Startup geek around town

Top 10 legal related mistakes startups make

Today I ventured out to Beaverton to attend a lunch and learn sponsored by OTBC.  The topic of the discussion was “Top Ten Legal-Related Mistakes Startups Make”.  The talk was presented by attorney Jon Summers of the firm White & Lee.   Now before I summarize the talk for you please remember that this information is for your consideration.  I make no claim that I am an attorney, CPA or any authority what soever that you should follow direction from.   This is just my understanding of what was presented today.  For complete and accurate details and advice, please consult your own legal counsel and CPA.

OK, so now that I’ve made it clear that I’m just the messenger let’s talk about the lunch. This was my first OTBC lunch and learn and it was definitely worth my time.  The presenter was well organized and extremely knowledgeable about the subject.  He even took questions during the presentation and tried to answer each and every one of them.  Jon spent nearly an hour discussing the ins and outs of organizing tech startups to avoid legal pitfalls.  At the end of the presentation he wrapped it up with his David Letterman style top 10 list.  Since most is covered in the summary, let’s dive into Jon’s option on the top 10 mistakes that startups make.

10 – Missing the 83(b) election deadline

When it comes to stock and stock options, the IRS rules are long and confusing.  This is yet another one of those loop holes that if you miss you’ll pay dearly for.  This applies to the purchase of restricted stock or the early purchase of stock options by employees.  The net of the 83(b) is that when you make this election you are telling the IRS that you elect to take the income difference between the purchase price of  your shares and their fair market value.  Typically this is a net zero election that does not result in an income event.   But if you don’t take the election, you will be paying the IRS taxes on the difference between the strike price of the stock and fair market value of the stock EVERY time you vest.  OUCH.  The time frame is 30 days from the time you purchase your stock.  So….if you don’t get all of this stock mumbo jumbo…consult an accountant or an attorney to make sure you file your IRS 83(b) election in time.

9 – Selling stock to non-accredited investors

There are two types of investors in this world according to the SEC.  Accredited and non-accredited.   An accredited investor (person) is one that has over a million dollars in assets or earns over $200k a year individually or over $300k jointly with a spouse.  Everyone else is considered a non-accredited investor.  The rules for selling stock to the non-accredited investor is significantly more strenuous and can have negative ramifications when it comes to any potential liquidity event (ie sale of your company).  Jon’s advice…just don’t sell stock to non-accredited investors, period.

8 – Forming the business entity as an S Corp or LLC

Number 8 on his list brought up some discussion with the group and a little controversy.  Jon stuck to his guns and said that in most cases he recommends a C Corporation.  The basis for his recommendation is that fact that professional investors demand C Corporation status before they will invest.  He went on to say that the main reason is that with an LLC the profits of the company are passed back to the partners of the LLC and that has cash flow implications.  Another approach that was discussed was to start with an LLC and then prior to taking any type of capital investment, the company may switch to a C Corporation.

7 – Failing to register the stock option plan with the State of Oregon

The State of Oregon requires that stock option plans that meet certain criteria be registered.  Jon said that this was probably the single most common mistake found among the startups he works with.  So if you have a stock option plan, find out if you are subject to the registration requirements before you find yourself with a steep fine or worse yet a roadblock to a funding or liquidity event.

6 – Waiting too long to form the business entity

Jon made it clear to the audience that the first thing you should do is create your business entity.  His rule of thumb was that whenever a business had two or more people, is creating intellectual property or is transacting business with others – they should have a business entity established.  The main reason is for protection of the business.  Once an entity is formed then there is liability protection for the principals, there is a place to park the intellectual property, there is investor appeal, survivor-ship upon death and business can be transacted more easily including contracts and employees.

5 – Failing to vest founders stock

The vesting of founders stock was an interesting recommendation that I really never paid much mind too.  But after Jon explained a few scenarios where founders decided to leave the company after a short tenure, it sure made sense.  Imagine if you and your friend started a company and split the stock 50/50.  After a year your friend decided to go off an pursue a different idea.  If you granted the founder shares on day 1, half of your shares would be walking out the door no longer providing value to the company.  If you vest the founders shares say over 4 years, then the company would get at least four years of value from the founder or have the option to recover some of that stock if the founder decided to leave.

4 – Bringing in tainted people

Hiring was an interesting topic during the conversation.  The discussion revealed an important piece of advice for each of us running a company.  Jon’s advice was to make sure that we get a copy of every potential employees non-compete/non-disclosure agreement PRIOR to making them an offer.  He said that the burden is upon the hiring company to make sure that they aren’t hiring tainted employees (ones that may be subject to non-compete or non-disclosure agreements).  When the audience was surveyed no-one had either asked for or given a copy of prior agreements.  I guess this is something we all learned.

3 – Disclosing information without a sufficient Non Disclosure Agreement

Although the risk of someone running off with your business idea after a presentation is small, it is still there.  A simple NDA can ensure that this won’t happen.  Jon said that small companies are usually at the will of the bigger companies when it comes to the legal forms.  He did offer the advice that before we sign a “standard” agreement from another company we look out for what he called dangerous terms.  These include residual clauses, independent discovery clauses, non-solicitation or other restrictive provisions as well as short lived terms.  By watching out and preventing these elements from slipping into NDAs you’ll be better protected.

2 – Missing the non-compete window

In Oregon the window of opportunity to have an employee sign a non-compete agreement is very limited.  As a matter of fact there are only two times where an employer can get an employee to legally sign a non-compete agreement.  The first opportunity is prior to hiring of a new employee.  There is a two week waiting period from the time the new employee is alerted to the requirement of the non-compete to the time that they can sign it and join the company.  The second opportunity is when there is a significant promotion of an employee.  As the discussion continued and Jon explained how non-solicitation agreements really work, this is one of those areas you really need to pay attention to.  There are several restrictions of what makes a non-solicitation (non-compete) agreement enforceable.  And there may even be compensation required on the part of the company enforcing the Non Compete.  So when you are ready to head out to your next gig and your employer tries to force you to sign a non-compete on the way out the door, you can rest easy that it won’t be enforcable in Oregon.

1 – Waiting for funding to fix problems

As Jon wrapped up the talk he finished his top ten list with the most obvious mistake that startups make.  He said that too many times startups will allow problems to compound themselves with the hopes that it all will get figured out AFTER funding.  Well there is a fundamental problem with this line of thinking.  Unless there is a magic wand, companies who have not paid attention to legal issues up front will never be getting that funding they were hoping for.  The only course of action for a company is to correct all of the problems before they can finalize funding and this can mean months of delays, expensive penalties and missed opportunity to close the finance deal.

My thanks to Jon for providing us with the information at the lunch and learn and thanks to OTBC for organizing. Much of the content in the article above comes directly from Jon’s talk, so I attribute this article to him.  Finally a bit of promo since we were able to absorb some free advice…..If you are in the Portland area and need legal assistance with your startup entity formation, stock plans or IP protection, give Jon Summers a call at White and Lee.