Three Legal Mistakes That Can Sink Your Company
Every now and then I like to bring in guests to address topics that I consider to be as important as the nuts and bolts of building your product.
I was having a drink with my good friend Jesse Jones, who is a kick-butt startup attorney here in Raleigh, NC a few weeks back, and I asked him “What are the three biggest legal mistakes you see inexperienced technology founders make?” He rattled off a really great answer, and I asked him if he’d be willing to share it with you, my beloved readers. He said yes, so I’m really happy to share the following post with you. You’ll find Jesse’s contact info at the bottom of the article, and if you have further questions on any of these topics, you can reach out to me or to Jesse directly.
Obligatory disclosure: None of this post should be considered legal advice provided by me. I’m not an attorney, nor do I have any desire to be one!
Without further ado, here’s Jesse’s Three Legal Mistakes That Can Sink Your Company.
As a business attorney, I’ve focused much of my legal practice on advising founders and early stage businesses on a whole host of issues. Where I see them put their businesses in peril is perhaps not in a particular area, but in moving forward without knowing what they don’t know.
Founders can make some common mistakes as a result of this need to act before understanding. Three of the most common areas are entity formation decisions, handling founder equity, and intellectual property ownership. Let’s look at each of these areas in detail.
Entity Formation
Often, companies form around ideas. Many ideas fail quickly, others die a slow death, and some succeed beyond your wildest dreams. You have to plan for success, otherwise what is the point? And as soon as ideas turn into money, things can get really complicated.
Founders often hurt themselves severely and their ideas by making a very bad decision at the outset – by choosing the wrong form of entity or (even worse) failing to set up any entity at all. Think of it this way: the formation of a company—in North Carolina or Delaware (primarily), and whether you choose to be a corporation or an LLC—can set you up for success or force you to re-boot.
Choosing the right entity has multiple benefits. You ensure that the business has proper legal protection, solidify the ownership of intellectual property, and provide the strongest foundation for future growth. On the contrary, failure to make the correct choice will waste time (and money) and hamper any growth on the horizon.
Finally, the failure to set up any entity at all is a crazy choice that can lead to legal liability at both business and personal level for founders, and will make you look like an amateur.
Once you’ve decided that you’re going to pursue your idea, seek legal counsel on the best way to establish the entity under which you’ll be doing business.
Handling Founder Equity
Founders often start businesses at great personal costs, expecting that one day they may recoup these costs, as well as any rewards, from the growth of the company. While most founders take great pains to set up their companies with regard to ownership percentages, a big mistake that they make is in failing to draft founder vesting schedules.
A vesting schedule is, in basic form, the schedule by which a founder’s share in the company is transferred to them by the company. For example, a vesting schedule of four years means that a founder would receive one-fourth of their shares each year for the next four years.
There are two primary reasons that every tech startup (and most other businesses) should use founder vesting schedules. First, most investors will require them. If you, as a founder, willingly subject your shares to vesting at the outset, you will probably be in a better position from a vesting perspective than you would be if you let the investor dictate what the schedule will be.
Secondly, every set of founders starts off on the right foot, but a lot (A LOT) of the time, relationships fall apart and people stop acting rationally. Subjecting each founder’s shares to vesting protects the company and each founder against a founder going nuts and holding the company hostage. Without a vesting schedule, a founder who quits with 25% equity is now what we call “dead equity”. The only way to get rid of him or her is to negotiate, and negotiating with a disgruntled founder is second only to a 3 year old in terms of difficulty.
Intellectual Property Ownership
We see a lot of problems for startups very early in their life cycle with regard to intellectual property ownership. This is especially true with regard to technology. This fast-moving space can often outstrip a founder’s ability to make decisions that protect the business.
Here’s a scenario:
A Duke grad, a UNC grad and an NC State grad walk into a coffee shop and pull out their laptops (not a joke). After discussing their newest idea, they decide to throw some code together and see what they have.
Q: What have they created? A: A mess.
Q: Who owns the code they just put together? A: They all do!
Q: Who can go use that code on their own? A: No one!
That’s right, they all have to now agree because they all own 1/3 of the whole thing.
This dovetails with the first point about setting up an entity. What they should do (if they intend to pursue the idea) is set up an entity and have each individual assign all their ownership rights in that IP to that entity through an assignment agreement. Without this agreement, investors will not touch the company with a 10-foot pole.
Unfortunately, a lot of groups will ignore advice and just keep building. Let me assure you, as everyone starts to see that the idea has legs, it is not going to get easier to get the intellectual property assigned. So start as if you expect to be successful.
About Jesse Jones
Jesse Jones joined the Forrest Firm after six years representing corporate clients at Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan in Raleigh and Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Delaware.
Jesse focuses on counseling early stage and high growth business clients in all types of transactions from formation to exit, in addition to serving as outside counsel to more mature organizations. He seeks to provide practical and thoughtful advice to help clients refine and achieve their goals. Specific areas of practice include start-up counseling, seed, venture capital, and debt financings, mergers and acquisitions, and the negotiation and structuring of a wide range of contracts and transactions.
If you want to contact Jesse directly about anything you’ve read here, you can find him on Twitter at @jjonesJD or via email at jesse@forrestfirm.com.
Your Assignment
If you’ve started building your product and haven’t addressed the issues Jesse identified, now is the time. As Jesse said, none of this matters if your company doesn’t succeed. If you start to have success, everything Jesse has talked about will matter more than you can possibly imagine.