Jack Donenfeld made a stop at Gateway CEI in Phoenix, Arizona, last month. He delivered an interesting presentation on “Avoiding Legal Mistakes That Could Kill Your Startup.” He created a list of the 22 most significant mistakes he repeatedly sees from startup companies. Here’s my top 10 list from his presentation:
- Selling securities to non-accredited investors
Let’s start by defining an individual who is an accredited investor (as defined by the US Securities and Exchange Commission):
a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
If a person invests in your company and do not meet the above guidelines, then you are selling securities to a non-accredited investor. Do not do this, as you are then subject to securities fraud and potential criminal charges.
- Advertising or generally soliciting for investors
Regulation D prevents startups from “general advertising” or “general solicitation.” Which means no “Big Game” commercials when you are ready to raise funds.
Unless there is a “substantial and pre-existing relationship” between the startup company and the prospective investor, your startup company can’t even email prospective investors about investment opportunities in your company.
- Violating employment laws
Let’s face it, startups are cash-strapped, scrappy businesses and like to get a dollars worth out of a nickel. If you hire an independent contractor but treat them like an employee, they are employees in the view of the law. Your company may unknowingly bring on legal implications and employee risk. Understand the employment laws with your state.
- Forming the wrong entity
Do your homework and consult with an attorney when structuring your entity. LLCs and C-Corps are the most common entities for emerging companies. LLCs are unique because they can be changed into C-Corps or S-Corps after formation, but the process is expensive.
- Co-founders getting together too fast, without knowing each other well enough
Choose co-founders carefully; they’ll be in the trenches in the good and the bad times. The relationship is like a marriage. If you get cold feet about your co-founder, move on until you find the right fit. Not only will having a bad co-founder create legal issues, they will also slow down the growth of your company.
- Not having all founders sign a founders agreement
Many well-known startup horror stories exist because of poorly executed founders agreements. Voting rights, lock-up provisions, veto rights on company sale, borrowing, and investment rounds. How do you get rid of an unwanted co-founder? These are all issues for an attorney to help you navigate through so you can be prepared for all potential scenarios.
- Not establishing an options/equity compensation plan for key employees, directors, and advisors
Without an options or equity compensation plan, it’s hard to attract qualified people and good advisors. A strong director and advisory board brings credibility to the company and helps with investor introductions. A benefit of the compensation plan is that securities given as part of compensation are exempt from securities registration.
- Failing to ensure that IP created by outside developers is assigned to the company
We all know the Winklevoss and Zuckerberg story. The reason why the Winklevoss twins don’t run Facebook is because Mark Zuckerberg never signed a work made for hire agreement. This would have given the twins complete ownership over the work. The billion dollar lesson is to make sure there are written agreements with everyone who works on the IP.
- Not requiring employee agreements and IP assignment agreements
As a startup or any business, work done for the company should remain the company’s property. Without having these agreements in place the company is not guaranteed ownership over the work. Even worse, without non-compete agreements in place, a worker may acquire trade secrets and use them with a competing company.
- Thinking legal issues can be dealt with later
This is the most common excuse startups make. They will assume because it is not an urgent issue now, it can be put off until later. Unfortunately, most legal issues arise once it’s too late and nothing can be done. It will cost much less to get it right at the beginning than to try to sort it all out later and correct. Prevent the problems before they happen.
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