Top Legal Mistakes Entrepreneurs Make When Launching Startups
High-impact entrepreneurship is not for the faint of heart. Most venture-backed businesses don’t achieve the levels of success their founders and investors hoped for. Indeed, a significant number will fail.
Having worked as legal counsel for dozens of venture-backed startups over the years, what frustrates me most is the number of companies that fail not because of the inherent challenges of creating “the next big thing,” but rather because the founders made some early, simple mistakes that doomed their startup before they ever left the starting gate. Here’s a quick look at some of the common mistakes that entrepreneurs should avoid when launching a new company:
Company Structure Mistakes
Businesses can be organized in any number of ways. The two most common structures for startups are the Limited Liability Company (LLC) and the C Corporation. The LLC is often chosen because it offers certain tax advantages (often more in theory than in practice). Usually, though, going the LLC route is a mistake, at least for startups that expect to court venture capital investors. Professionally managed venture capital funds are generally prohibited from investing in LLCs. Finding this out after the fact is not always fatal; converting an LLC to a C Corp. is usually possible, but it can be expensive and complex if the company has been operating for some time.
Having avoided the LLC trap, many startups then step into a somewhat less dangerous, but still problematic, choice of entity trap: which state to organize their C Corporation in. The obvious choice for most inexperienced entrepreneurs is the state in which the business is physically located. A somewhat less obvious choice is some other jurisdiction that is perceived to offer cost and/or legal advantages. The right choice, though, is almost always Delaware.
There are several reasons for this, but the bottom line is that venture capital investors and the leading law firms that represent them are familiar and comfortable with Delaware corporate law. Most lawyers that regularly represent venture capital investors and their portfolio companies have done their share of “Delaware reincorporations.” I don’t know one that has reincorporated a company out of Delaware.
Bottom line on choosing a business structure? If venture capital is part of your vision, stick with the tried and true: set up a C Corporation in Delaware.
Securities Law Mistakes
It would take a lot more space than I have in this blog to explain the ins and outs of federal and state securities laws-–-that is, the laws that restrict the ways startups can sell ownership shares in their companies to venture capital and other investors (including friends and family). So, once again, I am going to focus on the most common issues that trip entrepreneurs up. Issues that, when mishandled, can result in extra expense, create a situation where investors can demand their money back, and can make it difficult or even impossible to raise capital in the future.
First, there are, broadly speaking, two types of investors in the world (at least for the purposes of securities laws): “accredited” investors (generally, institutional investors and people that earn several hundred thousand dollars a year and/or have a net worth of at least seven figures) and “unaccredited” investors (everyone else).
As far as the law is concerned, accredited investors are generally expected to look after themselves. So long as you don’t mislead them and you answer their questions truthfully, they are generally considered capable of protecting themselves when they invest in your company. On the other hand, the legal powers that be generally consider unaccredited investors incapable of protecting themselves. Therefore, selling shares of stock to unaccredited investors is generally more expensive (you will typically need a private placement memorandum, which is significantly longer and more expensive than the simpler business plan that typically suffices for venture capital investors and experienced angel investors), and ultimately riskier than selling to accredited investors.
Another issue with taking money from unaccredited investors: selling stock to them often makes it more difficult to sell shares to accredited investors in the future. That’s particularly true for professional venture capital investors, who don’t want to find themselves serving as the “deep pockets” behind the company should things go south and the unaccredited investors cry foul.
Thus, the general rule for entrepreneurs looking for venture or other “smart money” risk capital is to stay away from unaccredited investors whenever possible. If for some reason you do talk to unaccredited investors for capital, do it very carefully and with your eyes open to the likely added expense and risk.
Another securities law issue that often bites entrepreneurs is the use of third-party “finders” to assist with fundraising. Typically, their assistance is in exchange for some form of compensation (stock, money, services, etc.) that is tied to a successful capital raise. The fee could be fixed or calculated as a percentage of the amount of capital raised. Simple rule: Unless a “finder” is registered with the SEC, stay clear.
Founder Vesting Mistakes
High-impact startups often include multiple co-founders: two or more people who share ownership of the startup at its inception. While there are myriad ways co-founders can divide their ownership, the simple two co-founder, 50/50 split suffices for the illustration of the all-too-common founder-vesting mistake that often kills deals. Or, perhaps more accurately, let’s call it the founder lack-of-vesting mistake.
In simple terms, vesting is a concept based on the notion that ownership of the company among founders should be based not just on what they bring to the table on day one, but also what each founder is … Next Page »