BASICS OF EMERGING COMPANIES—AVOIDING LEGAL MISTAKES WHEN FOUNDING A NEW BUSINESS
Posted: September 15, 2020 | News
When new companies seek legal guidance soon after a start-up gets off the ground, it’s usually because disputes have bubbled-up among founders. Some legal issues can be easily fixed, while others are more difficult and may lead to litigation. Some OT these mistakes include:
- Forming the wrong type of entity (e.g. LLC v. corporation v. partnership)
- Not specifying in the LLC Operating Agreements how and when profits will be distributed to members and who will make these decisions
- Issuing too few shares or membership units to set the company up for a customary capitalization (e.g. dividing 50 shares between the founding members)
- Failing to properly document board approval of corporate actions (e.g. no board minutes or failing to maintain any books and records
- Ill-advised promise of equity
- Failing to assign intellectual property
- Not implementing vesting schedules on founder equity
While these mistakes may cost you time and money, and with proper planning could have been avoided, many are fixable with a little expense and trouble. Others can become long-term, festering problems.
Certain mistakes are more difficult than others. Founders of new businesses need to give particular attention to these issues:
1. Failing to Specify in an Operating Agreement Whether and When Profits Will be Distributed to Members of an LLC
The California Corporations Code requires an LLC to allocate profits to the members, but allocation and distribution are different. The law does not require distribution of profits regularly, unless the operating agreement specifies. This agreement should also specify when and how profits are calculated.
Failing to specify how profit distribution will be handled is a recipe for future conflict. A majority member can “rule the roost” and fail to distribute profits that members may expect and need. If this occurs, it’s not too late to specify the details in the operating agreement.
2. Casual or Ambiguous Promises of Equity
Whenever you are considering giving someone equity in your company—think twice or maybe even three times—and you’ll probably want to call your lawyer. Start-ups have limited cash and founders often resort to promising equity as payment for helping with capital needs. These promises are sometimes made casually, via email or text, and without any binding agreement or further discussion. Beware, as these casual comments that you expected would not be binding until formal documents are signed, can indeed be binding.
For any number of reasons the promised equity is never issued (e.g. the proposed recipient disappears and does not do the work expected, the parties forget about memorializing the arrangement, or the work that seemed so important at the time the promise was made turned out to be not so important). Likely, a couple years will go by. Your new company is growing fast. In fact it’s on track to financing, being acquired, or close to a huge payoff – an IPO! About that time the potential investor, who got an email from you a couple years ago promising equity, shows up with the email or text and says, "Where is my stock?" Your IPO is de-railed. The next thing you know is you are on the phone with your attorney to prepare to fight a lawsuit. Not what you expected.
Resolving disputes like this can be costly and contentious. Needless to say, be very careful about when you offer to give someone stock in your company or membership interests in your LLC, and make sure you have a binding agreement in place to memorialize the arrangement. Better yet, don’t promise anyone anything. Below is a similar scenario that can potentially occur.
Sometimes the promise may be for a certain percentage of the company. The problem is here that 10% percent of the shares just after a startup is founded, can escalate into a much different number of shares (than 10 percent of the shares after another financing or two). Similarly, how should the 10 percent be calculated? For example, would you include the shares reserved for an option plan in the total number of shares? These casual promises of equity seldom have any detail and are ambiguous. This is grist for a future dispute and litigation. To avoid ambiguity, you should always commit to a fixed number of shares, not a percentage of shares.
3. Failing to Get Intellectual Property Properly Assigned
In order to ensure your startup owns its intellectual property, you must be certain it has been validly assigned to the company, in writing from the individual who helped create it. Or, put in writing it was a “work for hire.” If you are not sure what this is, this may be sign of a problem and a sign you need a lawyer. This is not limited to just employees, as it includes founders, designers, consultants, advisors, or any other person who has contributed to the business. If you fail to get a valid assignment when the services are being provided, good luck in getting one on the verge of a financing, when the lawyers say you need to produce proof of ownership. Sometimes the lack of IP ownership evidence inconveniently becomes obvious, only on the eve of the first financing. By now, the individual who contributed the intellectual property has flown the coup. Now what?
Some founders mistakenly dismiss concerns about IP ownership as hyper-technical, gobbledygook that applies only to “tech companies.” This is big mistake. A few questions to ask would be: Is it recipe or formula? It is IP for a food and beverage company? A design for a new office chair? IP for your furniture store? Your business plan? IP. Your marketing plan? IP. Your business customer list? IP. You should always think about intellectual property in the broadest sense of the term when thinking about this issue.
At the end of the day, why are these mistakes so important? There are several reasons:
- First, it will be almost impossible to find an investor willing to invest money into a startup, where there is uncertainty as to who owns the company. Or, where there is a big question mark regarding the chain of title to the intellectual property.
- Second, if a dispute arises with a third party regarding these matters, the only way out is to litigate or settle. If the mistake is caught early, the cost of settlement may be modest or less punitive. But these issues tend to come out of the woodwork, once the startup has established some success. Everyone wants to cash in on the deal. The more successful the company, the bigger the settlement, and sometimes regardless of the validity of the claim.
While these mistakes may seem obvious and avoidable, in the rush of doing a million things for a start-up, when you are working 100 hours a week seven days a week, mistakes happen much easier. Silicon Valley is littered with stories of startups that have had to pay out enormous dollars to put behind them just these situations.
If You Only Remember Three Things…Remember These Things
1. Create the operating agreement to specify profit distributions and who decides.
2. Don't make casual promises of equity in your startup.
3. Always make sure you get intellectual property assignments from everyone involved in developing the business or have everyone sign a work-for-hire agreement.
Just by doing these three things, you can save yourself legal headaches, sleepless nights, and wasted money.
At North Nash & Abendroth, our attorneys have big firm experience, but the experience we give our clients is extremely personalized. Don’t leave your new business venture vulnerable to unnecessary litigation, connect with us and we’ll help you set a course for success. Contact us at 949-752-2200 or email at email@example.com.
Author: North, Nash & Abendroth’s Attorney and Partner, Douglas W. Abendroth