Biggest Legal Mistakes That Startups Make – Part 1by Scott Edward Walker on May 13th, 2011
Below is a video of my presentation a couple of months ago at a TechZulu event at CoLoft in Santa Monica. I hope you enjoy it (despite the audio issues); it starts at the 9:43 mark. Cheers, Scott
For those of you who want to skip the video, here are the mistakes I discuss:
1. IP Ownership. Some entrepreneurs make the mistake of creating IP for their new venture while they are still working for someone else. They then quit and launch their startup, not realizing that the IP is actually owned by their prior employer. This is a tricky issue, and you should carefully review all employment-related agreements to determine if there are any provisions that may inhibit your new venture, including IP ownership. I discuss this issue in detail in paragraphs 2 and 4 of my blog post regarding formation issues (part 2).
2. Choice of Entity. Some entrepreneurs make the mistake of forming the wrong entity. Investors generally invest only in corporations – not LLC’s or partnerships. You should thus form a corporation – and consult with an accountant as to whether you should make an S corporation election (and then convert to a C corporation down the road). I discuss the issue of choice of entity in detail in my blog post “Choice of Entity for Entrepreneurs.”
3. Place of Incorporation. Some entrepreneurs make the mistake of incorporating the company in the wrong state. You should incorporate in Delaware – that’s what investors generally require. You should then qualify the company to do business in California and/or any other State in which it is “doing business.” I discuss this issue in paragraph 1 of my blog post regarding formation issues (part 1).
4. Vesting Restrictions. Some startups make the mistake of issuing stock to co-founders without imposing vesting restrictions. Then, one of the founders ends-up leaving in a few months and keeps all of his or her equity. You should make sure you and your co-founder execute a restricted stock purchase agreement with reasonable vesting schedules (typically four years) upon the issuance of the company’s stock. I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.”
5. Securities Law Issues. Some startups make the mistake of not complying with applicable securities laws; for example, they issues shares to “friends and family” who are not “accredited investors” without proper disclosure documents; or they retain a consultant who is not a registered “broker-dealer” to sell company stock for a commission. You should be very careful when issuing any kind of securities; non-compliance could cause severe consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution. I discuss this issue in detail in paragraphs 2 and 4 of my blog post “Five Common Mistakes Entrepreneurs Make in Raising Capital.”
6. Splitting Equity. Some startups make the mistake of splitting equity equally between or among the co-founders. The splitting of equity is a significant business decision which must be negotiated between or among the co-founder based upon their respective contributions to date and their expectations going forward. Simply dividing the shares equally may sound fair on its face, but it’s usually not the correct decision. I discuss this issue in detail (and the various factors to consider) in my blog post “Ask the Attorney – Splitting Equity.”