To many entrepreneurs hamstring themselves before even getting out of the starting gate. Attention to a few legal details as you are creating a business can make the difference between falling into a legal morass and realizing all that is due you.
This advice comes from Yale business law professor Constance Bagley, who developed these tips while teaching at Harvard Business School. We offer an edited version, but you can see the complete list here.
- Failing to incorporate early enough. Incorporating too late, and issuing inexpensive stock to the founders at the same time that much more expensive stock is being sold to investors, can create tax problems when the IRS argues that the difference in stock price is actually income to the entrepreneur.
- Issuing founder shares without vesting. Vesting protects the members of the founding team who take the venture forward against the claims of those who leave early.
- Hiring a lawyer not experienced in dealing with entrepreneurs and venture capitalists.
Lawyers who have no experience working with entrepreneurs and venture capitalists will most likely focus on the wrong things while failing to recognize some of the more subtle potential traps.
- Failing to make a timely Section 83 (b) election. An 83 (b) election allows the tax computation on issued shares to be made based on the value at the time the shares are issued, which is often pennies per share.
- Negotiating venture capital financing based solely on the valuation. There are many other ways for venture capitalists to get compensated if they end up paying a high price for shares including requiring participating preferred with a high cumulative dividend, redemption rights exercisable after only several years, and ratchet anti-dilution protection with no cap.
- Waiting to consider international intellectual property protection. Patents are granted on a country-by-country basis (with a single application available for the European Union). One must make intelligent choices of where they think their markets are, and how much money to spend at an early stage in order to insure that the brand is available in those markets.
- Disclosing inventions without a nondisclosure agreement, or before the patent application is filed. If patent protection hasn't been obtained, or in cases where a patent is not available, the only protection is to maintain something as a trade secret. To do so, one must show that they've taken reasonable steps to keep it secret from competitors.
- Starting a business while employed by a potential competitor, or hiring employees without first checking their agreements with the current employer and their knowledge of trade secrets. Would-be entrepreneurs should first go to their current employer and either resign or tell them what they're doing and ask them if they'd be interested in investing.
- Promising more in the business plan than can be delivered and failing to comply with state and federal securities laws. Trying to squeeze out a little extra valuation by fudging the numbers erodes credibility, makes investors less trusting, and ultimately impairs the ability to get subsequent rounds of financing.
- Thinking any legal problems can be put off until later. Many of the points made here are problems that can't just be fixed at a later date, so hire a competent lawyer. Excellent legal talent can be retained for relatively little money up front at the early stages.
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