Want to avoid making some big mistakes as you grow your startup? Heed the advice of these lawyers.
That Start the Smart Legal Series – an online event series hosted by the University of Pittsburgh Big Idea Centerthat Pitt School of Law and Project Olympus of Carnegie Mellon University — aims to answer legal questions related to business formation, intellectual property, technology transfer and more. Previous panels have focused on topics such as hiring and firing, starting a business on an F-1 student visa, and negotiating term sheets.
The latest, held on Tuesday night, gathered three lawyers to share some of the worst mistakes startups have made over the years. The three panellists included innovation works legal counsel Deborah Walker, The tone Head of the national group Venture Technology and Emerging Growth Companies David Calson and FJ Lucchinowho runs his own company Lucchino law.
The attorneys shared stories across a wide range of experiences they have gathered throughout their careers in technology and business law. We’ve rounded up some key advice shared by lawyers at the event below – but make sure to check out the full replay too.
Be careful when setting up your company
Before entrepreneurs can get off to a flying start with a business idea, they must legally form a corporation, whether it be an LLC, C Corp, nonprofit, or something else. While LLCs tend to be the most popular choice for young businesses due to lower tax rates and protection of personal wealth, Kalson and Lucchino cautioned entrepreneurs against jumping into this formation.
“There are times when it makes sense to be a C corporation,” Kalson said, especially when the company’s endgame is to raise millions of dollars in capital and be acquired or taken public through an IPO .
Lucchino agreed that a common mistake startups make is not thinking ahead about their end game. Another reason is “not getting good advice early on when considering it [business formation] decision, as opposed to the knee-jerk way of, ‘I’m going to do an LLC because that’s what everyone does,'” he said.
There can also be serious consequences for not starting a business early enough, aside from tax and investment inconveniences. One of the dangers of not having a formal incorporation agreement can be a vague way of thinking about intellectual property. Founders kept breaking up for a variety of reasons, Kalson said. Therefore, it is important to have an official agreement from the outset that any intellectual property created by Company employees must be transferred as Company property should they decide to leave the Company.
“If someone owns some of that intellectual property and they don’t want to share it, you can basically kill the company right there and then,” he said.
Beware of “dead equity”
One of the biggest motivations for founders and subsequent employees to create and join a startup is the promise of a return on investment. By joining a company early, employees can maximize their chance of receiving high quality stock options if the company becomes successful and is acquired or goes public. In a perfect world, an employee’s equity should be proportional to the amount of work he or she puts into the startup. Dead equity comes into play in cases where this proportionality is off.
Lucchino said he often sees this problem with university spin-offs that want to commercialize a faculty member’s research. In these cases, “You have a faculty member, maybe a tenured faculty member at Pitt or CMU, and they were advisors to some team members, so they have a role [at the beginning],” he said. “And so they end up getting a bigger share of the [equity]but they will be too busy to really do much with the company.”
This can discourage a company from attracting new talent and deter investors concerned about financial strength imbalances. It also presents an awkward situation for student or alumni entrepreneurs who want to decrease that faculty member’s equity down the line, as they may have conflicting interests in needing a professional recommendation from that individual and access to others tied to the university have resources.
So what can founders do? KitNeedham, the director of Project Olympus and associate dean for entrepreneurship initiatives at CMU, said she’s happy to show faculty members data on equity allocation for successful spinout companies. The hope, she said, is that once faculty members see this data, they’ll be more willing to step down, knowing that their dead equity could stand in the way of investment and growth opportunities.
Downloading forms for the web is probably a bad idea
To save money in the early days of a startup, founders might be tempted to download sample employment contracts, non-disclosure agreements, and other business forms from the Internet rather than paying for an attorney’s draft and consultation on those forms. But that can be a big mistake, Walker said.
“People know they should have NDAs, and that’s why they pull NDAs off the internet,” she said. But often they abuse templates for mutual nondisclosure agreements, when a unilateral nondisclosure agreement is usually required instead. Additionally, these NDA templates typically do not cover the transfer of inventions, which takes intellectual property protection into account.
“It’s critical for technology companies to cover those bases,” Walker said. During her time at Innovation Works, she has seen many young companies face this challenge. One of them “had a good agreement and knew what to do, but he failed to obtain the signed non-disclosure agreement and transfer of inventions from one of the co-founders.” The result was disastrous: “A few years later there was a dispute and he eventually sued the company for being a co-owner of the intellectual property without this transfer of inventions.”
The lesson? Even if your startup is short of funds, it pays to consult legal resources to ensure your IP protection, confidentiality, and employment contract bases are covered.
At least that’s what three startup lawyers say.
Sophie Burkholder is a 2021-2022 corps member for Report for America, an initiative of the Groundtruth Project that connects young journalists with local newsrooms. This position is supported by the Heinz Foundation. -30-