Ask the Expert: Harsh lessons for startups
Startups face many challenges early on, but some common pitfalls can be avoided with foresight and careful planning. This article, the first of two parts, describes five difficult legal lessons learned based on experiences gleaned from advising startups and their owners on a variety of issues.
Lesson Learned #1: Confirm founder contributions.
Be clear at the outset exactly what each founder is committing to contribute into the new company, whether it is cash, technology, future services or something else, and when it would be contributed.
Confirm that each founder actually has the funds or rightful ownership of the assets that he or she has committed to provide and that the founder is ready to make the contribution. Each founder needs to provide something in return for their ownership, and nailing down what that something is should be one of the team’s first priorities.
Lesson Learned #2: Have an equity ownership plan.
Don’t just decide how much equity each founder should have — also decide how that equity will be owned. For instance, what transfer restrictions should apply? What happens if founder leaves the company? Should the equity of any of the founders be subject to vesting? If so, what are the terms? These decisions should be reflected in an equity ownership arrangement that is carefully considered.
Lesson Learned #3: Don’t talk in percentages.
When issuing equity, avoid making promises of a “percentage of the company.” Rather than promising a percentage, the promise should refer to a fixed ownership interest, such as a certain number of shares or membership units.
As of the date on which a promise was made, the shares or units will in fact represent a certain percentage of the then-issued and outstanding ownership interests. However, as additional ownership interests are issued over time, there will be a dilutive effect on all previously-issued interests (meaning that the same number of shares will represent a smaller percentage ownership in the company).
Promising a specific percentage of equity can create misunderstandings and lead to claims that the equity holder should not be subject to dilution.
Lesson Learned #4: Protect intellectual property from the outset.
Consider what steps the company should take to make sure it has (and retains) the intellectual property rights that it needs. Depending on the nature of the intellectual property and the business, these steps could include putting in place intellectual property ownership agreements with the company’s employees and contractors, using nondisclosure agreements with third parties who will receive company information, and filing any necessary trademark or patent applications with the appropriate authorities.
Complications caused by omission or delay can be MUCH harder to clean up later. Tackling this issue early on shows that the company is protecting its assets and enhancing its competitive advantage.
Lesson Learned #5: Be aware — raising capital is selling securities.
A startup can find itself in serious hot water if it is not careful to comply with state and federal securities laws any time it issues securities. Securities take many forms, including shares of stock, convertible notes or membership interests in a limited liability company.
Generally, to avoid the prohibitively high costs of completing a full securities registration, a startup based in New Hampshire will need to be sure to comply with applicable federal law, New Hampshire law and the law of any state in which a purchaser of securities resides. A startup should always be aware that raising capital implicates various securities compliance obligations — therefore, it behooves the company to be proactive and make any necessary filings to ensure compliance with the applicable securities laws.
A botched equity issuance could not only expose the company to substantial penalties under the securities laws, it could make it much more difficult to raise capital down the road.
Stay tuned for Part Two, which will describe another five Lessons Learned.
Matthew H. Benson is a partner at Cook Little Rosenblatt & Manson in Manchester, where his practice focuses on representing startup and other entrepreneurial companies with various business and commercial matters. He can be reached at email@example.com and followed on Twitter @matt_benson.
Philip J. Shaw is an associate with Cook, Little, Rosenblatt & Manson in Manchester, where he focuses on transactional, securities and general corporate matters. He can be reached at firstname.lastname@example.org and followed on Twitter @shaw_phil.