Founder’s Guide: How to Avoid 10 Rookie Legal Startup Mistakes
Introduction
As a founder, you’re wearing many hats, but it’s difficult to be an expert at everything. We know dealing with legal issues can be daunting. Legal missteps can be some of the most costly problems that startups face, but it doesn’t have to be that way. So we’ve created this guide to make you aware of some common startup legal pitfalls and give you some ideas on how to avoid them.
Kyle Westaway
Managing Partner, Westaway
Founder’s Equity
Splitting up the equity in your startup at the outset can be tricky. The goal is to ensure that each founder is compensated properly for the value that she’s bringing to the company. That value could be expertise, intellectual property, capital, network affiliates or any other asset that’s valuable to the company. Though there are some benchmarks, much of the relative value is incredibly subjective at incorporation. So, splitting up the equity often requires some hard and honest conversations between founders.
In addition to the challenge of valuing each founder’s contribution, none of the founders have a crystal ball that can accurately predict how you’ll work together or whether personal priorities will change in the future. It’s common for founders to leave the company in the first 12 months due to team dynamics or a shift in personal priorities and interests. For this reason, founders’ equity should vest with a one-year cliff. This ensures that a founder that leaves within the first year doesn’t walk away with equity.
| DON’T | Issue founder’s equity that does not vest. |
| DO | Have the hard conversation with your founders about the value and commitment they bring to the company. Then speak to advisors and your legal team to get an outside opinion and help ensure that the legal documents accurately reflect your intentions. At Westaway, our General Counsel plans include advice on founder’s equity. |
Employee Pool
Though the founders will launch the company from idea to action, a team of employees, contractors and advisors are typically required to achieve success. Since your company will likely have little capital to compensate your team at first, you’ll need to issue them equity as well. So, you need to reserve equity to issue to employees. This is known as the Employee Pool. To formalize the employee pool, you’ll need to approve a stock plan that states the rules by which your startup can issue stock grants or stock options.
| DON’T | Issue all of the equity in your company to your founders. |
| DO | Reserve 10-20% of your equity to incentivize employees. Work with your legal team to ensure that you reserve the right amount of equity, and then draft and approve a stock plan that aligns with your vision. At Westaway, our General Counsel plans include structuring your employee pool. |
Invention Assignment
Unlike brick and mortar businesses, the core value of most startups is purely in intellectual property such as code base, business model innovations, design elements and business processes. So, before you build a huge company based on intellectual property, you’ll want to make sure you own it. The worst case scenario is that you incorporate somebody’s intellectual property into your company without thinking about it. Then five years down the line, when you’re a big successful company, that person re-emerges and sues you for millions of dollars for stealing their work.
| DON’T | Allow people to work for your startup without clarifying who owns the intellectual property. |
| DO | Ensure everybody working for your startup has signed a Confidential Information and Invention Assignment Agreement (CIIA). At Westaway, our General Counsel plans include advising on intellectual property ownership and drafting CIIAs. |
Employee Equity
Generally, startups issue equity to employees through either a stock option or a stock grant. A stock option is the right to purchase a certain number of shares in the company at the fair market value of the stock on the date of issuance. A stock grant is an outright issuance of common stock in the company. A stock option holder has a future right of purchase, whereas the stock grant holder actually owns the stock in the company. So when do you issue which? The founders and the first few employees / advisors will usually get stock grants, then everybody else will get stock options.
| DON’T | Issue the wrong form of equity. |
| DO | Make sure you’re issuing the right form of equity for the given context. At Westaway, our General Counsel plans include advising you on issuing employee equity |
Vesting
As mentioned, when you issue equity to founders, advisors and employees, ensure that it is vesting. However, it’s important to understand vesting equity has an impact on the personal taxes of recipients. They will need to report the value of that stock to the IRS on the annual tax form and will be taxed on the value of the stock as though it were cash. But if the stock vests over four years, when do they report the value on their taxes? The default setting is they will report the amount received that year. So, with a four-year vesting schedule, they will report 25% of the equity each year at the current share price. Assuming the value of your startup’s stock has increased, then recipients may be stuck with a big tax bill. Paradoxically, the better the company does, recipients get a more intense tax burden. This is not ideal. However, if recipients file form 83(b) with the IRS within 30 days of the receipt of the equity, then they can elect to report all of the equity at the price of issuance, which is presumably very low, before the stock value appreciates in future funding rounds. Though this is technically not a company responsibility, and it’s up to the recipient to decide whether or not to take action on this, it’s good form to make them aware of the issue and make it easy for them to file an 83(b).
| DON’T | Issue vesting equity without an 83(b). |
| DO | Draft an 83(b) form to make it easy for your employees. At Westaway, our General Counsel plans include advising you on 83(b) related issues. |
Independent Contractors
Most startups rely on contractors for many roles at their company, especially at the outset when funding is tight. Working with contractors can be great for your company because it allows you to have access to high-quality talent on a short-term or project-based engagement. Hiring someone as a contractor is also a great way to understand if they might be a good fit to join the team as an employee. However, contractors are outsiders that may have access to some very sensitive data such as customer information, business processes or other sensitive data. So, insist on a contract that requires the contractor to keep that information private.
| DON’T | Give away your company secrets. |
| DO | Protect your confidential information in your independent contractor agreement. At Westaway, our General Counsel plans include drafting a custom independent contractor agreement for you that protects your confidential information and has other key provisions that set you up for success. |
Privacy Policy
GDPR, CPA, CCPA, HIPPA, WTF? Most founders understand that data security and privacy are an increasingly important issue but feel completely confused about how it applies to their business. So, they do nothing or copy and paste a random privacy policy. Without understanding the implications, you may be opening yourself up to risks you aren’t aware of.
| DON’T | Copy and paste your privacy policy. |
| DO | Work with an attorney to understand how the privacy regulations apply to your startup. At Westaway, our General Counsel plans include drafting a custom privacy policy that protects your users and reduces your risk. |
NDA
You may have heard horror stories about startups getting their core intellectual property stolen by some competitor or big company because they didn’t have a non-disclosure agreement (NDA) in place before talking. It’s true. It can happen. But it’s rare. So, when is it appropriate to make somebody sign an NDA? Should you send one before every investor or biz dev meeting?
| DON’T | Send an NDA before every meeting. |
| DO | Have an understanding of when an NDA might be appropriate. At Westaway, our General Counsel plans include drafting custom NDAs and advising you on when specifically to use them. |
Handle your NDA hassle-free with our Non Disclosure Agreement services.
Board Compliance
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Even at an early stage, a startup board of directors still has to ensure it’s compliant. It’s responsible to:
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Adopt bylaws. Bylaws establish operating rules for the company and board procedures. It’s important to adopt comprehensive bylaws.
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Issue stock. When founders, and employees receive stock, the board is responsible to approve and document that issuance.
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Elect officers. Appoint people to serve in roles like CEO, President, Secretary and Treasurer. Document these appointments in board resolutions.
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Hold regular board meetings. Many states require corporations to hold at least one board meeting per year. It’s best practice for early-stage startups to hold quarterly board meetings.
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Approve financing. The board of directors of an early stage startup is responsible for reviewing and formally approving any fundraising efforts, including the terms of financial instruments like SAFE agreements and convertible notes that are issued to investors.
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Document board meetings with minutes. The board secretary should document what actions were taken and decisions made at each meeting.
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File annual report. Most states require corporations to file an annual report and pay a fee to remain in good standing. Make sure to file this report annually.Â
| DON’T | Shirk your board duties. |
| DO | Work with your legal counsel to ensure you’re in compliance. At Westaway, our General Counsel plans include drafting board guidance and drafting board consents to help keep you compliant. |
SAFE
Most early funding is raised on a Simple Agreement for Future Equity (SAFE). The SAFE has streamlined funding and allows founders to close funding quickly, which is great for them. The downside is that it becomes so easy to raise capital that some founders aren’t taking time to understand the ownership impact when those SAFEs convert into equity. You might be shocked to realize how much equity you’ve given away when you get to your Series A.
| DON’T | Wait to understand how much equity you’ve given away until Series A. |
| DO | Update your cap table after each new SAFE to ensure that you have a granular understanding of your equity in all scenarios. At Westaway, our General Counsel plans include raising capital and cap table management. |
Get the professional help you need for your SAFE.
To stay informed, ensure to check our other Founders guides on Public Benefit Corporation, and Convertible Notes.
