferences during 2017Q1, two-thirds were in the 1X to 2X range, and one-third were in the 2X to 3X range. Also, for 2017Q1, only 22% of the financings provided for participation; the remaining 78% were non-participating.

In smaller and new startup ecosystems, you don’t have a lot of strong startups, and you may only have a handful of investors operating. This is frequently the case in some of the emerging Midwestern startup ecosystems, like Louisville, Indianapolis, Columbus, Pittsburgh, and Cincinnati, where I’m located. As a result, the investors feel more emboldened, or more risk-averse, so they demand terms that are way out of the norm for places like San Francisco and New York. I emphasize the word “demand,” because that’s what these investors do – they demand these terms, with a “take it or leave it” attitude. If you don’t like what Investor A is offering, good luck with Investor B – they probably are offering the same terms. There is no Investor C.

As long as this persists, these smaller ecosystems will be weak. In order to improve and strengthen the ecosystem, you need stronger startups to attract more investors who will offer fair terms. These weak ecosystems, however, risk losing the best startups to more favorable ecosystems. Also, startups have to be prepared to look outside their community for funding. If you are a startup in a place like Cincinnati, and you aren’t trying to raise funds from investors in Chicago, New York, Austin, San Francisco, and LA, you are putting yourself at the mercy of your local investors. You may say that you can’t afford to fly all over the country seeking out investors, but the truth is that you can’t afford not to. Your obligations are to the shareholders, to produce the highest returns. If you give away a 3X participating liquidation preference to a local investor because you didn’t seek out investors in stronger ecosystems, you are basically taking the money out of your pocket and putting it in your investors’ pockets.