Failing to ensure that the company secures all legal rights to own (or license) the intellectual property (IP) which the founders created (or which a university owns) necessary to run the business can be a company killer. Securing IP is critical for the viability of the business and one of the areas on which institutional investors will focus their diligence. Generally, investors will not invest in a company, and buyers will not acquire a company, unless the company owns or licenses all the necessary IP to run the business (or if they are willing, the company’s valuation will be significantly lower). Fortunately, this critical step is often easy and relatively inexpensive. All founders should (we really mean must) assign any IP they may have created to the company when the company is incorporated or formed (often as consideration for the equity they receive in the company). This assignment is typically documented in a proprietary information invention assignment agreement, and any IP that is created post-incorporation or post-formation belongs to the company. (See #2 below) IP that was created in a university lab should be licensed from the university that owns the IP (subject to the university’s policy on ownership of IP). Once this step is completed, any time a company brings on a new employee or consultant, before he/she begins providing services, the company should ensure each employee or consultant signs an appropriate assignment agreement that includes provisions assigning to the company any IP created during the course of employment or the consulting project. Following these simple steps will help to reduce one of the biggest legal risks that companies face when running their business.
While there are services you can pay online to form a legal entity for you , care should be taken to consult with an experienced startup attorney before forming the legal entity for your company (not your friend’s family attorney who needs to research what a corporation is). Aside from failing to include standard items because of incomplete or unsophisticated advice, many founders choose a legal entity that isn’t ideal or, in some cases, may simply be incorrect. At best such a mistake is only administratively time-consuming (and potentially expensive) to convert or restructure the entity, but at worst this mistake could pose a roadblock for investors investing into the company, and cause complex tax and incentive issues for employees. Most mistakes on formation can be fixed, but fixing the mistake is almost always more expensive and painful than forming the correct legal entity in the first instance. Starting with Latham’s incorporation package can make the formation process not only quick and inexpensive, but effective.
Similarly, delaying the creation of a legal entity can pose potential issues for the founder(s) and the company down the road. In particular (and most importantly), delaying this step poses a risk that the company doesn’t appropriately secure the ownership of IP created that should be owned by the company (or that founders thought was owned by the company), as original founders or inventors may no longer be with the company or difficult to track down. See #1 above regarding “Failing to Secure the Necessary IP”.
Dividing the initial equity pie among company founders is one of the most important decisions founders make when starting a company. The decision will have lasting consequences, not only to the founders personally, but also to the long term viability of the startup. Founders should therefore exercise great care to ensure that they all fully agree upon the initial equity split. Discussion should be frank, objective and should focus on what each founder will bring to the table now and in the future. Founders’ past contributions are relevant, but developing appropriate incentive structures to recognize future contribution is also important.
The equity split decision should be made as early as possible, as waiting too long can be a critical mistake. At first glance, this can seem paradoxical. Why make an important decision like allocating founder equity early in the company’s lifecycle based on limited information about the founders? Isn’t it prudent to wait and see how the founders perform, how the startup performs, and then make the decision?
While the latter line of thinking is logical, dividing up the pie when the startup is worth close to zero is a lot easier (and much more tax efficient) than after the company has gained some initial traction, or right before the company raises funding at a (paper) valuation that could be in the millions of dollars. From a tax efficiency (and economic) perspective, issuing equity in the enterprise when its value is as close to zero is critical. Waiting to issue equity until the startup suddenly has significant value, can result in large transfers of value to a founder (or cost founders significant amounts of money to purchase their equity). Additionally, when the company does have value, human nature can get in the way of pragmatic decision-making. As a result, the founders could fail to reach agreement, or worse, reluctantly agree to a split to which no party is satisfied, sowing the seeds of resentment that could eventually rupture the company prior to its next critical stage of growth.
The founder equity split discussion is rarely easy. But early, frequent and frank communication between founders can save a lot of future headache and heartbreak.
The media often portrays company founders as fiercely independent and individualistic people who famously buck the conventional wisdom and advice of others to create some of the most disruptive and valuable companies on earth. This stereotype can often lead founders to believe that this type of behavior is a prerequisite to their own success, causing them to sometimes ignore the advice of others often to their own detriment.
Successful founders may be independent and individualistic by nature, but are quintessentially critical thinkers and collaborators. They know how to listen to others and make their own informed decisions. They recognize that the perspective and motivation of each stakeholder is limited. Lawyers may see the inner workings of a company and possess great legal ability, but may not possess an in-depth knowledge of the industry and business in which the founder operates. Investors may have in-depth industry and business knowledge, but are not running the business on a day-to-day basis. Employees run the business, but may not see the bigger strategic picture or be privy to the founder’s relationships with other stakeholders. Rather than shut out the competing views and motivations of the company’s stakeholders, a successful founder welcomes these competing views, seeking out the best possible advisors and advice. The founder then synthesizes the information received and makes an informed decision.
Does the founder always get the decision right? No, but a thoughtful founder’s decision is easy to respect. What is difficult to observe is the founder that makes uninformed or poorly reasoned decisions without consulting anyone (or, worse, unquestioningly relies on the advice of one person or group to the complete exclusion of any other). Running a successful business is hard. The idea that many entrepreneurs have succeeded solely by their own sweat and blood is a myth. Do not underestimate how others can help you.
If “cleanliness is next to godliness,” then poor recordkeeping in startup land is a mortal sin. Keeping organized when your business is on the line can seem like a luxury that a founder doesn’t have time for, but it is critically important that you make time to be organized. When you go to raise money, an investor will want to perform extensive diligence on your company, including business, IP, capitalization and legal diligence. First and foremost, being organized, responsive and ready to respond to diligence inquiries shows your ability “do the little things right” and makes a good first impression with your investors. Remember if you can’t do the little things right, how can investors expect you to do the big things right? From a practical perspective, investors need to know what they are buying and how much they own (e.g., capitalization, etc.) Legal risks related to poor recordkeeping are avoidable risks. Will investors refuse to invest if the business idea is compelling enough? Likely not, but you can bet that they will not wire the company money until the company has gone through an extensive and expensive legal cleanup process. Sometimes this means going back to ex-founders and asking them to sign legal agreements when you haven’t spoken to them in months. You can imagine how awkward that could be. The best advice is simply to take the extra time to ensure that you have signed copies of all legal agreements. Sending copies to your legal counsel also ensures that there is a backup copy available in the event that you lose your copy. While keeping good records doesn’t mean that your company will succeed, it will certainly save you time, money and headache when you raise money and eventually sell your company.