Top 7 Legal Flops Entrepreneurs Typically Make
After hearing so many stories from Founders about what they wish they would've known starting out, we made a list to help future founder avoid the same pitfalls.
Check out the top seven legal flops entrepreneurs typically make when starting a business.
1. Failing to incorporate early
Imagine your company gets financing or is ready to go public. Right as you are getting ready to sign the documents, a forgotten founder returns. Involved in starting the venture, they decided to drop out, but now have an inflated view of their contribution and demand equity. All of a sudden you have a legal issue at hand that can completely dissolve your deal.
This problem can be eliminated by incorporating early and issuing shares to the founders, subject to vesting. As partial consideration for their shares, each founder is required to assign to the new corporation all inventions and works related to the company's proposed business. Incorporating early—before significant value has been created and well in advance of any financing event that establishes an implicit value for the shares—also helps prevent potential tax problems for "cheap stock."
Incorporating too late, and issuing inexpensive stock to the founders while much more expensive stock is being sold to investors, can create tax problems since the IRS can argue the difference in stock price is actually income to the entrepreneur.
There are many ways to incorporate depending on the type of business you want to build. How you incorporate will dictate how you manage books, taxes, investment and other matters. Do your homework. If you are going to raise money from professional investors, they'll likely require you to incorporate as a C-corp.
2. Issuing founder shares without vesting
Vesting protects the members of the founding team who take the venture forward. If people remain on the team and are productive, their shares will vest. If they leave earlier, that stock can be retrieved and given to whoever is brought in to replace them.
3. Hiring a lawyer not experienced in dealing with startups or venture deals
Please don't hire your uncle, who happens to be a real estate lawyer, to manage your legal matters. Experienced investors often rate the judgment of entrepreneurs by their choice of legal counsel. Lawyers who have no experience working with entrepreneurs and venture deals will most likely focus on the wrong things and fail to recognize some of the more subtle potential traps.
It's better to hire someone who has played the game, knows what's standard and what isn't, and will get the deal negotiated and closed promptly.
4. Failing to make a timely Section 83 (b) election
If advice in #2 is followed then shares will be issued, subject to vesting, to the founders as well as new employees. If stock is acquired, and it's subject to what the IRS calls a "substantial risk of forfeiture," then the IRS doesn't view the purchase as being closed until that risk goes away. When the stock vests, that risk evaporates and the IRS considers the deal closed.
The IRS calculates the difference between the price paid at the outset and the fair market value at that later date. They then tax this difference as ordinary income. An 83 (b) election allows the tax computation to be made based on the value at the time the shares are issued, often pennies per share.
If you hire the right lawyer (#3!), they will know about this and make sure the company is covered.
5. Negotiating venture financing solely on valuation
Valuation is not the only thing you should consider when selecting investors or negotiating a deal. There are many other ways for investors to get compensated if they end up paying a high price for shares. This can include requiring participating preferred stock with a high cumulative dividend, redemption rights exercisable after only several years, ratchet anti-dilution protection with no cap, and others.
Overall, make sure you know what investors you are dealing with. Investors perform a great deal of due diligence on you, we suggest you do the same. Search the reputation of the firm or investors you are working with. Do they have a history of standing by the founders when things go south? Do they have good contacts in the industry? Do they know the other big players and influencers?
6. Starting a business while employed by a potential competitor, or hiring employees without checking non-compete agreements
The law is clear that if someone is currently working for a company, particularly if they are a key employee, they cannot operate a competing business. Even after leaving the current employer, one still cannot use or disclose the company's trade secrets.
Under the so-called inevitable disclosure doctrine, if someone has been exposed to trade secrets at their job and leaves to work for someone else with sufficiently similar responsibilities, some courts will conclude that it's inevitable they will use the information from the earlier position. They could face an injunction prohibiting them from working for the new employer until a number of months go by and whatever trade secrets they had are stale. It also helps to know whether potential recruits are subject to covenants not to compete.
7. Thinking legal problems can be solved later
There's a tendency to think, "Once I get funding, I'll hire a lawyer." This is risky. Many of the points made here are problems that can't be patched up later. Does that mean you should devote all of your time and money to legal issues? No, just hire a good and competent lawyer. It's a worthy investment.
There are many good lawyers (not always local) that can be retained for relatively little money up front at the early stages of your company. It will cost you much less to get it right at the start than to try to sort it all out later.
- the Crew