INSIGHTS

Emerging Companies 101: 6 Avoidable Mistakes

January 30, 2022

Entrepreneurs frequently begin with an intuitive idea or an intricate product leading them to think about founding a startup. The startup itself will be a vehicle for both making money in the long run and raising money in the short run while the entrepreneur’s idea, product or service is what hopefully drives both prospective investments and future profits. Beyond the idea, product, or service, entrepreneurs are often lost—and that is entirely okay!

The founding of a company and many early decisions you make as a founder are often the most difficult and confusing; that is why this article is meant to help you navigate the legal dos and the don’ts of founding a company.

Some early decisions can later be changed and, if caught quickly, will likely have minimal impact on the venture. These reversable (and common) mistakes include:

1. Founding the business as one entity when it should have been formed as another (ie an LLC when it would have been most advantageous to be a corporation);
2. Not including vesting schedules on equity the founders receive (ie the founders get all 100% of their equity vested up front with no further incentives to stay on while the startup is starting out);
3. Taking actions as a board but not properly documenting such actions or having requisite documented approval (ie no written consent of the board, stockholder, or no meeting minutes); or
4. Not issuing enough shares in the company to the founders or not giving the business the authority to issue enough shares (ie giving the company the authority to issue just 100 shares in the company).

These are just a few examples of the many legal mistakes a startup can make in the beginning of the life of the business. The good news is, though, that while making such changes will cost time and money, they can be made relatively easily.

The bad news, however, is that not all early legal decisions are reversible. Here are two of the biggest, often irreversible mistakes seen among startups:

5.   Not Properly Assigning Intellectual Property

First off, be sure that you understand what intellectual property is. Often, startup founders whose company is not in the tech industry falsely assume that they have no IP. This is false because IP is more than complex patentable and trademarkable content: IP can be trade secrets, formulas, designs, recipes or even the plan for the business.

The reason this IP must be assigned to the company (via a standard assignment agreement) is that whoever creates the IP (a founder, employee, advisor, consultant, etc) or brings the IP to the company is technically the legal owner. That being said, if the individual owns the IP and not the company, the company becomes at the mercy of the individual: for example, if the individual has left the company it can be a pain financially, legally, and logistically to gain possession of the IP.

Perhaps more importantly in regards to startups is that investors will be hesitant to invest (or often won’t invest at all) in a company that does not own its own IP. While some companies build businesses around licensing other people’s IP, they are always at the mercy of the true owner of the IP and this frightens investors away. Furthermore, if the IP is not the company’s from the beginning (ie you have not had a valid IP assignment signed), then you will sometimes have to pay up for the IP if a dispute arises—in the form of a settlement or even litigation. What is even scarier is the more successful a startup is the more that startup will often have to pay to “regain” its intellectual property.

Avoid these disputes, headaches, and costs by just properly assigning any and all IP to the company from the get-go—regardless of how “close” the owner is to the founder or the company itself.

6.   Informal Promises of Equity

Any active entrepreneur or venture capitalist has seen a pitch (or watched an episode of Shark Tank) where the product is great, the valuation is on point, and the projected sales are decent, but everything isn’t adding up. That’s when the pitching entrepreneur drops the caveat that they gave 20% to his brother who he no longer speaks to, 5% to a random lawyer from 10 years ago, 33% to a shady angel investor, and has “promised” another 15% to some buddies over beers.

The main issue being illustrated with all of this (though there are many) is that entrepreneurs and startup founders need to avoid giving verbal, casual, or ambiguous “back-of-the-napkin” promises of equity to anyone. It can often be tempting when there is only a single founder in the infant stages of startup who is short on cash to promise a percentage of the company instead, but this can lead to big losses in the long term.

Take, for example, the story of sports lawyer Howie Busch and Under Armour founder Kevin Plank. In the late 1990s, the athletic clothing brand was nothing more than a startup with inventory being stored in Plank’s grandmother’s basement when he reached out for Busch to negotiate and draft a small deal with NFL Europe. After Busch completed the work, Plank let him know that he was low on cash and asked if he would take equity in what would become Under Armour instead of the few thousand or so in cash. While Busch ended up regretting opting for the cash and losing out on equity that would be worth over $250 million two decades later, Plank would have been the one in regret if he gave up the equity for a small contract negotiation. Although not every startup will become the next Under Armour, giving away pieces of the business is often not advisable. At the very least, discuss with your lawyer first.

Another issue with such promises is that they are often informal and without any binding agreement. Due to this, it often goes unissued and unnoticed by both the startup and the alleged recipient until after a few years when the startup starts to really take off—then the alleged recipient will come asking for the promised equity. Without any written agreement, the resolution of the dispute can often be costly—again, in the form of a settlement or litigation. For this reason, be sure that if you really do plan on issuing equity, talk it over with your lawyer, memorialize it in writing, and be sure the terms are clear.

Finally, although granting someone “5% of XYZ Corporation” sounds clear, it often is not clear enough. For example, did you mean 5% of the corporation at the time of grant, 5% vesting over a certain period of time, or 5% when you are about to file your registration statement on S-1 and that 5% you offered for a simple contract negotiation 10 years ago went from being worth $10,000 to being work $10 million? Due to this ambiguity, it is often advised to granting fixed number of shares in the company, not percentages.

In conclusion, be sure to properly assign your IP and to properly memorialize all equity grants (after discussion with your lawyer) in order to avoid often irreversible mistakes and also protect yourself, your finances, and your company.