Major Legal Pitfalls for Startups – The Case for Hiring a Lawyer before you “Start Up” – Part 1

Heidi Hubbeling

 

In this two part series, Kelly Laffey discusses the legal pitfalls that startups can avoid when forming their company. Kelly counsels clients on issues related to corporate governance, mergers and acquisitions matters, and securities regulation and compliance. She also assists with financing for large private corporations, and entity formation and succession planning for professional services firms. Kelly provides general business counseling on a variety of up-and-coming regulatory issues for small and emerging companies that offer commercial services, allowing them to explore new business opportunities in various states. Drawing on her diverse work experience in the entertainment arena, including time spent with talent agencies, and music and television production companies, Kelly also assists on matters related to licensing, marketing, and exploitation of intellectual property rights.

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In my practice as a corporate attorney, I work primarily with startup and emerging growth companies.  This article may read similar to an advertisement for legal services and there may be some truth to that.  My ultimate goal as an attorney, however, is to save startup companies time and money (and stress) in the long run by doing things right from the start which will allow the company to put more resources to work on growing the business rather than fixing mistakes that could have easily been avoided.

Attorneys are often brought it in to work with clients who have done a significant amount of the formation and organization work themselves or through an online legal service provider at a low cost.  While it is certainly understandable that a very early stage company does not want to incur more legal cost than it has to, what seem like very minor issues to founder can lead to a lot of unnecessary clean-up work and time spent determining the best way to fix those issues including if and how to disclose them to potential investors, strategic partners or others that are critical to the business.

The unfortunate fact is that errors in company formation usually come to light when a company is about to engage in its first major financing or strategic transaction and potential investors or strategic partners start doing their “due diligence” on the company, i.e., looking into its formation documents, the founder agreements, employment agreements, etc.  This is often a critical time for the company as the founders have begun conversations with potential investors or a strategic partner, built momentum and are usually geared to start scaling the business. When the problem areas are identified and those activities are put on hold, it can cause a panic at the company, requiring lawyers to address the errors on a tight timeline in order to minimize the damage and not lose momentum. The result is typically a very high legal bill for a financing or strategic transaction.

In this two-part series, I describe some common legal issues encountered by startups that are not properly considered without legal counsel and which, when thoughtfully discussed with legal counsel prior to forming the company, should spare the company from legal expenses for corrective measures.

Choosing the right entity AND the right jurisdiction for you.

One of the first decisions a new company has to make is what legal entity form to take.  There are without a doubt dozens of articles that say you should be a C-corp for these reasons or you should be an LLC for those reasons.  Maybe you’ve read or know something about S-corps and you think that sounds like a good idea.  The reality is that the right entity form for your company is very specific to the facts and circumstances of your company.  Factors we consider include, among others: How many founders are there? How many employees will the company have? Will the company raise money from VCs or angels (and if so, does it expect to do so right away or will that be much further in the future of the company)? What is the anticipated size of the business? In what industry does the business operate? What might make the most sense now might not serve as the best form later and the form of entity can generally be changed later if necessary.  These are all factors a good lawyer or tax advisor can talk through with a new business and provide guidance regarding which options to select based on the company’s business plans.

The less often thought about issue is where to form the company.  As a lawyer practicing in what’s been termed “Silicon Beach,” most of our clients are based in California and so many assume they should organize or incorporate in California.  For some companies, being formed in California is perfectly fine, however, California can also be problematic for a number of reasons.  Many outside investors do not like to invest in California entities because California does not have the established corporate jurisprudence that Delaware has and so there is an element of unpredictability in California.  Companies will often be advised to incorporate in Delaware because Delaware corporate law is seen as both business and investor friendly.  However, if a company incorporates in Delaware, it has to engage a registered agent located in Delaware and so for some companies, it does not always make sense to pay the registered agent fees. Other factors to consider when choosing a jurisdiction are filing fees, franchise taxes and required annual filings. These are all considerations a corporate lawyer can help startups navigate.

Division of Ownership; Dilution and Vesting.

This can be an awkward conversation amongst founders but it is an important conversation to have early on in the life of the business.  How much of the company should each founder own? What is each founder bringing to the company in terms of skills, resources and service and how do we value what each founder adds? How much dilution are the founders willing to endure and from which sources, i.e., outside investors, an employee option or stock pool, venture debt transactions, etc.? Should the equity be subject to vesting and continued service to the company?

I’ve often encountered very early stage clients who have 2 to 3 initial founders and they have already diluted themselves by giving away equity such that together, they own less than half of the company.  Founders are so passionate and focused on developing the idea and growing the business, they don’t necessarily have good insight when it comes to managing the cap table.  Further, I’ve seen companies provide equity grants to service providers or intended partners of the business without subjecting the grants to vesting or continued service to the company over time.  We typically recommend that all service-related equity vest over a certain number of years to ensure the company is getting the intended value in exchange for that equity.

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For more information about Startup Formation and other emerging growth issues, contact Kelly Laffey at [email protected].  Stay tuned for Part II of the Startup Pitfalls Series on Monday, October 16th.

 

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