A Few Common Pitfalls for Startups to Avoid

As attorneys for early stage and emerging growth companies, we often hear from entrepreneurs after they’ve realized that a mistake has been made. They often seek our help in cleaning up that mistake. We are, of course, glad to assist in such situations. That said, the purpose of this post is to shine a spotlight on just a few common mistakes that will hopefully help entrepreneurs avoid making them in the first place.

Protecting Intellectual Property Starts Immediately

Other than human capital, your company’s intellectual property is very likely to be among your company’s most valuable assets. It is, therefore, critical that you protect that intellectual property. When operating at the speed of business, this is often overlooked by startup founders and the consequences can be very severe.

Immediately upon incorporation, the founders and any other initial service providers of the Company should assign all IP created by them to the company. Every future employee and consultant should do the same. Investors (or potential acquirors) will expect the company to own all of its IP. Being able to clearly show the chain of title to the company’s IP is critical. It is important to distinguish between employees and consultants here, as the law treats them differently here. With respect to consultants, the rule is “he or she who creates it, owns it, unless there is an agreement to the contrary.” This seems counterintuitive to some. If the company pays the consultant to create the IP, one might assume that the company will own it. But that’s not the case. The reason is that the law is intended to value innovation and so the innovator owns whatever he or she creates, and the company receives a right to use it. That is a bad result for the company. Accordingly, it is crucial that consultants execute an assignment of IP in the form of a work-for-hire arrangement.

To the extent you intend to share confidential information with a potential business partner (such as a developer or a manufacturer), a nondisclosure agreement should be executed, essentially stating that the business partner will not share with anyone any confidential information they learn through their relationship with the company or use the confidential information for any reason other in connection with a stated purpose. These NDAs are often “mutual NDAs,” meaning that both parties agree to maintain the confidential information shared by the other party.

Allocation of Equity? 

Where there are multiple founders, it is important to have a rational conversation (albeit often an uncomfortable one) about the relative ownership of the company. How you divide up initial ownership among the founders ultimately is a business call (and not a legal one) and is certainly more of an art than a science. It is important to think hard about relative roles, contributions, expectations, etc. Equity allocation should be based on such relative contributions. Many founders will default to an even split but that is very often not appropriate. While it can be difficult, it is important to try to get the allocation of equity right from the start (it can be much harder to fix later on).

The Importance of Vesting

In addition to the allocation of equity, where there are multiple founders, it is critical to consider whether a founder’s shares should be subject to vesting/risk of forfeiture. What happens to a founder’s ownership interest if they decide to leave the business? Should they keep all of the equity that was initially issued to the founder? 

A quick example:

There are two co-founders who have split the shares equally (again, often not the right choice). After a few months one founder decides to leave. Absent a vesting schedule the departing founder walks away with 50% of the company. The founder who sticks around would then be left trying to run the business with only 50% of the upside. He or she would likely need to bring on another person to replace the departing founder and will likely need to provide equity incentives to that person. This results in even more dilution. A common solution is to require that each founder’s shares vest over time, which grants the company the right to take back the unvested portion of that founder’s shares (and in some instances the vested shares as well) when that person leaves. The number of shares the company has the right to take back usually depends on the length of time the founder has been with the company (current market standard tends to be four year vesting with a one year “cliff”).

Vesting protects not only the founders who stick around, but also the company generally. For example, when an investor comes along, they will want to ensure that the critical members of the team are sufficiently incentivized and motivated. If there is a lot of dead weight on the cap table, investors may think twice before investing.

A Very Unforgiving Mistake:

While this list could go on for many more pages, I will end this post with one final common mistake made by founders. This one is extremely unforgiving.

When a stockholder receives shares that are subject to a risk of forfeiture (like a vesting schedule), they should strongly consider filing an 83(b) election with the IRS. In the case of a new company with nominal value at the time of the stock issuance, it almost certainly in the founder’s best interest to file this 83(b) election. Absent an 83(b) election, the IRS does not consider stock that is subject to a risk of forfeiture to be fully owned by the taxpayer until the risk of forfeiture lapses. The IRS will not tax the stockholder on these shares until the risk of forfeiture goes away. The obvious problem here is that when the risk of forfeiture goes away, the shares will (hopefully) have significantly more value than they do when granted and you will have to pay the tax based on that higher amount. An 83(b) election allows you to play another game of let’s pretend, that just for tax purposes, you own the shares outright today. This election allows the founder to pay the tax at the time of grant based on the current, nominal value (for founders receiving shares at incorporation, this is typically a fraction of a penny per share). So what is so unforgiving here? An 83(b) election must be made within 30 days of the date of grant and there is no cure for failure to timely file.

In addition to the above, there are many other ways in which a business’s prospects can be harmed in the early stages of a company’s development. The last thing a company wants is to be on the cusp of receiving financing only to learn that a potential investor has uncovered a problem in the course of its due diligence. At best, fixing such a problem can be time consuming and expensive; and if the problem is severe enough it can even derail the whole financing.

Fortunately, many of the common legal pitfalls startups encounter are easily avoided by keeping your lawyer informed about your plan so they can help identify issues before they arise.