7 Legal Fundamentals Every Startup Needs to Get Right
Forming a new startup is an exciting time filled with optimism and potential. Finding the right people for your team, landing some early investors, and building out your product are all thrilling milestones. But just as important (if not quite as thrilling) are some key legal fundamentals that you’ll have to nail early on.
Every startup needs to get these tasks right at the beginning; failure to do so will lead to difficult, protracted, and costly problems. I should know, my first job after being a partner at a big law firm was cleaning stuff up at Oculus, so it could do its Series A.
Despite legal forms you can find on the internet or from DIY websites such as Clerky promising to make forming a startup easy, more often than not, these seven items are not done right:
Setting Up Your Cap TableThis could be called understanding Venture Economics 101: how to split up the equity among the founders, how much to allocate to a stock incentive plan, how to put your money into the company, and how much dilution you really can or want to have before you do a round of equity financing.
Forming a Delaware CorporationIf you are going to raise venture capital, you need to form a Delaware Corporation. You would be surprised how many Nevada, California, Utah, New Jersey, and other states limited liability companies and corporations we have had to convert into Delaware corporations. These conversions are always costly and have some degree of complication. Venture capitalists invest in Delaware corporations for two primary reasons: 1) C Corps are not “pass-through entities,” which allows the business’ losses to be used to offset future revenue for tax purposes, and 2) Delaware has the most developed body of corporate law in the country and a very specialized system of courts and judges, which is why the National Venture Capitalist Association (NVCA) bases their financing templates on Delaware Law. So, if you want to raise venture capital, you need to start with a Delaware C Corp.
Founders’ Stock Purchase Agreements and 83(b)sYou need an agreement to purchase the stock in your company, and if you have more than one founder, you will want the stock to vest in case someone leaves. This is done through a stock buyback and 83(b) election. We see everything here from people not even having an agreement to purchase the stock to completely missing the 83(b) election, which creates real tax problems. We once started a Series Seed and the founders were worried about the stock incentive plan being too big, but when we checked their paperwork, they had not even granted their own shares to themselves, let alone set up a stock incentive plan. Recently we had a startup that received a term sheet for roughly $2,000,000, but because they didn’t file their 83(b) on time, each of the founders would’ve needed to pay taxes on the gains of the value of their stock. In this case, that gain would have added up to a few $100k. Needless to say, the investor didn’t want their money being used to pay off each founder’s tax liability, which led to the deal blowing up. Filing an 83(b) on time is critical and could mean the difference between raising $2,000,000 and raising nothing.
Getting Founders’ and Key Employees’ Intellectual Property Into the Company We once represented a football-game tech startup for one of the greatest quarterbacks of all time, and he had failed to license in the rights to his name and likeness for the virtual-reality game branded on his name. You can’t make up some of the stories and scenarios that we have encountered. But if the company does not own the intellectual property, then there is nothing there.
Establishing a Stock Incentive Plan (SIP), Pricing the Common Stock Properly and Issuing Options or Restricted Stock Properly Employees, contractors, and advisors receive stock from the SIP, and often, startups use these options to compensate for a lower salary. What makes options so valuable to early employees is that their stock is valued at nearly zero since the company is not profitable. This could lead to a huge payday for these employees if the company is successful. However, if you don’t adopt the SIP at the beginning and you begin to generate revenue, you’ll need to conduct a 409(a) Valuation to calculate the value of that stock. This leads to higher valued stock, which is bad for employees receiving options. For example, if an employee had 100,000 shares valued at $0.00001, the exercise price (the price paid to own the options you received) would be $1. If those 100,000 shares were valued at $1, that employee would then have to pay $100k to exercise those options. The difference between $1 and $100k is glaring and a difference that most people can’t afford to pay.
Financing Properly With SAFEs and Convertible Notes In the early days, you will need capital and need it quickly, so financing the company with SAFEs or Convertible Notes instead of pricing the common or issuing preferred stock can save time and money and also avoid problems with raising the exercise price of the stock options. Again, we have had founders price the common with sales to friends and families (which messes up the stock incentive plan) or lend the company a lot of money and have an investor get upset when that loan was repaid after a round of equity financing.
Hiring Contractors and Employees CorrectlyThis is critical, but again, I kid you not, we cleaned up a five-year-old tech company where the CTO, a contractor, had never signed a Confidentiality Invention Assignment Agreement (CIAA). Then, when a new investor asked him to sign a CIAA, the CTO held the company hostage for a month with salary demands as the company did not own its tech stack.
How do you accomplish the 7 things every startup needs to get right?
We have found that systems, processes, knowledge and counseling, good decision-making – and then recording decisions in such a way as to be able to automatically translate those decisions into legal paperwork – can solve 90% of these problems (and avoid $100,000 cleanups later).
In broad terms, you’ll need:
A good checklist to ensure you’re executing on all the details. Putting together this checklist, especially for first-time founders, can be difficult. With StartupProgram.com, we’ve built a checklist based upon the decades of experience and hundreds of startups we’ve helped.
An education in venture law and venture economics and tools to help you apply that knowledge when sorting out the details on how to form your business.
A “blueprint” for building your business that’ll serve as a starting point for completing all the necessary forms. This document is your guiding reference when filing incorporation papers, securities filings, and more.
A method to generate, review, and file all the legal documents to form your company. This can be a rather heavy lift to try to take on yourself.
As you see, it’s a lot of work to take on those seven things, especially if you’re a first-time founder – but they’re absolutely critical to your future success. For that reason, we put together StartupProgram.com, or SUP, so that our clients can efficiently and cost-effectively get these nuts-and-bolts items checked off their to do lists. We’d love to help your startup, too.
Join us on 6/9 at 12 pm ET for the first of our quarterly Legal Lab learning series and our monthly, 1:1 Legal Lab Office Hours with Dan Offner! 🧪
Dan Offner, Founder, O&A + SUP
Dan Offner is the Founder and Managing Partner of O&A and StartupProgram.com, as well as our guest attorney in our Legal Lab + Office Hours series. Drawing on 27+ years of experience as both an angel investor and a practicing venture law attorney, he is an expert in key aspects of venture law and financing that all entrepreneurs and early-stage founders need to know to ensure their companies are formed correctly.
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