Top Legal Mistakes Entrepreneurs Make When Launching Startups
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expected to contribute over some period of time. Shares are divided among founders based on initial contributions (capital, idea, etc.) and also as an incentive for each founder to stick around and deliver the goods as the company develops.
Alas, too many co-founding teams forget the “over time” or “sweat equity” part of founder stock. In our example, they each get their half-ownership stake “fully-vested.” That means if, say, 10 days later one of the founders finds a better opportunity, that person gets to seize that opportunity-–-and keep all of his or her founder stock.
The solution? Co-founders should, when they initially divvy up their ownership shares, include vesting of some of their shares in chunks over time, consistent with what they expect their future contributions to be. The details can vary considerably, but a typical situation might be that one quarter of each co-founder’s shares are immediately vested, with the other three quarters vesting in equal monthly portions over two to four years. Upon a co-founder’s premature departure, the unvested shares would be sold back to the company at cost (which is usually pennies per share at most).
Intellectual Property Mistakes
Most startups with venture capital-worthy growth objectives are “know-how” driven—they have a “secret sauce” that gives them a material, sustainable competitive advantage. The secret sauce might include patents, copyrights, trademarks, trade secrets, customer relationships, etc. Many entrepreneurs are neglectful of identifying and protecting critical intellectual property assets, and too many of them don’t figure this out until the damage has been done.
This is not the place for reviewing the finer points of patent, copyright, and other laws regarding intellectual property rights. Besides, most entrepreneurs are smart enough to engage with legal counsel when it comes to the finer points of these laws. The focus here is on some basic blocking and tackling mistakes that get made before entrepreneurs even know they have an issue.
—Assignment of Intellectual Property Rights: Often, the first time an entrepreneur thinks about ownership of his or her intellectual property rights, like the software code he or she has developed, is when a prospective investor asks whether those assets have been assigned to the new company. (No reasonably intelligent investor wants to invest in a company that doesn’t own the secret sauce.)
In the case where the founder owns all of the relevant IP, neglecting to sign it over to the startup is usually no big deal: it is more a loose end that can be tied up as part of the first round of capital investment. But when there are two or more founders involved—or when there are folks other than founders, perhaps people not even involved in the business going forward-–-things can get much more tricky. Persuading someone with no future role at the startup-–-say, a former roommate who helped with some of the early coding-–-can get expensive when the entrepreneur waits until there is serious money at the table, money that won’t stay at the table unless all of the IP has been assigned to the startup. Friends can be quite problematic in these circumstances. Just ask Mark Zuckerberg, the Facebook co-founder and CEO who spent several years mired in expensive legal battles with former Harvard classmates arguing over the origins of Facebook.
The lesson here is simple. If an entrepreneur is bringing any intellectual property to the startup that he or she doesn’t fully own-–-the classic example being software code or designs that some third party had a hand in developing-–-deal with getting that IP assigned to the startup before there is much at stake, and certainly before an investor is willing to write a big check on the assumption that all of the necessary IP has been assigned.
—“Work for Hire” Rules: When you buy a car from your local car dealer, you don’t expect that the car dealer will share ownership with you. Alas, in the case of property subject to copyright law (including software), when you pay someone to write code for you, what you get when the code is delivered is not exclusive ownership but, rather, shared ownership with the coder. Unless, that is, you get the coder to specifically assign his or her ownership interest to you as part of the contract.
The so-called “work for hire” trap has bitten too many entrepreneurs, who only find out after the fact-–-often when an investor asks the entrepreneur who wrote the startup’s software code, and whether the same specifically agreed to grant his or her “creator’s” interest in the software to the entrepreneur-–-that he or she doesn’t have exclusive ownership of the software. Unfortunately, “we both knew what we meant” strategies about ownership seldom work. So be careful when you pay someone to develop software or any copyrightable property for you, and be sure and get the developer to assign his or her rights to the product to you at the front end of the deal. And get the agreement in writing. If you don’t, you will likely find yourself having to pay for the property twice.
This short (well, perhaps “not too long” would be a better description) blog hardly does justice to the numerous legal traps that can trip up entrepreneurs before they even get their startup off the ground. It should, however, give an entrepreneur thinking about starting a company some important boxes to check before proceeding too far down the startup path.