4 Deadly Legal Mistakes That Startups Makeby Scott Edward Walker on September 28th, 2011
My co-founders and I are working on a cool new site, and we’ll be ready to launch in a few weeks. I’ve been reading a lot on the web about incorporation and other legal stuff. We have no money – so we’re going to do the legal ourselves. Assuming we mess something up, are there any mistakes that can’t be fixed down the road? We know that once we get money in we can clean things up, but we’re worried about mistakes that just can’t be fixed. (And please don’t tell us to hire a lawyer.)
Below are four mistakes that could destroy your venture down the road if not handled properly today.
Vesting Restrictions. The first deadly mistake relates to vesting restrictions. Indeed, you must make sure that all of the shares of common stock issued by the corporation to the founders are subject to vesting restrictions – which means that ownership of the shares would vest over time (instead of all of the shares being owned outright on day one). Otherwise, if one of the founders quits after a few months, he would take all of his shares with him. In short, this is a nightmare scenario – particularly if there is bad blood with the other co-founders.
The only solution in such a scenario is to negotiate a repurchase of those shares, which could be very expensive or impossible (if the departing founder wants to screw with his co-founders). And if the departing founder has a huge chunk of equity, it is unlikely that the company will find many sophisticated angels or VC’s interested in investing.
The most common vesting schedule is an equal percentage of stock (25%) every year for four years, on a monthly basis; however, it may be appropriate (for example, if the founders don’t know each other very well) to impose a one-year “cliff” (meaning that the first 25% tranche would vest on the one-year anniversary of the issuance date and then monthly thereafter). In addition, sometimes a portion of the shares will be deemed to be vested “up front” – meaning that they are not subject to vesting — particularly where a founder has made a significant contribution prior to the company’s incorporation.
Vesting restrictions are addressed in a restricted stock purchase agreement, which each founder would be required to execute and which would grant the company the right to repurchase any unvested shares (at the initial purchase price) at the time of the founder’s departure. You also need to remember to file your 83(b) election with the Internal Revenue Service within 30 days after the grant/purchase date of the restricted shares (see tip #3 of my post “Founder Vesting: Five Tips for Entrepreneurs”).
IP Ownership. There are three deadly mistakes that relate to intellectual property (IP) ownership, all of which usually surface when the investors conduct their due-diligence investigation:
1. You must confirm that none of the founders’ prior employers has any rights to the venture’s IP because he or she was “moonlighting” while previously employed. This is a particular concern if the startup is in the same space as a founder’s prior employer.
You should carefully review all employment-related agreements (e.g., offer letter, non-disclosure and inventions assignment agreement, etc.) and the employee handbook to determine if there are any provisions that may give the prior employer rights to your startup’s IP. If there is a problem, some employers will agree to execute a waiver, which you can show investors down the road.
2. Any IP created or acquired by a founder (e.g., code, logo, domain name, etc.) prior to incorporation must be assigned to the company. Usually this is done as part of the founder’s restricted stock purchase agreement, pursuant to which the IP is contributed as full or partial consideration for the shares of common stock issued to him or her in a tax-free transaction under Section 351 of the Internal Revenue Code.
Similar to the vesting issue above, a huge problem arises if one of the founders leaves prior to incorporation and takes his rights to the IP along with him; or if the assignment of IP is not properly made and the founder leaves prior to this issue being cleaned-up. In both cases, the company is once again in the difficult position of trying to negotiate with a departed founder.
3. You need to make sure that any IP created by outside developers (i.e., non-founders) is assigned to the company. Sadly, this issue comes-up all the time — just ask the Winklevoss twins. Indeed, had Mark executed an inventions assignment agreement, there probably would be no Facebook; or if there were, the twins’ (or their company) would own the IP.
This is a particular problem prior to incorporation. The IP created by the developers often never gets assigned to the company either because there was no written agreement or because the company was not a party to the agreement (because it didn’t exist at the time). Then when it’s time to fix the problem because investors are requiring it, the company needs to chase-down the developers (some of whom may be outside the U.S.) and start negotiating with them.
I hope the foregoing was helpful. Another post that may be helpful is “How To Launch a Startup and Avoid Ending-Up in Jail.” Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles). Many thanks, Scott