Most startups are built through trial and error. Founders then build, test and run. This process is essential to build breakthrough products. But it’s not the best way to approach legally. When it comes to legal matters, trial and error can get extremely expensive.
Below you will find the top five most common legal mistakes for startups and some tips to avoid them.
Top 5 legal startup mistakes
Table of Contents
Pre-split the power
Many founding teams avoid the difficult conversation about individual contributions and commitments by distributing equity equally in advance without a vesting schedule. This can lead to a number of problems and that’s how you end up with “Zombie Founders” – holders of significant equity in your startup who don’t contribute anything of value.
To avoid this, have that difficult conversation with your co-founders first and make sure everyone is on the same page. Determine the level of contribution and commitment each founder can make, and be absolutely sure that all founders’ shares become vested with a gap of at least 12 months. This means that if one of your co-founders fails to deliver value, fails to relinquish previous commitments, or simply loses interest before the year is out, you can let them go without having to buy off their equity, making the equity assets are diluted by issuing a ton of new shares or starting a new company.
No Assignment of Intellectual Property
Founders are often too busy 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 problems.
By default, the creator of any intellectual property (IP) is the owner. The creator must assign that IP address to the company for it to become company property. If your startup fails to secure IP assignments from everyone involved, an early contributor could come back years later and take over a large chunk of your business.
To protect against this, you should use a technical assignment agreement, also known as a Confidential Information and Inventions Assignment or Proprietary Information and Invention Agreement. This document must be signed by everyone in your company: founders, employees, contractors, everybody. It states that all intellectual property contributions and inventions of those working on the project are owned by the company.
When your startup grows to the size of an enterprise, an early-stage contributor can do serious damage by claiming ownership of a key part of your product or operating model, costing the company millions. A technical assignment agreement prevents this risk.
Improper handling of employee equity
Attracting a strong team with the limited resources of an early stage startup is incredibly difficult. Since you probably can’t afford market rates for top talent, you’ll need to offset them with equity.
Some founders do not plan this and divide all the equity among themselves. Without setting aside an equity pool for employees, they are forced to rely on junior professionals or contractors, which slows down the company’s development.
Set up an employee pool immediately after incorporation. High-potential startups can easily collapse when early-stage employees think they own a piece of the company, only to find out there’s no equity for them. They get disappointed and leave. To attract passionate and talented people who want to build something great, they must have an ownership interest in the company.
Another problem founders may run into with employee equity is failure to clarify the details of the grant. Equity must vest, but there are other important details as well. There are two types of equity you can give your employees: stock grants and stock options. Grants hand over part of the company to the employee, while options allow them to buy that piece at a heavily discounted price.
To avoid nasty surprises or hurt feelings, decide early on who gets equity grants and who gets options. Be very clear with your employees about the specific type of equity they earn. This can also have significant tax consequences for the employee, so you want to avoid an unexpected assessment.
Spamming everyone with a non-disclosure agreement
Many new founders inundate everyone they talk to with non-disclosure agreements (NDA). They think they have a really unique idea and they fiercely try to protect it. In reality, this is rarely the case. Execution, not the idea, is the most important factor in a startup’s success.
This often does not provide them with the protection they need and can even scare off potential partners and investors. Refusing to meet venture capitalists because they don’t want to sign an NDA marks you as a rookie and can kill a deal before it even starts.
Instead of hiding behind a non-disclosure agreement, figure out how to explain your product or service without getting too technical. For example, don’t reveal the details of your algorithm or proprietary technology, but generally explain how your product works, how you add value, how you differ from your competitors, and what you think your impact will be on the market.
Stack safes
Most startups raise their first capital using the Simple Agreement for Future Equity (SAFE). This tool is quick and easy, so many founders pile on SAFEs without understanding the implications.
Imagine getting to your Series A financing and discovering that all those SAFEs have converted, leaving you with only a small piece of your business. This can severely limit your ability to raise enough money in the future. Even if you succeed, your personal financial benefit will be negligible.
To avoid this, always keep a current pro-forma cap table 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.
Conclusion
You invest a lot of time, your own capital and perhaps the most productive years of your life in building your business. Inattention to your dressing table can rob you of the rewards of your hard work.
Checking out this video learn more. For a deeper dive, read this guide.
