I see the same mistakes over and over again when founders form their startup. These mistakes are predictable and are the result of a lot of misinformation and confusion. I’ll walk through the common mistakes here:
1. Not forming their Startup in Texas or Delaware
What people do: A lot of entrepreneurs do some “research” and form their startup in Nevada or some other jurisdiction that supposedly has a lot of corporate law benefits. This is a classic problem of a little bit of knowledge being a dangerous thing.
What you should do: form the startup in Texas (or if not located in Texas, then home state) or Delaware.
This is one of those issues that people overthink. Really it’s not hard. Form your company in Delaware if you want to raise money from venture capital investment groups and go the more traditional startup route. If that’s not much of a concern then form your company in Texas (or your home state).
Why: Delaware is good for companies in regards to corporate law. Yes, there are now a number of states that are good for incorporation purposes. The reason for this is a “race-to-the-bottom” where a state makes their corporate law so favorable to companies that companies will want to come to that state to do business. I’ll save my comments on this race-to-the-bottom for some other post. The point is that Delaware is good for corporate law; and forming in Delaware is an acceptable process when investors look at your company. It’s become a best practices standard now. Many of these investors and individuals who demand a company to be formed in Delaware don’t even know exactly how Delaware is favorable when it comes to corporate law, they just heard it somewhere and they parrot it.
If you don’t form in Delaware (because you’re not raising money, etc.) then form your startup in your home state. Forming in your home jurisdiction saves a few bucks during formation, but that’s generally not a strong consideration for founders. One of the reasons why forming in your home state is cheaper than forming in Delaware is because when you form in Delaware your home state will want you to pay a foreign qualification fee in order to authorize your Delaware entity to do business in your home jurisdiction.
There ARE times when you should form an entity in a state like Nevada or Wyoming or other. The decision to make maneuvers like that concern asset protection and the like—particularly if the company is going to do a more complicated set up with operating and holding companies or other. If you don’t know what that means or if you’re going the more traditional startup route don’t worry about it.
2. No Vesting Provisions
What people do: Outright dish out half of the company to their partner and half to themselves at formation of the entity. Or give out 1/3rd to a partner, 1/3rd to another, and 1/3rd to themselves. Or similar.
What you should do: Allocate those shares as according to a vesting schedule instead of giving shares outright. Typical vesting schedule is between 3-5 years with a 1 year cliff.
Why: When shares are given to individuals as according to a vesting time schedule that means that the individuals do not own the shares outright. The shares are allocated to them. However, if they leave the company before the shares fully vest, then the shares go back to the company. For example, if shares are set to a 4 year vesting schedule, the shares will not fully vest until the end of that time period. If the founder leaves after year two, then (depending on the fine details) half of the shares will go back to the company.
Think of it like this. If you and your friend form a startup and he gets half of the company and you get half of the company and he decides to leave after day 1, then without any vesting provisions in place, he just left the company while keeping half of the company in his pocket. So you need to vest shares properly.
Allocating founders shares as according to a vesting schedule (a) protects the company— the company cannot operate properly if a founder owns half of the company and isn’t present; (b) protects investors—investors want that protection from a founder that goes rogue and just leaves while owning large parts of the company; (c) protects other founders—it protects founders from other founders from leaving.
3. Not being organized with legal documentation
What people do: Founders either don’t do corporate governance at all, or create scrappy documentation, or just toss papers in a folder without any kind of system.
What you should do: Make sure your corporate governance, e.g. corporate minutes, book, bylaws, operating agreement, etc. are in proper order.
Why: How you do anything is how you do everything. Make sure your business is in proper order. This also has a very practical effect. When it comes time to exit, this stuff will be looked at. Don’t be sloppy when it comes time to have investors look into your company.
4. Not dealing with intellectual property (IP)
What people do: Ignore IP issues.
What you should do: Make sure that IP gets assigned to the company—both regarding IP that was created before the company gets formed and IP that is created while the company is operating. This is done by manner of contract—the contracts assign the IP to the company.
Why: The company is the one that should own the intellectual property created in anticipation for and created by individuals on behalf of the company. If the IP doesn’t belong to the company and instead belongs to the individuals working for the company directly, then the individuals can hold the company hostage by running away with the IP. Think about what investors of the company want. They do not want to invest in a company that doesn’t own it’s own IP and that instead belongs to the founders.
5. Not documenting funds properly
What people do: Whenever the company needs money a founder deposits some cash into the company without documenting it or taking any kind of formal action.
What you should do: A few things: (a) Documentation is important. Write down what has been contributed to the company. Put that document in with your corporate governance paperwork. (b) Figure out what type of contribution, loan, etc. that it is that you're putting in. Let’s say you deposit 10k into the company coffers. What is the result of that action? Do you get more equity issued to you? Is it a loan that the company must pay back? You and your fellow founders need to decide these kinds of issues. Know what you’re doing. Have a system for it.
Why: I see this situation occur way too much and it happens a lot particularly at the very beginning of the life of a company. The issue is a tricky one because founders often do not know how to deposit and put money into a company to begin with. I suspect that one of the reasons for this is because a lot of advice these founders receive are more applicable to when the company has started to chug along. For example, many founders know about or have heard about board members, advisory boards, etc. But what about at the very beginning of the company? What does that look like? People don’t talk about the technicalities involved with the very earliest beginnings of a company. Use the sidebar articles to understand these processes on a better level.
6. Not having proper agreements or contracts between startup founders in place
What people do: Often founders have known each other for decades and they are best friends, etc. This often results in founders flying by the seat of their pants and not formalizing any type of agreement properly.
What you should do: Actually decide roles in the company and write everything down. Decide ahead of time how the company will function, how voting is to be done, what type of vesting for what type of equity needs to be in place. You also need to figure out management issues. How will decisions be made? Should someone get veto rights with particularly extraordinary circumstances involving the company? What about the board? What will that look like?
Why: There are a few reasons why it’s important to have proper agreements in place between founders. (a) It adds clarity to the whole operation. When you define roles more clearly, when everyone knows what the stakes are, and what to do then the operation runs a lot more smoothly. (b) It shows to investors that you and your partner are on top of what kind of organization you’re running. Beyond adding proper structure to the company it’s a signaling device to others that this is a well-oiled machine. (c) Even marriages that start off well end in divorce. Things get ugly between founders when things go wrong. Having documentation from the get-go that sets the house in order adds clarity to this process.
7. Not authorizing proper company stock
What people do: Authorize and issue themselves preferred stock or some kind of super voting stock.
What you should do: Founders receive common stock. Investors receive preferred stock.
Why: Common stock is the barebones standard type of ownership in a Texas startup. Investors receive preferred stock, in large part, because they bring the money and they can dictate that kind of term. This has been the general setup for some time now. Yes, there are special types of founder stock, with special rights such as more voting power but it is best to keep it simple and standard. Do not try to get too fancy with these types of stock.
8. Not sorting out issues with current or previous employers while forming a Texas startup
What people do: Start their company without considering their employer or employment situation.
What you should do: You need to look at issues with your current and previous employer. In particular, look at contracts that you have in place with them and see if there are any no-moonlighting clauses, competition clauses, or similar. Note that even if these contracts aren’t formally in place you still need to approach this situation carefully as your role with your previous employer can hamper your startup plans. Tips: don’t use your employer’s trade secrets; don’t use their time, tools, space, etc. to work on your personal startup projects; don’t solicit fellow employees to work on your startup.
Why: Your previous and current employers have many rights to the type of work-product you create, particularly if it’s done on their time. Your employer may be able to claim that whatever IP you created for your startup actually belongs to them. This can seriously hamper your startup.
9. Improper classification of workers as independent contractors or employees
What people do: Categorize individuals they hire to work for the company as independent contractors.
What you should do: Decide and figure out if the individuals hired are actually independent contractors or if they are employees as according to the rules and regulation. There are some objective and subjective qualities to look at in order to make this determination.
Why: One of the most important reasons to make the proper determination of contractor vs. employee concerns taxation. The IRS, while strict on this classification, has broad guidance on this determination. If an individual is an employee and not a contractor, then employment taxes are triggered as well as other types of duties. Tax ramifications can be quite substantial so it is crucial in getting this correct. Use the sidebar for more information.
Concluding thoughts:
There are a lot of legal mistakes founders make. Here are the common ones. Avoid them.