Most startups are built through trial and error. Founders build, test, and then pivot. This process is essential to build innovative products. But it’s not the best way to approach legally. When it comes to legal matters, trial and error can be extremely expensive.
Below are the five most common legal mistakes for startups and some tips on how to avoid them.
Top 5 Legal Mistakes by Startups
Divide the capital in advance
Many founding teams avoid the difficult conversation about individual contributions and commitments by dividing the capital equally up-front without an vesting schedule. This can lead to a number of problems and is how you get “Zombie Founders”: holders of significant shares in your startup who add nothing of value.
To avoid this, have that difficult conversation with your co-founders early on, and make sure everyone is on the same page. Calculate the contribution and commitment levels each founder can provide, and make absolutely sure that all founders’ shares are vested with at least a 12-month run-in. This means that if one of your co-founders can’t build value, can’t give up on previous commitments, or just loses interest before the end of the year, you can let them go without having to buy their equity, diluting it by issuing a ton of new shares or starting a company. new company.
Do Not Assign Intellectual Property
Founders are often too preoccupied with developing their product to keep track of who wrote what code or who came up with an idea or strategy. This can leave your startup vulnerable to serious legal trouble.
By default, the creator of any intellectual property (IP) is the owner. The creator must assign that IP to the company so that it becomes the property of the company. If your startup fails to secure IP assignments from everyone involved, an early contributor could come back years later and take a large chunk of your business.
To protect against this, you must use a technology release agreement, also known as a Release of Inventions and Confidential Information or Proprietary Information and Inventions Agreement. This document must be signed by everyone in your company: founders, employees, contractors, everyone. It establishes that all contributions of intellectual property and inventions of those who work on the project belong to the company.
When your startup grows to the size of a company, an early-stage contributor could cause serious damage by claiming ownership of a key part of your product or operating model, costing the company millions. A technology transfer agreement will avoid this risk.
Mishandling of employee equity
Attracting a strong team with the limited resources of an early-stage startup is incredibly difficult. Since you may not be able to pay market rates for top talent, you’ll need to compensate them with capital.
Some founders do not plan for this and divide all the capital among themselves. Without reserving a capital fund for employees, they are forced to rely on young professionals or contractors, which slows down the development of the company.
Establish an employee capital pool immediately upon onboarding. High-potential startups can easily collapse when early-stage employees think they have a piece of the company, only to find there’s no capital left for them. They get disappointed and leave. To attract passionate and talented people who want to build something great, they must have an ownership stake in the company.
Another problem founders can run into with employee equity is failing to clarify the details of the grant. Equity must be granted, but there are other important details as well. There are two types of capital you can give your employees: stock grants and stock options. Grants give a part of the company to the employee, while options allow them to buy that part at a greatly reduced price.
To avoid unpleasant surprises or hurt feelings, make the decision early on who gets stock grants and who gets options. Be very clear with your employees about the specific type of capital they are earning. This can also have significant tax implications for the employee, so you want to avoid an unexpected tax bill.
Spam everyone with a nondisclosure agreement
Many first-time founders inundate everyone they talk to with non-disclosure agreements (NDAs). They think they have a truly unique idea and try to protect it fiercely. In reality, this is rarely the case. The execution, not the idea, is the most important factor in the success of a startup.
This often doesn’t give them the protection they need and can even turn off potential partners and investors. Refusing to meet with venture capitalists because they won’t sign an NDA marks you as a rookie and can kill a deal before it starts.
Instead of hiding behind an NDA, figure out how to explain your product or service without getting too technical. Don’t reveal the details of your algorithm or proprietary technology, for example, but explain, in general, how your product works, how it offers value, how it differs from your competitors, and what you think its impact on the market will be.
Stacking of safes
Most startups raise their first capital using the Simple Arrangement for Future Equity (SAFE). This instrument is fast and simple, which is why many founders stack SAFE without understanding the implications.
Imagine getting to your Series A funding and finding that all of those SAFEs have been converted, leaving you with only a small part of your company. This could severely limit your ability to raise enough money in the future. Even if you are successful, your personal financial advantage is negligible.
To avoid this, always maintain a current table of pro forma limits that takes into account the dilution impact of every dollar raised. If you don’t know where to start, Foresight can help any founder learn and improve their financial modeling skills.
Conclution
You are investing a lot of time, your own capital, and perhaps the most productive years of your life building your business. Inattention to his limit table can rob you of the rewards of his hard work.
Take a look at this video to learn more. For a deeper dive, read this guide.