Legal issues, post #11 of “Startup Briefs”
One of the first thing that inexperienced entrepreneurs want to do is actually start the company, which means form the legal entity. I counsel them to wait until they need to do this. At the beginning you need to do this if you are: 1) raising money; 2) getting a check from a customer; 3) needing to sign a contract; or 4) entering into any other kind of legal agreement (CDA, etc.).
“But it’s so fun to name a company!” they tell me.
“Yes, that’s right,” I agree. “But you shouldn’t pull the trigger until you have thought through all of the legal issues.”
“The only reason to form the company,” I say, “is to protect you from liability.” And I will continue to tell them things that they never considered. Because they didn’t do their homework!
OK, here goes. Here is what I think you should know at the beginning about the basic legal issues. I am NOT giving legal advice here. Just outlining some of the considerations and things to think about.
Do you want to be a C Corporation, a Subchapter “S” Corporation, or a Limited Liability Company (LLC)? I am leaving off sole proprietorship as that’s are not really an entity. Do you know for sure that you are a for-profit company? I find that many folks are naïve about these types of entities. I send them to the Internet to get some basic descriptions. And regarding non-profits I ask them not to jump to conclusions. I have lots of examples of social innovation companies that are actually for-profit entities with a double or triple bottom-line focus: social impact, environmental benefits, and financial sustainability. B Corporation might be the way to go for many social innovators who are looking to reach financial sustainability while still being able to fundraise from foundations.
Conclusion: do your research so that you know what type of entity you want to be. Don’t pay your lawyer for such basic information that you could have learned easily on your own.
Further entity considerations
In what state do you want to incorporate? It’s not always obvious. Many startups are incorporated in Delaware. Why? Because it’s the second smallest state? No, of course not. Half a million businesses, including more than half of all U.S. publicly-traded companies and 60% of Fortune 500 companies, are incorporated in Delaware. Generally people cite reasons like: 1) the extensive case law in Delaware, 2) the flexibility of corporate statutes, 3) lawyers and investors are familiar with the state and its laws governing corporations, and 4) since so many others incorporate in Delaware, if you do the same you send a message that you too are a national growth-oriented company whose management knows the ropes. Great, but there are some disadvantages too like extra expense, distance, and other things to consider.
What do you have to do before you incorporate?
Besides doing your research and understanding the issues outlined above, you need to have a shareholder agreement in place. This legal document usually addresses: shareholder rights and responsibilities; share ownership and valuation; management of finances, business, assets, capital, and shares; and rules for issuing new shares and restrictions on share transfers. There’s a lot of meat in that agreement so you don’t want to rush into it. You need to carefully consider all of your options and be knowledgeable about what is going to be best for your startup.
Choosing a lawyer
The best thing you can do is get a referral, ideally from another entrepreneur or someone who knows entrepreneurs. Get several recommendations and then interview them. Also, make sure that you talk to a few of their clients and find out if they are responsive and effective. You will work with this lawyer for years, perhaps, and having a strong relationship will help enormously, particularly during difficult times. I’ve made mistakes with choosing the wrong lawyer in the past – twice. The circumstances were totally different and the types of lawyers were also – one was a patent lawyer who turned out to be just plain wrong, and another was not good for my startup. Correcting those mistakes was time consuming, costly, and very painful. Now, I have lawyers that I know, trust and refer regularly. If there are any questions after they are signed with a client through my referral, I can always call them.
This is an important decision and you need to make it wisely. Cost is an issue but should not be the main consideration. Pick a lawyer who you believe will fight for your company. And whom you trust. With your life.
Lots of books and blogs will also counsel you to not choose your uncle, who is a divorce lawyer, simply because he/she will do the work for cheap or free. It’s not worth it! Go with a lawyer who does startup work.
A few questions to ask in the interview:
- What percentage of your practice over the last few years has been startups?
- How many startups began with you and remain with you after having revenues of or having raised more than $1 million?
- How many investment deals have you been the lawyer for over the past few years? What was the smallest investment? The largest?
- Do you charge for attending board meetings? (the answer should be “No”)
- What clients can I talk to about your representation?
People are confused about non-disclosure agreements (NDA), also known as confidential disclosure agreements (CDA). They are confused because they jump right to asking someone to sign one before understanding the nature of the conversation that will occur. I generally counsel folks to have a first non-confidential discussion. There is no reason to disclose secret sauce or other confidential information in a first or second conversation. The time to disclose is when conversations are pretty far along.
Entrepreneurs who ask potential investors to sign NDAs are usually surprised when they get a resounding “No way!” Think about how unreasonable your request is. Investors talk to multiple entrepreneurs. They look at many deals. They won’t sign an NDA early on. They might sign one down the road, if they are serious and if they need to know the inner workings of your cool technology. But not during the first few conversations.
Entrepreneurs should be talking about WHAT they do not HOW they do it. Keep your early conversations general, high-level, and non-confidential.
You will need NDAs with your early employees and consultants. You need to ensure that your confidential information remains inside your company. So protect yourself with ALL those who come into contact with confidential, mission-critical information.
You will do this through employment or consulting agreements. In those agreements, you should also include “assignment of invention and non-compete language. You can find standard agreements out there, including at sites like LegalZoom.
Stay tuned for more posts – next up intellectual property.