5 Legal Pitfalls Every New Business Should Avoid

By QuickBooks

12 min read

Almost every startup faces the same two challenges. First, the formation and early-stage operation of your company presents many complex issues that can create severe problems if not handled correctly at the outset. Second, you have little or no money available to help solve these issues until sometime in the future when your vision can attract capital.

Cutting corners and efficiently solving problems are things every early-stage entrepreneur needs to do. However, don’t let your lack of financial resources cause you to make these five critical mistakes that could cost you much more to fix and even perhaps derail your efforts entirely.

1. Failing to Use Contracts Between Founders

Co-founders often feel comfortable enough to “trust” each other at the outset of their business venture. Why not? Your co-founder is probably someone you have known a long time, perhaps a close friend or someone you worked closely with in school or prior business experience.

You know that you intend to work hard and that you will be unduly devoted to the success of your new startup. Isn’t it appropriate that you assume your co-founders will do the same?

Unfortunately, it is more likely than not that you and your co-founders will not end up together when—and if—your venture achieves success.

There are many reasons for this. The things that brought you together, like friendship, common experiences and camaraderie, are not necessarily the attributes that will make you good business partners.

Just because someone is your friend or you have shared meaningful common experiences together, or even that you perceive them to have an appropriate skill set, does not mean that each of you will bring the proper skill set to the venture to make it successful. And let’s face it: Creating a startup is hard and can be very taxing on a person’s life. Everyone handles that kind of stress differently.

These are the reasons why, no matter the trust level, co-founders of a startup should always have a very clear understanding of their expectations of each other and create meaningful contractual relationships so that the venture (and maybe even your relationship) can survive the loss of one or more founder.

First, make sure you have honest and frank discussions about what level of commitment will be required. These talks should cover issues such as the time commitment each founder will devote to the venture, particularly if one or more of them are working “day jobs,” how long one can devote to the venture prior to a funding event occurring before that person will necessarily need to depart, what each founder’s specific role and responsibilities will be, and perhaps even a methodology for resolving contentious situations.

Specific actions you should consider are:

  1. Entering into written employment agreements specifying roles and responsibilities.
  2. Creating contractually binding “vesting” arrangements with respect to founder stock, typically over a four-year vesting period.
  3. Having a clear understanding as to when and under what circumstances early founders will step off the board of directors or out of senior management roles as the company grows and requires those functions be performed by others.
  4. Creating a shareholders’ agreement to cover issues such as voting for a board of directors, restrictions on transfer of founder shares (buy-sell, co-sale, drag-along rights and rights of first refusal), and other transfer issues such as death, disability, divorce and dispute resolution among shareholders.

2. Not Protecting Intellectual Property

Another common mistake that early-stage entrepreneurs make, particularly when resources are tight, is failing to properly document the creation, contribution to, modification and protection of intellectual property.

Most entrepreneurs think that they will “eventually” get around to looking at their intellectual property protection and decide whether there are inventions that can be patented or trademarks that should be filed. Intellectual property is the lifeblood of every startup. Your intellectual property begins the day you start thinking about and planning your venture.

The most common mistakes are failing to properly transfer existing intellectual property into the business venture, not documenting or ineffectively documenting the contribution of independent contractors, failing to implement proper employee protocols and investing effort in a brand without fully understanding its availability.

When you go to raise money for your venture, investors will perform diligence on your company and expect to see that you have properly protected all of your intellectual property from inception. If the venture starts off with intellectual property that existed prior to the formation of the venture (perhaps existing assets of one or more of the founders, or assets that were created prior to the creation of the legal vehicle), make sure those assets are properly transferred and/or assigned to the business venture.

This process should also be coordinated with the issuance of equity to the founders (see discussion below), as these intellectual properties can often serve as the basis for the issuance of equity and can create tax issues for the founders if not properly transferred.

Frequently, founders utilize the services of independent contractors, whether they are developers or otherwise, to assist in the development of the company’s creative works, such as software or other technology. However, contributions to your intellectual property can include other, less obvious things such as questions, comments, ideas, images, writings, music, sounds, audiovisual works or effects, artwork, design elements, graphics, suggestions, concepts, notes or other materials.

As a general legal matter, any of these types of contributions that are created by an independent contractor (i.e. someone who is not an actual employee) are owned by the author and not by the company absent a written agreement to the contrary. Therefore, it is critical that independent contractors sign a written agreement prior to the commencement of any efforts on behalf of the company.

Similarly, although an employer generally owns the results and proceeds of intellectual property created by its employees, there are a number of tricky issues relating to employee development that should also be covered in a written agreement. These documents are typically referred to as Employee Proprietary Invention Agreements and should be executed by every employee, including the founders, prior to commencement of employment.

Finally, while meaningful intellectual property protection, such as a patent filing or a trademark registration, can be cost-prohibitive to an early-stage venture, you should nonetheless pick your brand or branding attributes carefully and review publicly available resources, such as the U.S. Patent and Trademark Office (USPTO) website, before investing significant effort in branding your business.

Entrepreneurs frequently pick a brand because of a convenient URL, only to find later that a potential trademark-infringement claim forces them to entirely rebrand their business. With a little bit of guidance at the front end, these problems can be avoided.

3. Issuing Securities (or Promising to Do So) Without Proper Documentation

The issuance of equity securities (i.e. any ownership interest in your business) is regulated by both the federal government and each state in which the company is domiciled, the recipient of the securities is domiciled or the transaction is effected. It is essential that the initial issuance of “founders” shares and every subsequent issuance of equity securities be properly documented and comply with regulatory requirements.

This is a particularly tricky issue with respect to equity granted to persons who will either work for or contribute to the success of the venture other than simply by investing in the business. Equity that is granted to persons for services is “compensatory” and raises additional issues relating to the valuation associated with the performance of those services.

Founders often promise equity in consideration of the performance of services. If those promises are not contemporaneously documented, they cannot subsequently be documented at the same value at a later time. Because of complicated tax regulations that are beyond the scope of this article, the granting of any equity in lieu of services must be made at the fair market value of such equity on the date of grant.

There are severe penalties for the failure to do so, which generally result in excessive tax liability or costly economic consequences when these transactions are attempted to be documented after the fact.

4. Failing to Understand Your Cap Table

Many investors end up walking away from a deal because of issues associated with the company’s capitalization table and/or a fundamental misunderstanding surrounding the valuation they believed was being negotiated. You may not be a “math person” as a founder, but you need to fundamentally understand your cap table. Investors expect to see your company presented in a certain way, and they don’t like surprises.

Cap-table issues occur when equity transactions are offered, discussed and/or documented without precision. For instance, you tell a programmer that, in exchange for reducing their hourly rates, you will issue them 3% of your company. Sounds pretty simple, right? Wrong.

Did you just give the programmer 3% of the amount of stock that is currently outstanding among the founders? Did you give the programmer 3% of the total amount of stock that is outstanding among the founders plus the number of shares the programmer is going to receive as their 3%? In other words, does the programmer have a full 3% after they get their shares, or does the issuance of their own shares dilute their 3%? Furthermore, what about stock options and other promises that may be outstanding? Is the 3% fully diluted, meaning does it contemplate the entire stock-option pool in any other contingent promises that may be out there?

These simple questions illustrate that a simple equity transaction may be more complicated if you don’t fully understand your capitalization structure.

In an investment scenario wherein you negotiate for a particular value of the company—say 20% for a $2 million investment—what have you actually agreed to? On the surface, it seems like you agreed to an $8 million pre-money valuation, which, when combined with the investment, implies a $10 million post-money valuation. However, what happens if there is a prior convertible note issued? Is that converting into the pre-money valuation or post-money valuation? What happens if other investors join in the investment alongside the investor, so that the total investment is more than $2 million? Is the investor still getting 20% post-money? What about the stock-option pool?

These issues are intended to illustrate the necessity for a founder to fully understand what a cap table is, how it is impacted by every transaction in the company’s equity (including transactions in convertible or derivative instruments like convertible notes and stock options) and to have clarity in the negotiation process.

5. Raising Seed Capital Under Egregious Terms

Many entrepreneurs raise capital under instruments commonly referred to as “convertible notes.” Convertible notes are frequently used as an appropriate way for a company to take in investment without having to deal with valuing the company at a stage of its development where doing so is impossible because of a lack of valuation metrics.

Generally, the parties simply agree that the amount invested will convert into future equity of the company at a valuation negotiated with investors at the time of the more-recent investment, subject to a discount on conversion (typically in the 20% to 25% range) to compensate the early investor for taking the additional risk of investing prior to the evaluation transaction.

While the concept seems simple enough, founders need to keep their eye on a few significant issues. Here are the three big ones.

First, convertible notes will almost always include a “cap” on conversion, so the investor is getting a discount equal to the greater of the negotiated discount, or what it would receive upon a conversion at the cap. There is a legitimate reason for including a cap. The investor is agreeing not to value the company (which would likely result in a much larger equity stake given the relative proportion of the investment to the overall value).

The investor should not therefore be “punished” because the company is able to use that initial investment and bootstrap to a very large pre-money valuation at the time of the investment. Negotiation is often one of the most difficult aspects of raising money through convertible notes, and there should be a reasonable compromise between what would be a very low actual valuation at the time of the convertible note and a meaningful guess as to what a reasonable pre-money valuation might be when the company achieves what it is intending to accomplish with the proceeds of the convertible-note financing.

Second, when the venture capital financing ultimately occurs, the investors will receive what is called a “liquidation preference,” meaning they will have the right to get all of their money out of the company first before any distribution is made to the founders. In most circumstances this is simply a downside protection, which the investor must waive (and take their ownership percentage as opposed to the liquidation preference) in the event the liquidity transaction would return substantially more than the amount of their investment.

This is commonly known as a 1X, non-participating preference. The problem that the convertible note presents is that the investor is getting a discount, perhaps even a substantial discount in the event that the conversion occurs at the cap, which means the investor receives a liquidation preference that is substantially greater than the amount of dollars it actually invested.

For example, if $100,000 is invested in a note with a 25% discount, the investor receives $133,333 in liquidation preference because they are buying each $1 in equity for $0.75 ($100,000/$0.75 = $133,333). In a downside scenario, this adversely impacts the founders’ ability to recover any portion of their own investment. This problem is easily solved if it is specifically addressed in the language of the note that provides for the “discounted” portion of the conversion to be issued as common stock or some other kind of equity that does not include a liquidation preference.

Third, while everyone expects that a convertible note will ultimately convert into equity, it is nonetheless a note that gives creditors remedies to the holder upon maturity. It is not uncommon for a startup to take longer than expected to reach an inflection point, and oftentimes founders find themselves up against a maturing convertible note that gives the investor a great deal of leverage. Consider this factor carefully when entering into the convertible note, and negotiate for enough runway to achieve success.

Now that you know what to look out for when starting and funding your business, download our free e-book, The Complete Guide to Equity Financing, to learn how to pitch and land investors.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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