Most startups are built through trial and error. Founders build, test, then pivot. 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 are the top five most common legal mistakes for startups and some tips on how to avoid them.
Top 5 Startup Legal Mistakes
Splitting the Equity Up Front
A lot of founding teams avoid the hard conversation about individual contributions and commitments by splitting the equity evenly up front without a vesting schedule. This can lead to a number of problems and is how you get “Zombie Founders”—holders of significant equity in your startup that don’t contribute anything of value.
To avoid this, have that hard conversation with your co-founders up front and make sure everyone is on the same page. Work out the levels of contribution and commitment each founder can provide, and make absolutely sure that all founders’ shares are vesting with at least a 12-month cliff. This means if one of your co-founders can’t deliver value, can’t give up prior commitments or just loses interest before the year is out, you can let them go without having to buy out their equity, diluting the equity by issuing a ton of new shares or starting a new company.
Not Assigning 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 issues.
By default, the creator of any intellectual property (IP) owns it. The creator must assign that IP to the company for it to become company property. If your startup fails to secure assignments of IPs from everyone involved, an early contributor could come back years later and take a large portion of your business.
To protect against this, you should use a tech assignment agreement, also known as a Confidential Information and Inventions Assignment or Proprietary Information and Invention Agreement. This document should be signed by everyone in your company—founders, employees, contractors, everyone. It states that all intellectual property contributions and inventions of those working on the project belong to the company.
When your startup grows to the size of an enterprise, an early-stage contributor could cause serious damage by claiming ownership of a key part of your product or operational model, costing the company millions. A tech assignment agreement will prevent this risk.
Mishandling Employee Equity
Attracting a strong team with the limited resources of an early-stage startup is incredibly hard. Since you’re likely unable to pay market rates for top talent, you’ll need to compensate them with equity.
Some founders don’t plan for this and split up all of the equity among themselves. Without setting aside an equity pool for employees, they are forced to rely on junior professionals or contractors, slowing down the company’s development.
Establish an employee equity pool immediately after incorporation. High-potential startups can easily collapse when early-stage employees believe they have a piece of the company, only to find out there is no equity for them. They become disappointed and leave. To attract passionate and talented people who want to build something great, they need to have an ownership stake in the company.
Another issue founders may encounter with employee equity is not clarifying the details of the grant. Equity should be vesting, but there are other important details as well. There are two kinds of equity you can give your employees: stock grants and stock options. Grants hand over a piece of the company to the employee, while options allow them to buy that piece at a deeply discounted price.
To avoid nasty surprises or hurt feelings, make the decision early about who gets stock grants and who receives options. Be very clear with your employees about the specific type of equity they are earning. This can also have significant tax implications for the employee, so you want to avoid an unexpected tax bill.
Spamming Everyone with a Non-Disclosure Agreement
Many first-time founders inundate everyone they talk to with non-disclosure agreements (NDA). They think they have a truly unique idea, and they try to protect it fiercely. In reality, this is rarely the case. Execution, not the idea, is the most important factor of startup success.
This often doesn’t provide 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 begins.
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 do explain, in general, how your product works, how you deliver value, how you’re different from your competitors and what you think will be your impact on the market.
Stacking SAFEs
Most startups raise their first capital using the Simple Agreement for Future Equity (SAFE). This instrument is quick and simple, so many founders stack SAFEs without understanding the implications.
Imagine getting to your Series A funding and finding out that all those SAFEs have converted, leaving you with only a small sliver of your company. This could severely limit your ability to raise enough money in the future. Even if you succeed, your personal financial upside is 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’re investing a lot of time, your own capital and maybe the most productive years of your life into building your company. Inattention to your cap table can rob you of the rewards of your hard work.
Check out this video to learn more. For a deeper dive, read this guide.