The 5 Biggest Legal Mistakes That Startups Make

by Scott Edward Walker on July 1st, 2014

My law firm recently entered into a new partnership with This Week in Startups and sponsored their live fireside chat last month in San Francisco with authors Nick Bilton and Brad Stone.  Prior to the event, I conducted a legal workshop entitled “The 5 Biggest Legal Mistakes That Startups Make,” which I have uploaded above.  If you would like to jump to different sections of the video, here’s how it breaks down:

Mistake #1:  forming the wrong entity (at 1:25)

Mistake #2:  not buttoning-down IP ownership issues (at 10:20)

Mistake #3:  not setting-up vesting schedules (at 17:19)

Mistake #4:  not complying with applicable securities laws (at 29:21)

Mistake #5:  not doing your due diligence on potential investors (at 38:36)

BTW, my favorite part of the workshop is when an entrepreneur (and former lawyer) walks in late and acknowledges that she made the first three mistakes (at 33:14).  Below is my personal outline.  Cheers, Scott

Introduction

  • SEW/corporate lawyer
  • Walker Corporate Law/boutique corporate law firm based in SF
  • doing this for 18+ years
  • different perspective as a lawyer (lots of phone calls from founders with problems)
  • purpose of workshop: to discuss some of the significant problems/mistakes I’ve seen in the last six months

Mistake #1:  Forming the Wrong Entity

  • you want to form a Delaware corporation
  • not an LLC or a partnership; the world of startups is the world of corporations
  • LLC’s are geared for private equity funds, hedge funds and real estate guys, not startups, for a number of reasons: (i) extremely complicated tax partnership rules; (ii) creates capitalization/capital raising problems – e.g., essentially does not allow for stock options plans and convertible notes, etc.; (iii) VC’s typically don’t invest in pass-through entities; (iv) more costly and complicated on an ongoing basis
  • Delaware is the place to incorporate regardless of where you are located for a number of significant reasons: (i) VC’s and other sophisticated investors will require you to be incorporated in Delaware; (ii) Delaware has an extremely efficient and sophisticated court system geared to business and corporate law; (iii) Board protections, (iv) administrative ease, and (v) demonstrates a certain level of credibility with investors and potential acquirors
  • S corp vs. C corp – “qualified small business stock” 

Mistake #2:  Not Buttoning-Down IP Ownership Issues

  • Two potential problems: (i) the “moonlighting” problem and (ii) the “Zuck” problem
  • Moonlighting problem – if you work on your startup while currently employed by another company, your employer may have rights to your intellectual property/invention
  • CA exception – CA Labor Code Section 2870: (i) different space, (ii) not using employer’s facilities and (iii) idea/IP is not based upon work done for employer
  • Zuckerberg problem – IP is not assigned to the company by the founders and/or third-party developers (including foreigners)
  • Confidential Information and Invention Assignment Agreement
  • Startup Weekend issues 

Mistake #3:  Not Setting-Up Vesting Schedules

  • Vesting schedules must be established to protect the other co-founders (plus, VC’s will typically require them)
  • Restricted Stock Purchase Agreement executed by all co-founders; unvested stock is repurchased upon departure
  • Typical vesting schedule: four years on a monthly basis
  • One-year cliff appropriate if you don’t know your co-founder
  • Up-front vesting possible
  • Must file 83(b) election – VERY IMPORTANT
  • Acceleration issue upon change of control – single trigger vs. double trigger 

Mistake #4:  Not Complying with Securities Laws

  • Very complicated area – could be a separate seminar
  • Rule #1: only sell “securities” to “accredited investors” – why? (i) Rule 506 preempts State law, which means all you have to do is file a Form D and pay a filing fee; and (ii) no disclosure requirement/PPM
  • Possible to sell to “friends and family” (e.g., in California), but opens a pandora’s box of compliance issues
  • Crowdfunding exception to “accredited investor” – SEC rules not promulgated yet
  • Rule #2: do not pay “finder’s fees”/commissions unless the finder is a registered “broker-dealer”
  • New JOBS Act law re advertising and solicitation – SEC rules not fully promulgated (potential problems: pre-filing of Form D, one-year penalty, filing requirement with SEC, new “reasonable steps” to confirm “accredited investor”) 

Mistake #5:  Not Doing Your Due Diligence on Potential Investors

  • do your due diligence prior to accepting any money (The number one mistake I have seen entrepreneurs make in any deal is the failure to investigate the guys on the other side of the table)
  • you will be married to your investors for a number of years – but cannot divorce them (more like brother/sister)
  • surf the web and learn everything you can about the particular firm making the investment and, more importantly, the particular individuals with whom you are dealing (and who, presumably, will be sitting on your board for a number of years)
  • break bread and have a beer with the potential investors
  • get references and talk to other founders who have done deals with them
  • issues to address include: How have they treated their other portfolio companies? Are they good guys or jerks? Can they be counted-on and trusted? Do they share your vision for the venture? Will they add significant value (e.g., through contacts, domain expertise, etc.)?  When they say they are going to do something, do they do it?

July 1st Update:  As of July 1, 2014, the U.S. Congress still has not retroactively amended Section 1202 of the Internal Revenue Code to permit  the exclusion of 100% of the gain realized on the sale or exchange of “qualified small business stock” (see video discussion starting at 6:10).  Accordingly, effective as of January 1, 2014, the Section 1202 exclusion percentage has been reduced to 50% and an alternative minimum tax preference further erodes the exclusion’s advantages.  

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