Do More Faster

by Brad Feld

  Many entrepreneurs are surprised to learn that a business is already a legal entity—at least, technically—even if the owners did not act to legally form the company. This is like thinking you’re not going to the prom only to find out that your parents have already arranged the date.

  Like a prom date arranged by your parents, the default entity for your business is probably not the one that you want to dance with, let alone get married to. The following are three key drivers to guide when and why you need to select a legal entity that fits your business.

  First, a legal corporate structure will limit your personal exposure. Ask yourself—if something goes wrong, could my business create liabilities (costs) that should be separate from me as an individual? Can the business, rather than me, shoulder the costs? Every operating business is, by default, either a sole proprietorship (if operated by one person) or a general partnership (more than one person). Here’s the problem: these legal forms do not separate a business’s liabilities from a person’s individual liabilities. As a result, an owner in a default entity is personally liable for the business’s problems.

  For example, suppose your partner signs the business to a year-long lease and the startup fails. Guess who might be on the hook to pay the rent owed for the remainder of the lease? Both you and your partner, and it doesn’t matter who signed the lease. The time to get protection and to separate company liabilities from individual liabilities is when your startup is ready to enter into contracts, release a product, or take on debts—not during or after these events. Proper formation of the right legal entity for your startup (typically, a limited liability corporation [LLC], an S-Corp, or a C-Corp) will ensure that a business’s liabilities are separate from a person’s individual liability. Formation is not particularly complicated, and your company is not married to a certain form forever. If you start out as an S-Corp the conversion to a C-Corp, for example, is pretty straightforward.

  Second, lock down your intellectual property (IP). Make sure you do not inadvertently leave critical IP outside the company, including trade secrets, processes, customer data, pricing formulas, and outsourced engineering. If you are involved in a technology startup and the crown jewels of your company relate to its IP, you want to protect it! It sounds easy, but following this advice is not always intuitive. For example, roughly over half of the companies that come to the CU Boulder Entrepreneurial Law Clinic previously worked with independent contractors on a handshake basis. These companies are surprised to learn that the contractor, not the company, may own the IP developed by the contractor, even though the company paid for it. A simple solution when working with independent contractors is to have a written contract that unambiguously assigns IP over to the company. By having a legal entity formed, it is easier to have agreements and assignments that get IP into the company.

  Third, decide who owns what. When you organize a company, sort out the ownership among the founders. Ownership disputes are a startup killer. Ownership matters can be delicate discussions; however, it is always easier to address ownership percentages before the business succeeds, instead of after there is real money to fight over. Founders not being able to navigate ownership discussions early on is a red flag of communication failures to come.

  A classic problem following the inability to address ownership is the wayward founder. Imagine a team of four friends who work on a product but never organize an entity or talk about ownership shares. Six months in, one team member moves on in life (graduates, gets married and moves away, or takes a “real” job). The three remaining team members keep going. Two years later, the company starts to click. Guess who inevitably learns of the company’s success, thinks his contribution was the most important part of the business, and returns to claim 25% ownership of the company? Yep, old friend number four. Forming the company and explicitly determining ownership prevents the wayward founder problem.

  A great resource for first-time entrepreneurs is their local university. Most schools have at least one professor who is focused on entrepreneurship; many have entire departments and programs. But don’t limit yourself to just the business school. As Brad and his team at Silicon Flatirons have demonstrated, the law school can often be a source of entrepreneurial education. Furthermore, most of the actual innovation is happening in other departments, such as engineering, computer science, and the life sciences.

  While advice and opportunities around entrepreneurship are available from universities, the real power develops when the university engages in the local entrepreneurial community. The stories of entrepreneurship surrounding MIT and Stanford are well known, but they aren’t limited to these two schools. The University of Colorado at Boulder—especially Silicon Flatirons—has done a brilliant job of engaging with Techstars, including them in the Entrepreneurial Law Clinic, hosting them at the New Tech Meetups that occur at the CU Law Wolf Building, and getting them involved in the Entrepreneurs Unplugged Series that Brad Feld cohosts with Brad Bernthal.

  Don’t overlook the power of your local university and its engagement in your entrepreneurial community, especially early in the life of your company.

  Chapter 71

  Default to Delaware

  Jon Taylor

  Jon is a partner at KO, where he specializes in corporate and securities law with extensive experience in emerging company issues, venture capital, M&A, and private equity. He has been a Techstars mentor since 2008.

  Corporate law is generally a matter of state law. Each state is free to develop its own rules and regulations regarding how a company is formed and operated. And each state develops the fiduciary duties of the board of directors, management, and majority stockholders, providing guidelines on the governance of your company. Because each state thinks about corporate matters differently, there is great uncertainty for investors who need to have clear guidelines regarding the legal structure of their investments. If they have many investments in many different states, as is typical, their fiduciary duties as board members are incredibly complex. Most investors will encourage or require any new startup companies they want to invest in to incorporate in Delaware.

  Why Delaware? Delaware corporate law is generally considered pro-company. Delaware provides shareholders flexibility in creating specific terms for corporate governance and has systems in place for quick and painless corporate filings. Additionally, Delaware provides management and directors guidelines based on a well-developed body of corporate law as to how to comply with their fiduciary duties in a number of different situations. In short, Delaware law provides founders, investors, and directors with certainty and uniformity regarding their relationship to the company and its stakeholders.

  Delaware case law provides clear guidelines for directors on how to act in certain situations. Over the past 90 years or so, Delaware courts have refined concepts such as the business-judgment rule regarding decisions made by the board of directors, as well as the Revlon and Unocal tests regarding the fiduciary duties of the board in connection with a sale of a company. For the most part, Delaware courts have recognized the inherent riskiness of business and don’t attempt to second-guess the decisions of the board of directors.

  Other states do not have this body of case law to help guide directors in making decisions on behalf of the company. Without that body of case law, board members don’t know which actions they need to take in order to comply with their fiduciary duties. Although many corporate attorneys assume that a particular state court will follow Delaware’s guidance on an issue, such courts have no obligation to do so. This uncertainty can be avoided simply by incorporating in Delaware.

  Jon’s advice may seem overly lawyerly, but it’s really important. We’ve been in many bizarre situations because companies incorporated in different states. California law is different from Texas law, which is different from Illinois law, which is different from Massachusetts law, and so on until you count to 50. Many lawyers don’t know the corporate laws of states other than their own, or worse, think t
hey do and then immediately get you into trouble because they really don’t. Keep it simple—incorporate in Delaware.

  Chapter 72

  Lawyers Don’t Have to Be Expensive

  Michael Platt

  Michael is a partner at Cooley LLP and represents emerging companies throughout their lifecycle, with a particular emphasis on exit transactions, including complex M&A and public offerings. He has been a Techstars mentor since 2007.

  I’ve run into a lot of founders who, when it comes to lawyers, think along the following lines: “Lawyers are too expensive. We’re a stealthy, scrappy startup. We’re just going to use the family lawyer or, better yet, file an LLC certificate ourselves. When we get the prototype finished and we get a VC term sheet, we can fix whatever we mess up. Let’s just initial the page with our equity splits so there is no dispute later.” This type of thinking is a great example of the 80/20 rule, and 80% of the time it’s the most cost-effective answer. But 20% of the time something different from what you anticipate occurs.

  As a founder, your experience is unique and you haven’t had the opportunity to see 300 startups in formation and financing. I’ve seen this situation many times: cofounders who are close friends split the stock of the company, and later one of them can’t stomach the lack of income or meets her true love and moves across the country. Without the correct vesting agreements, you are destined to share the upside with someone who didn’t share the risk and economic pain of your startup. There are thousands of simple mistakes, ranging from bad decisions that can be fixed with money to fatal problems that can kill a financing.

  Given that lawyers charge by the hour and do cost a lot, how can you keep this cost under control? Following are a few key ideas to keep legal costs under control and still assure an effective outcome.

  Spend time picking the right lawyer or law firm for your business. Who is that right lawyer? You want someone who has worked with hundreds of startups and the companies you want to emulate as you grow and are successful. Most corporate formation mistakes aren’t legal malpractice or bad lawyering; they are bad business decisions or structuring issues that may not be identified if your lawyer hasn’t done the drill hundreds of times. If you are going to seek investment capital, talk to a few of your target investors for recommendations.

  Discuss the budget with your counsel up front. Ask him how you can save on expenses by doing the nonlegal work yourself (for example, cap tables, collecting closing signatures, or preparing agreement schedules). If no one on your team is accustomed to the level of precision required in corporate maintenance, don’t take things on if you won’t do them as well as the lawyers. You might offer to manage your option grants and records, but if the grants or records aren’t perfect, you could have problems in a financing or liability to a departed employee.

  Work to develop a collaborative relationship with your principal contact at the law firm. Make her a part of your mentoring team. Make sure she understands the product, the market you are chasing, your business plan, and your team’s skills. Introduce her to key members of your ecosystem and get her to talk to mentors who will be helping you make corporate or business decisions. If you do this early, most lawyers will make this investment of time on their own nickel.

  Suggest to your legal counsel that they do “just-in-time” legal work. In the first year you’ll need lots of legal advice on a range of issues, but you don’t have to do everything at once. Ask your lawyer what needs to be done now and ask how to extend your budget over time.

  Finally, don’t start drafting documents until you figure out equity splits, vesting arrangements, and basic governance concerns with your cofounders. If you are doing a seed financing or business transaction, do a detailed term sheet and make sure you have buy-in from all (or almost all) of the people involved before moving to drafting the final legal agreements. Companies blow their legal budgets because of excessive rewrites trying to make terms clear, not in drafting their final legal documents.

  If you are a part of a promising startup with traction or have a track record of successful entrepreneurial projects, your lawyer may be willing to take some risk on fees. If you don’t fit in that category and don’t have money for a retainer, consider ways to provide some upside for your lawyer’s willingness to essentially be your first investor. Ask your lawyer if their firm would be willing to extend payment terms for a small piece of the action. But, be cautious here: You don’t want your lawyer as a large equity owner in your company, so don’t pick someone by how much free service you can get for stock.

  When you are designing the legal agreements to create your business model (for example, terms of service, end-user licensing arrangements, revenue-sharing arrangements, or privacy policies) don’t ask for a standard form. Business relationships are anything but standard. Spend time with a lawyer who does only technology transactions to think through your business model before having her put pen to paper. Then be willing to invest in getting it right (or close to right) the first time.

  Following these ideas from the very beginning will, ultimately, reduce your long-term legal costs and help you avoid costly mistakes that have to be addressed later down the road.

  Chapter 73

  Vesting Is Good for You

  Jon Fox

  Jon was the founder and CTO of Intense Debate, acquired by Automattic in 2008, and the CTO of Torbit, acquired by WalmartLabs in 2013. He was in the 2007 cohort of Techstars.

  Many founders look at vesting as something designed purely for the investors. To them, vesting is simply a way for the investors to protect their own investment and keep the founders involved in the company. While this is certainly true, vesting can also be a good thing for founders.

  If you’re not familiar with vesting, the idea is that you earn your stock over some period of time as opposed to owning it outright at the founding of the company. The length of time it takes to become fully vested can vary but is typically four years. How frequently you vest—annually, quarterly, or monthly—also varies.

  How could not receiving all your stock up front be good for a founder? Well, the big way this comes into play is with the people you start the company with. Your motives as cofounders are aligned with the investors: both investors and founders want the cofounders to stick around, to be motivated, and to protect their own interests. Without vesting, a company would be left with no recourse if one of your cofounders decided to leave the company, suddenly became unable to work, or needed to take another job to earn some money. In any of these situations the cofounder is no longer contributing to the company and, if you don’t have a vesting agreement, they will own all of their shares. This not only means you’re working harder for less of the company, but also that the investors will be less excited to put their money in if a large portion of the equity is tied up with someone no longer helping the company.

  We ran into a related situation at Intense Debate. We started with three founders, who all had other jobs at the time. As we gained momentum and got into Techstars, two of us decided to leave our existing jobs behind and jump 100% into Intense Debate. A few months later, our third cofounder also quit his day job and focused on Intense Debate full time, but things weren’t going well for him. He was forced to keep long hours without bringing in a paycheck since we had not closed our round of funding. He had no money, had moved away from his family and friends, and was straining his marriage as all these issues piled on top of one another. In the end, he decided to leave Intense Debate and move on to other things to try to get his personal life back under control.

  This could have created a major problem for me and the other remaining cofounder. If the departed founder retained all his original ownership, not only would it mean we’d have less for ourselves, even though we were forced to do more of the work, but we were also afraid it would scare off potential investors. Luckily, the three of us had already agreed on a vesting schedule for ourselves. Our departing partner got only a small percentage of his original equity for t
he handful of months he was working with us. In the end, it all worked out. He took his shares and was happy with the result. We retained enough ownership to make it worthwhile for ourselves, to find and compensate his replacement, and to close our funding. Our investors stayed with us since they felt the value of the stock was going to the right people.

  Although it’s common for some founders to perceive vesting as a risk, there are many cases when it can work in their favor. Understand the terms of your vesting and make sure everyone is comfortable with them.

  Jon’s point—that vesting protects the founders from each other—is the most important point about vesting. We often hear from entrepreneurs that their attorneys and advisors have encouraged them to own as much of their stock as they can outright, so they can’t get shafted by their investors. This is bad advice that shows a lack of experience and perspective on the attorney’s or advisor’s part.

  It usually takes many years for an early-stage company to be successful. At the beginning, all of the founders are excited about the journey they are planning. But to be successful, they have to be committed to each other and the journey. While four years is an arbitrary length of time for vesting, and we’ve often seen arrangements ranging from two years to eight years, it has settled out as an acceptable length of time to earn your founder’s equity. Basically, if everyone is still around four years later, they’ve earned their share of their founder’s stock.

  By agreeing to vesting up front, Jon and his cofounders put the rules of engagement in place at the beginning. When one of the founders was in a position in which he couldn’t continue to work with the business, the additional pressure of figuring out who owned what was eliminated since the rules were already in place. Once it was agreed that the partner would leave, there were no other decisions to make.