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Legal Mistakes that Startup Founders Make

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There are a lot of legal mistakes that startups make when getting their feet off the ground. These mistakes can be easily avoided which can save you time, money, and effort down the line. 

After speaking with experienced startup founders and top startup lawyers, we came up with a list of the top 10 common legal mistakes that startups make–and how to fix them.

Mistake 1: Missed 83b Election

You buy restricted stock, but don’t file an 83(b) election.

Founders can file an 83(b) election within 30 days of their first vesting day to eliminate the vesting tax. This deadline is not extendible. Therefore, if you miss this date, you would be liable for paying taxes on this first vesting day and every vesting day after that. 

For those who are unfamiliar with this, founders buy restricted stock in their own company, which is stock that can be bought according to a schedule through a process called vesting. The IRS taxes, on every vesting day, the difference between the fair market value of the stock on that day compared to the price that the founder bought it for. On the first vesting day, this isn’t a problem because the difference is zero or very small, but this becomes a significant problem over time because the difference grows as the company grows.

If you file an 83(b) election within thirty days of the first vesting day you can eliminate the vesting tax entirely. The 83(b) election lets the IRS tax you only on the first vesting purchase rather than over the entire vesting schedule. Your vesting tax burden effectively becomes zero.

Solution: Eliminate your vesting tax by filing an 83(b) election within thirty days of making the first vesting purchase.

Mistake 2: Company ownership

You go to an attorney with a certificate of incorporation, but haven’t bought any stock. 

Sometimes, founders file incorporation papers with their state and call it a day.  They think that they own the company just by the simple act of filing the paperwork.  But, simply founding a company does not mean you own it outright. You must own stock to own any part of the company. Stock can only be bought when it has been issued. 

To own a company explicitly, you must do the following at the founding of your company;

  1. Directors must be appointed.

  2. Officers must be appointed.

  3. The Board of directors must issue an approved stock.

  4. The founder must write a check to the company to buy stock.

Solution: You should go to an attorney who has experience in startup stock issuance so that they can guide you through setting up company procedures, issuing stock, and buying stock.

Mistake 3: Raising money without issuing common stock

You secure funding without first setting up the company structure. 

Let’s say you have closed a funding round, but haven’t issued any common stock. Now you want to issue common stock so you can start to buy stock in your company. Because you’ve added value to your company by securing funding before your board of directors issued stock, now you have to pay significantly more to buy your company’s stock than if you had issued stock before securing funding.

Solution: Be sure to set up your company’s structure, have your board of directors issue stock, and buy your company’s common stock before securing funding.

Mistake 4: Sole reliance on incorporation services

You use an incorporation service as a crutch. 

Online incorporation services can seem to be a cheaper alternative to an attorney. These services claim to save you time by acquiring the forms and doing research for you. 

In practice, this is not always the case. Incorporation services are sometimes inconsistent and require the founder to be very detail-oriented. Incorporation services will give you all of the paperwork and get everything teed up for you but, at the end of the day, you are in charge of putting everything into motion and making sure all forms are turned in on time. This can be overwhelming for some.

Also, there are some problems with contracts that arise from using these services as well. When you hire one of these services, the contract is between you, an individual, and the service. After incorporating, you are no longer an individual entity so you must amend the contract so that it is between your company and the incorporation service. These types of services usually charge a higher fee upfront to cover the legal fees to amend such contracts. 

So at this point, you now have a mountain of paperwork and deadlines to worry about and you’ve likely paid more than you would for an attorney. Had you hired an attorney in the first place, they would have been able to act on your behalf in getting your incorporation started and you would have saved money and time in the long run.

Solution: Hire an attorney so that downstream problems are less likely or have someone on your startup team be the point person on this so things don’t fall through the cracks.

Mistake 5: Being tempted by secondary shares and founder re-ups

The founder is tempted to make a bad deal for the company because it has secondary shares and founder re-ups as terms.

Secondary shares and founder re-ups are often used by investors to win the deal. Secondary shares are existing shares of common stock sold to investors which do not dilute the shares of existing shareholders. A founder re-up is when shares are given to the founder to offset their share dilution. 

Let’s say you are meeting with two different investors that are hoping to do business with your company. One proposes a deal that has founder re-ups and secondary shares to sweeten the pot and the other doesn’t. Don’t pick the first deal just because it benefits you. This is a tactic that investors use to try and bribe you into taking a deal that might not be good for the company as a whole. Once they’ve done this, these investors are in a more powerful position in the discussion because they have you on their side. 

Solution: Don’t just take a deal because it has founder re-ups and secondary shares. 

Mistake 6: Starting as an LLC*

You start a company as an LLC with the intent of acquiring venture capital.

Starting as an LLC can seem to be a cheaper and less time-consuming alternative to starting as a corporation. LLC filing fees are cheaper and you don't need to issue stock. Plus, as the thinking goes, you can always convert to a corporation in the future. 

However, as your company grows, converting to a corporation becomes more problematic because of:

  1. Cost of conversion because of hiring attorneys, hiring accountants, and paying taxes

  2. Potentially a large tax bill because of different tax rates

  3. Inability to give stock options to employees as an LLC

Starting as a corporation has an initial startup cost and time commitment but will save you time and money in the long run. 

Solution: Start as a corporation if you have the goal of securing venture capital.

*The caveat here is, of course, if you have no intention of raising capital, then a LLC may be a perfectly fine selection.

When founding a company, agreements and contracts aren’t signed between co-founders.

Founding a company with friends can often leave you overlooking the possibility of conflict between co-founders in the future. Sometimes you and your co-founders are not on the same page about the time commitment, effort commitment, and vesting schedules.

When conflict does occur, company details and structures are unclear so it opens the possibility for you to run into legal trouble with your co-founders. Imagine you and one of your long-time friends start a company together. You just go straight into it without establishing a baseline of how much time both of you are going to spend, how much effort, and a vesting schedule. Your friend owns the entirety of their portion of the company and things are starting off strong. A year down the line, your friend slacks off. You aren’t able to hold him accountable. Signing agreements upfront can have something down on paper so this doesn’t happen.

Solution: Sign agreements and contracts with co-founders at the founding of a company before moving on.

Mistake 8: Not vesting shares over time

All co-founders of a company decide to fully vest all of their shares instead of vesting over time.

In addition to agreements, vesting schedules give founders accountability for the amount of effort and time they are investing into the company. 

Vesting shares all at once can open the possibility of one or more co-founders becoming less interested in the company when there is no incentive to keep up the momentum of working. This can lead to one co-founder abandoning his or her duties, leaving the work to be picked up by you and your other co-founders You have to pick up the slack while you grow their equity. 

Solution: Create vesting schedules for all co-founders so that they can all be held accountable for the company over time.

Mistake 9: No IP Protection

Founders don’t sign IP assignment agreements before starting work.

An IP assignment agreement is a contract that transfers intellectual property from a creator to the company. Without an IP assignment agreement, IP is owned by the person who created it.

Transferring these IP rights from employed creators to the company can be difficult later on when the company is valued higher. Let’s say you make a small startup with a great idea. You hire talented employees that create technology or products for you. No agreements are signed to establish who this IP belongs to. A year later, your business starts to boom. One of your employees who created some of the technology for your company decides to take advantage of the situation and try to leave to start their own company in direct competition with you. You have no recourse because that IP belongs to that employee because you didn’t make them sign an agreement to transfer all IP they create (at the company) to you.  

Establishing an IP assignment agreement before your employees start working ensures that all of the IP that they create while on company time belongs to you. This puts you in a more defensible position.

Solution: Have founders and employees sign IP assignment agreements before starting work on the company.

Mistake 10: Super-voting shares

The founder(s) ask for super-voting shares early on.

Super-voting shares are assignments of a disproportionate amount of votes per share owned. (ie. 50 votes per 1 share). Super-voting shares are used to give more power to the founder over the activities of the company that are voted on. 

While this can make it easier to influence decisions in the company, it costs more money to draft this type of term in company agreements because it requires careful legal counsel. Requesting this type of term does not guarantee that it will be accepted. The first round of investors might ask for the removal of super-voting shares which can rack up even more legal fees to remove.

Solution: Refrain from asking for super-voting shares to mitigate the legal fees without much benefit.

Conclusion

Avoiding these 10 common startup legal mistakes can put you miles ahead of the competition. Some of these tips can take some initial money and time investment but they will save you money and time in the long term.