Having worked with and counseled countless startups over the years, I often see founders and entrepreneurs make key mistakes that inevitably create problems down the road. These key mistakes can cost time and money to correct, or in some cases derail the company entirely. This article touches on a few of those key startup mistakes.
Getting Good Legal Advice
One of the most common startup mistakes is not getting good legal advice early on. The first and best way to avoid key startup mistakes is by having an experienced attorney in your corner. I have had more than a few founders seek my advice after setting up their entity on their own only to realize that in their haste to set up their entity or minimize their expenses, they missed a few important steps. We can often come in and correct some of these mistakes to get the company back on track.
Proper Documentation
An important way to avoid a key startup mistake is to ensure you have proper documentation. Proper documentation is key at all stages of the startup lifecycle, but especially in the beginning. It sets the stage for what’s to come, and poor or non-existent documentation can create delays and result in considerably more cost to correct than having it done properly in the first place. Keep in mind that when you get to your first financing, investors and their counsel will be reviewing your documentation. Missing key documents or having poor documentation can raise red flags with investors.
Company Formation
Proper documentation starts with ensuring you have all the proper corporate documentation for your entity. For example, was the corporation set up with enough authorized shares for the initial issuance of shares to the founders, early employees, advisors, and consultants? A typical setup may consist of 10,000,000 authorized shares of common stock with a par value of $0.00001 per share and an initial issuance to the founders of approximately 60% to 80% of those shares. Some or all of the remaining balance of the authorized shares will be reserved under an equity incentive plan for issuance as restricted stock or stock options to employees, advisors, or other consultants. Mistakenly, some founders initially issue all of the authorized shares to themselves without realizing that this prevents any further issuances of stock unless the certificate of incorporation (the charter) is amended to increase the authorized number of shares. Amending the charter will result in additional fees and expenses. Proper company formation includes a myriad of other considerations, all of which require proper documentation prepared by or with the input of an experienced attorney.
Vesting of Founder and Early Personnel Equity
When issuing shares, you should consider restricting those shares by ensuring the company has the right to repurchase those shares if the founders, employees, or consultants leave the company before a certain time period. This is typically achieved by subjecting the issued shares to a right of repurchase if the person’s relationship with the company ends before a certain time period. Typically, restricted shares will vest over four years, and as the shares vest, the right to repurchase those vested shares lapses. A common vesting schedule is to have 25% of the shares vest (i.e., the repurchase right lapses) after the first anniversary of service, with the remaining 75% of the shares vesting monthly over the remaining 36 months until all the shares have vested and are no longer subject to the company’s repurchase right.
Vesting helps incentivize those with equity in the company to stick around and help the company grow. A critical startup mistake is not subjecting early personnel (including the founders) to vesting conditions only to have a key person leave early on, taking their equity with them. The company now has a person on their cap table that is not contributing to the company’s success yet still has equity. If the amount is significant, this can be a turn-off to investors who typically don’t like non-participating employees, advisors, or consultants on the cap table.
The same vesting concept applies to stock options, which are essentially a right to purchase stock at a future date (i.e., when the stock options have vested). Stock options typically vest over the same four-year time period. However, vesting works a little differently with stock options. Instead of the company having a right to repurchase stock that has not yet vested, persons who are granted stock options cannot exercise and purchase shares until the stock options have vested. If an option holder leaves the company before the stock options have vested, the unvested stock options are typically terminated and cannot be exercised (except for limited circumstances that provide additional time to exercise the options, the details of which are beyond the scope of this article). Thus, restricted shares and vesting stock options create an incentive to stay engaged with the company or risk missing out on shares that could have significant value if the company has a successful exit down the road.
Confidentiality and Intellectual Property Assignments
Another key startup mistake is not having proper confidentiality and intellectual property assignment agreements in place with the founders, employees, and consultants. When setting up your startup, it is imperative to ensure that anyone who will create, provide or have access to confidential information of the company agrees not to use or disclose such confidential information, except as required or permitted by the company. Similarly, you should make sure that anyone that will create, develop, or improve any intellectual property relating to the company and its business assigns all such intellectual property and related rights to the company. These agreements are commonly referred to as confidential information and invention assignment agreements (aka CIIAAs) or proprietary information and information assignment agreements (aka PIIAAs).
CIIAAs and PIIAAs help to ensure confidentiality and ownership of the company’s intellectual property and are an important issue for investors who will want such confirmation as part of their due diligence before making an investment. For example, I’ve seen founders realize the importance of such an agreement when a key developer who wrote the code for the business’ core technology left the company without having ever signed any CIIAA, essentially leaving the company without any rights to the technology. This can leave the company in the very unpleasant position of having to negotiate with the former developer to have the technology assigned, often at the mercy of the former developer.
Protecting Your Intellectual Property
As your startup creates and develops technology, be sure to speak with an experienced intellectual property attorney. Besides failing to have founders, employees, advisors, and consultants sign CIIAAs, another key mistake is failing to protect intellectual property. Understanding what intellectual property can be protected and how best to protect it is important to the success of the startup. Once the company begins fundraising from outside investors, potential investors will want to know if the company has carefully and strategically approached safeguarding its intellectual property. An experienced intellectual property attorney will not only help identify what intellectual property can be protected today but will also strategically plan for the company’s growth and current, as well as anticipated markets.
Moreover, founders should be strategic and forward-thinking in their approach to branding, domain names, trademarks (or service marks), copyrights, and patents. It is best to consult with an intellectual property attorney early on so that they can help guide founders on important issues about disclosure and filing timelines, as well as what jurisdictions to file in to provide protection for current and anticipated markets. An important, often overlooked, startup mistake is inadvertently disclosing too much of the company’s proprietary technology, which can then eliminate the ability to file for a patent later on.
The path to startup success is paved with failure, which includes a few mistakes made along the way. The above are but a few examples of big startup mistakes that can be easily avoided with a little planning and foresight.
Special thanks to Sarina Rogers, a summer associate in Foley’s San Diego office, for her contributions to this article.