Most entrepreneurs will tell you that it’s okay to fail, and fail hard. That advice is not wrong in the grand scheme of things, but when your startup experiences legal failures, it can become painful and costly. Over the past ten years we’ve experienced the whole kit and caboodle of startup legal failures, and we’re sharing ten DOs and DON’Ts in hopes that entrepreneurs can spot the red flags early on.
1. DO hire a business transactional lawyer from the get go
After starting your business, this could be the first time you’ve ever hired an attorney. It can be a daunting process. To lighten the stress, we highly recommend the following action items when hiring your lawyer.
Read the lawyer’s website bio and LinkedIn profile. You should quickly be able to figure out if the attorney is (1) local; (2) works with companies like yours (startups v. multinational corporations); (3) is licensed in your state; and (4) has the appropriate skillset for your startup’s needs.
Look for these practice areas/specialties:
- “business law”
- “corporate law”
- “emerging growth”
- “venture capital”
- “mergers and acquisitions”
- “Intellectual property”
Nix attorneys that have any of these practice areas/specialties:
- “family law”
- “trust & estates”
- “civil litigation”
- “labor & employment”
- “data security & privacy”
We will reiterate this point: do not hire a litigator for transactional work. We’ve seen this more times than we should, and it never turns out pretty. For more on hiring the right attorney, read our blog post about what else to look for and the kind of questions you should ask during the initial meeting.
2. DO make everyone sign the damn PIIA, please!
All owners, founders, contractors, interns, and employees (aka anyone who does any work for the startup, especially creative and tech work) MUST sign a Proprietary Information and Inventions Assignment (“PIIA”) agreement. This agreement will assign all intellectual property ownership rights to the company, and not live with the individual who created the IP. If an independent contractor does not sign an PIIA agreement, the default rule is that the contractor owns all of the intellectual property that she creates. Make sure all workers sign this agreement before they start any work.
Don’t believe us? Google “Snapchat Intellectual Property Assignment Issues”. One of the original founders walked to the bank with over $100 million to retroactively assign his intellectual property rights before the IPO.
3. DON’T let any founders’ stock vest immediately!
The reality is that most startups or new businesses will say goodbye, adios, au revoir to at least one of the initial founders. Your startup needs a plan for the beginning that clearly lays out the process for what happens when a founder leaves…or else it will be one big mess.
One of our clients experienced a co-founder who was behaving very badly but the co-founder never signed a PIIA agreement, did not have a vesting schedule for his stock, and the startup was trying to raise money. HINT: no investor is going to give your startup money without IP assignments and vesting schedules (among other things). Thankfully, we came to a conclusion, but it is not always sunshine and rainbows — these issues can get very ugly, very fast.
The point is, you need “vesting schedules” for all founders/officers who have a piece of the equity pie. It is standard for startups to have their founders fully vest at four years time, with 25% of the stock options vesting each year. Make sure your lawyer gets this right!
4. DON’T ignore securities laws, please!
If you mess up securities laws at the onset, you will ruin investment opportunities for the future, plan and simple. Don’t let any unaccredited investors invest in your startup. What about Uncle Bob? Is he not-accredited? Then, no! Don’t pitch publicly to non-accredited investors, either. When you’re ready to raise money, get a securities lawyers involved and do this right. If you don’t, you will pay the consequences when you’re ready for bigger fundraising rounds.
5. DO make sure your prior employer doesn’t own your startup!
Moonlighting (working for your prior employer and working on your idea) can compromise the startup’s intellectual property and ownership rights, particularly if the venture is related to or in direct competition with the prior employer.
For example, a data scientist, while working at Amazon, moonlights and builds a company that tracks and analyzes data for shipping companies. Amazon could possibly own the IP rights to that company because it is heavily within the scope of work. Of course, this all depends on the contractual agreements that the entrepreneur signed with her prior employer, as well as how she executes the idea. Want more information about Moonlighting? Read our blog post.
6. DO file form 83(b) with the IRS right away!
30 days. That is the short deadline for filing form 83(b) with the IRS after you are issued equity subject to vesting. Again: You must file Form 83(b) with the IRS within 30 days from receiving your vesting stock options. By filing Form 83(b) you are letting the IRS know that you want to be taxed from the time the equity was granted, not the date that it vests. If your stock fully vests at the onset, you don’t have to worry. If your stock is subject to vesting and you don’t file the form, you subject yourself to high tax rates.
7. DON’T wait too long to form a legal entity!
There is no tried and true timeline for when you should form a legal entity; however, it should be sooner rather than later. We’re advocates for forming the limited liability entity as soon as possible to avoid any liability, valuation, and intellectual property issues (to name a few). Consult with an attorney early on to best understand when you should make the company legally official.
Once you form the legal entity, make sure you set up a separate business bank account and hire an accountant to take care of your financials. By hiring a professional to keep your finances buttoned up, you will hopefully avoid financial evaluation issues during due diligence.
8. DO set up the right entity for your startup’s needs!
This goes with #1 and #7: you must 1) hire the right attorney and 7) don’t wait too long to form the legal entity. There are various legal entities you can choose from: partnerships, limited liability companies, corporations, associations, and the list goes on. Most startups form an LLC or corporation, depending on their financing plan. The most important factor is that you form a limited liability entity to protect your personal assets from any of the business’s wrongdoings. If you get #1 right, the attorney will take care of #7 and #8 for you.
9. DON’T infringe on trademarks. DO check before you select a name!
It is a sad and expensive tale when a startup has to change its identity, branding and marketing materials, website domain, and all other aspects that come with trademark infringement. It is essential that the startup selects a name and branding strategy from the onset that does not infringe on any trademarks or copyrights.
We had a client whose prior attorney did not check for trademark infringements. They received a cease and desist from a company operating in a similar industry with the same name, and unfortunately lost that fight. The client had to completely rebrand, hire naming consultants, and restart the creative process. Lesson learned: make sure you’re in the clear before you choose a name and run with it. You can easily check for existing registered trademarks on the USPTO’s website; however, it is best to have an attorney research for you.
10. DO organize your documents and get due diligence ready!
It is important to enforce the habit of keeping all legal documents organized. For an easy system, create a “legal documents” folder on the cloud and file the documents by type, name, and date signed. (TYPE_NAME_DATE). Why is this so important? Time kills all deals. When an investor is ready to conduct due diligence, time kills all deals. Most founders don’t have their ducks in a row (i.e. the legal documents are scattered) and it takes too long to send the required legal documents.
There is a big difference between a startup that is ready to provide the requested due diligence materials within a day than a startup that takes a week or month to get organized. Delaying the process can lower the company’s valuation or completely kill the deal. Set up a system for organizing legal documents and stick to the system. When an investor expresses interest, you want to respond immediately and show that you’re buttoned up and investment-worthy.
We hope this list helps you feel confident with your legal strategy (or realize you have some work to do) and help you focus on growing your business!