By: Cheryl Conner, Forbes.com Contributor
This article originally appeared on Forbes.com on March 29, 2014: http://www.forbes.com/sites/cherylsnappconner/2014/03/29/top-10-legal-mistakes-by-early-stage-entrepreneurs/
Once in awhile the attorneys do know best. This week I interviewed Andrew Buffmire, attorney for Michael Best & Friedrich LLP’s Salt Lake office. The firm’s Utah team is particularly specialized in the issues of early stage technology companies, although many of the principles he addressed apply to other sectors as well.
“To a start-up, cash is like the jet fuel on a plane–something you don’t want to run out of at the wrong time.” — Andrew W. Buffmire, Attorney at Law
On the whole, he notes that Utah is a destination of increasing focus for the development and growth of west-coast born technology companies. (Here’s a recent analysis from Forbes’ Tom Post on the 50 top U.S. cities for early stage ventures.)
Buffmire reports 110 merger and acquisition deals in Utah in 2012-2013 worth a total of $10 billion, and that 39% of the sum came from tech. Not a bad outcome. Yet many early stage companies continue to fail, even in technology and entrepreneur friendly markets.
So what’s up with that? As presented in a recent address to the Utah State Bar Association, Buffmire shared these early-stage companies’ top 10 fatal mistakes.
1. Getting in business with the wrong team. It’s a given that most, if not all, start-up companies will struggle through some difficult financial and operational times. This is particularly true for technology companies, which must address technology risks as well as managerial, market and financial challenges. Consider carefully who you’d want to have in the lifeboat with you, as well as the psychological ability of your early partners to weather those storms. Your partnership and hiring decisions will rank among the most important early business decisions you’ll make.
2. Failing to form a legal operating entity early. While a Limited Liability Company (LLC) has tax advantages that may appear attractive, bear in mind that investors will want to see a C Corp holding the assets of a company with preference for a Delaware C Corp because of predominant prior investor experience with Delaware law. Without early formation of the entity, you run the risk of verbal commitments, side agreements and restaurant napkin business plans casting uncertainty on the technology and company ownership that could make capital raising much more difficult later on.
3. Not addressing ownership and vesting rights from the beginning. In that same vein, while all can be brothers and sisters in the early Ramen Noodles stage of a company, early-stage founders can fall away and end up not providing the benefits you had hoped for while holding ownership that should be saved for more valuable and productive participants. (“The Social Network” movie about Facebook’s early days is a great example of early ownership deals gone awry.) Get the ownership and vesting issues determined early. Vesting should occur by time and roles, not by poorly defined objectives or the matter of “who was here first.” This advice is vital: I recently spoke to an early-stage investor as he bemoaned the fate of a company whose initial CEO caved to the pressure to grant stock to a pushy incoming executive without a vesting schedule. The executive didn’t work out and was ultimately fired by the board, but despite the bad behavior was successful in walking away with significant ownership in the company.
4. Failing to do a timely 83(b) election. If the shares you issue are subject to a vesting schedule and carries a “substantial risk of forfeiture” (meaning the individual may depart before actually receiving the stock), the IRS views the purchase not complete until the risk of forfeiture goes away (meaning the stock has vested.) At that moment, the difference between the purchase price and the later fair market value is taxed as ordinary income. But it is vital (repeat, vital) that the company complete an 83 (b) election within 30 days of the initial stock purchase to allow for tax treatment as an initial issuance (when the value and tax is relatively small) and to allow for later capital gains tax treatment on the eventual gains. Failure to make this election in the allotted window can have extraordinarily adverse tax consequences for everybody involved.
5. Not affirmatively protecting intellectual property. The U.S. has now moved from the historic first-to-invent patent system to a first-to-file system. This makes it imperative that you do your patent filings early and often. As you anticipate future filings, be sure to protect all discussions and efforts with NDA’s (Non Disclosure Agreements) and label all associated materials with “Proprietary and Confidential” confirmation in all third-party discussions.
6. Failing to use experienced advisors in reviewing and responding to financing term sheets. Professional investors use a number of approaches to protect governance, liquidation rights and preferences in financing structure. You, the entrepreneur, enter the negotiations without the advantage of the nuances each investor and agreement will use. It is vital that you engage appropriate counsel to explain to you in detail what each of these ramifications will mean and to guide you in understanding in detail which of the criteria can be pushed back against and which can’t. You also need to understand how dilution will occur over time if you should pursue a venture-funded deal later on.
7. Failing to address all prior commitments and exposures from prior employers. Require all participants and prospective employees to disclose any prior (or current, if “moonlighting”) noncompete agreements and trade secret agreements and for any of these in force, seek a waiver (or avoid having someone with these limitations participating at a core level in the early days of your venture).
8. Failing to comply with applicable federal and state securities laws. I will be writing much more about these issues in the months and seasons to come. Review all of these issues with a specialized attorney from the start. Failure to do this could result not only in civil damages but even criminal penalties. Imagine the dire consequence of facing SEC sanctions such as a penalty from seeking further funding for a period of five years or even prison time over something as seemingly innocuous as a “business pitch” that gets broadcast on YouTube and gets interpreted as improper solicitation? Know the laws (which are currently changing, particularly as it pertains to Regulation D disclosure requirements and debt- and equity-based crowdfunding) and adhere to them strictly.
9. Failing to get the business basics right and in place early on.
- Business focus. Develop an early business focus that you can articulate clearly. 1) What do you do? 2) Who do you do it for; and 3) What is your unique and proprietary advantage?
- Customers. Who are your customers; what are your channels of distribution; what is your cost of acquisition; who are your competitors and how are you better than them?
- Money. Raise the right amount of money and do it without hurting your future money raising potential. Here’s a tongue-in-cheek rule of thumb: Consider that you will need 3x as much as you think, you’ll have 1/3 the revenue you think, and it will take 3x as long as you think to achieve exit. Also consider that too high a pre-money valuation, which may seem like a good thing at the time, will often lead to a painful down-round if and when professional investors come in. When you spend your money, do it frugally—remember that to a start-up, cash is like the jet fuel on a plane—something you don’t want to run out of at the wrong time.
- Management. Seek to build a team, systems and processes that can ultimately operate and scale without the founder.
10. Assuming the tough issues can be dealt with later. The simple answer to this assumption is “no.” Failure to address difficult issues early and well can lead to a later total failure and loss. Remember that first-mover advantage and time-to-market are key drivers of growth and value in technology companies. Delay in addressing hard issues is one of the primary mistakes that can kill an early stage business.
Has Buffmire’s thinking frightened you? As I review Buffmire’s ideas he smiles, acknowledging that many (if not most) of the top mistakes he cites are the result not only of observations of companies his organization is assisting, but also come from his own painful entrepreneurial lessons learned in years past.
May his 10 hard won entrepreneurial laws be your lessons. With thanks to Andrew Buffmire for the research he contributed to this interview, those who would like to reach Buffmire directly can connect with him here.