Legal Pitfalls When Structuring A Company – Effects On Fundraising Success

Navigating the startup landscape is confusing for a novice founder, and legal pitfalls when structuring a company are more common than believed. It’s not unusual for newbies to be so excited about their brilliant idea that they overlook the legal nuances of structuring the business.

Knowing and understanding the potential pitfalls at the onset can help you avoid them. These errors pose significant problems down the line when you’re ready to raise capital. VCs, PE firms, and other investors will conduct detailed due diligence at that time.

Trying the fix the errors will be more time-consuming and complex. And most of the damage will have already been done. Read through these common mistakes founders make and how to avoid them.

Make sure to collect the documentation as you go along to streamline the due diligence process.

Not Structuring the Company Per Legal Regulations

Structuring the company per federal regulations is crucial since it influences its other aspects. The taxes you pay, the personal liability you incur, and the ability to raise funding depend on the structure. You should incorporate the company even if you’re bootstrapping and available funds are low.

Investing the time and effort is worth it since investors, precisely venture capitalists, are more likely to back corporations. You’ll register the company in the state and city where you intend to conduct business. Future expansion plans will also determine the jurisdiction, such as state or federal.

For instance, if you plan to restrict operations within a particular state, you’ll follow the incorporation policies of that state. However, federal incorporation is advisable if you think the company can scale across state borders and possibly even overseas.

Once the company is incorporated in a federal jurisdiction, it can conduct business in any location across the country. Investors examining your company structure will want assurance that it can scale and capture markets in other geographical locations.

Not Registering the Company’s Intellectual Property

Not registering the company’s intellectual property is one of the crucial legal pitfalls when structuring a company. IP includes assets like the domain name, brand name, logo, trademarks, and trade secrets. Registering these assets clears ownership rights and eliminates potential chances of infringement or theft.

Since the company is an independent entity, all IP and ownership rights should remain with this entity.

Don’t make the mistake of allowing co-founders, advisors, employees, consultants, and third-party vendors and developers to own intangible assets. Particularly assets developed within the company as part of its operations.

When you pitch for funding, VCs and other investors want assurance that the company owns the assets. It should have full authority to utilize, transfer, lease, or sell the assets as needed without any encumbrances.

Ensure employees and third-party developers sign NDAs and IP assignment agreements to secure the IP and IA. They should formally cede ownership rights on the assets they create for the company.

Any assets the founders also create should be a part of the company’s assets, and that includes the IP you’ve created.

Most importantly, you may have started working on the company concept during your employment with another company. In that case, make sure your previous employer cannot claim any liens or rights on the property you created while working for them.

Legal documentation for intellectual property should also reflect the monetary compensation paid to the creator. This clause applies not just to employees and vendors but also to the founder.

So, make sure to draw up the IP contribution agreement. This paper confirms the company has no outstanding obligations to its founder.

Investors need to see clear ownership since they are unwilling to deal with expensive litigation and ownership lawsuits.

Not Clarifying the Company’s Cap Table

Clearly specifying your shares is crucial whether you’re starting the company as a solopreneur or with a co-founder. Another of the legal pitfalls when structuring a company is having only verbal agreements or assuming that founders will share equally.

Founders Agreements

Disagreements and fallouts down the line often lead to lawsuits that investors want to avoid. To eliminate this situation, you’ll have a written board resolution that authorizes issuing shares to the founders or founder’s agreement.

You’ll also have the legal team draw up a share purchase agreement or payment for shares. The documents should also specify the vesting schedules in detail and institute tracking procedures. The founders receiving the shares should understand the vesting requirements.

Typically, founder shares come with a four-year standard vesting schedule and a one-year cliff. Accordingly, no shares vest within the initial one year or 12 months. During the next one-year cliff period, 25% of the shares vest.

The remaining shares vest in equal installments, monthly or quarterly, until the four-year deadline from the vesting start date. Vesting means granting or releasing equity or stock to recipients who can be the founders or shareholders.

Founders also have the option to request reverse vesting, where the founders receive shares upfront instead of over a period. Without this documentation, 65% of startups will fail.

In addition to information about their shares, the founder’s agreement specifies information about their voting rights and decision-making powers.

Stock Ledger or Cap Table and Minutes

Other must-have documentation that minimizes potential pitfalls prior to fundraising includes a stock ledger or cap table. This document carries complete details about the company’s shareholders and the stock they each own.

Having minutes of every board meeting and event is also crucial. These are internal records that indicate the important business decisions the board took regarding the shares.

For instance, the company assigned stock to an incoming co-founder or transferred stock from one member to another. Accordingly, the minutes will reflect the decision, along with complete details.

The cap table, minutes, and shareholder agreements come under scrutiny from investors during the due diligence process.

Investors would want to see that the company stock ownership is clearly demarcated. Being unclear about this information is another of the legal pitfalls when structuring a company.

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Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Convertible Notes and SAFEs

Founders often use convertible notes and SAFEs to raise funding, but without giving up equity in the early stages. By offering these instruments to investors, they can get capital without valuing the startup. SAFEs award investors the right to purchase equity at a later date.

However, convertible notes convert into equity after a pre-determined interval. Depending on the type of instrument, founders may have to set a date for the investment to mature.

If the company cap table or stock ledger reflects multiple such instruments, VCs could be wary of investing more money.

Not only do corporate law conditions come into play here, but the promise of giving up equity results in dilution. Before selling SAFEs and convertible notes, you may want to check with an expert lawyer.

Understand their long-term repercussions and how they influence future growth and fundraising efforts.

Not Clarifying the Employee Option Pool

Entrepreneurs may promise stock options to their employees, consultants, and advisors during the initial days of founding the company. These options usually serve as partial compensation for the services they provide to the fledgling company.

However, documenting these options carefully and specifying details like the vesting structure is crucial. Without proper records, misunderstandings and confusion are likely to arise during the liquidation or fundraising process.

Most importantly, records should clearly reflect the vesting period and criteria. Particularly, what happens to the stock if the employees or recipients leave the company before the stipulated period. Employee stock option pools typically come with two-year schedules with monthly vesting but no cliff period.

To avoid legal pitfalls when structuring a company, it is advisable to draw up formal employment agreements and option grant agreements. Investors will need to examine these documents for information about when the company will issue additional shares to cover the option pools.

Any additional shares it issues will result in the dilution of the existing equity that shareholders own. That’s a situation investors want to avoid since it will also dilute their stake in the company.

Further, before offering capital, investors focus on the team slide for information about the core talent driving the company. Top-quality skill sets with an impressive track record have the potential to bring success to the company.

When examining the options pool, investors view it through the lens of motivation. And if the stock is adequate enough to retain the workforce and prevent employee attrition. Typically, investors like to see shares worth 7% to 10% reserved for deserving employees.

Not Researching Securities Law Exemptions

Any equity and stock that companies issue to the public must comply with The Securities Act regulations and the Securities and Exchange Commission (SEC). Each state also has laws regulating how companies sell equity, called the “Blue Sky” laws. These laws vary between states.

However, the Securities Act includes certain provisions that allow companies to overlook Blue Sky laws when issuing securities. They can pay a small fee and file a simple Form D notice to take advantage of the provisions.

Startups may also leverage Section 4(a)(2) of the Securities Act, which eliminates the need to register “private placement” offerings. Founders can offer securities to people they know on a personal level who aren’t part of the general public.

These individual investors may include the founder and co-founders, friends, and family members. However, it’s always advisable to use legal counsel to understand precisely which equity and stock are exempt under the law.

Misunderstanding the exemptions and not paying the applicable fee is another of the legal pitfalls prior to fundraising. Investors will examine compliance carefully during the due diligence process.

The legal aspect is only one of the many startup hurdles every entrepreneur needs to overcome. For detailed information about the other pitfalls you might have to face, check out this video I have created. You’re sure to find it helpful.

Non-Compliance with Employment Laws

During the initial stages of building the company, founders invariably look to economize on the skill sets they purchase. Accordingly, they may work with contractors and third-party vendors instead of hiring in-house employees.

Hiring off-shore contractors to provide remote work is also a great option to get affordable freelance work done.

However, founders should be clear about their status as in-house employees or freelance contractors before hiring people. Determining employment’s nature accurately is crucial because the company must comply with employment laws.

It’s always advisable to check with a legal expert to avoid being liable for making income deductions. The law requires companies to make deductions and income tax and remit it to the authorities when filing taxes.

Companies must also comply with federal, state, and local government laws pertaining to full-time and part-time employees.

The Fair Labor Standards Act (FLSA) regulates minimum wages, record maintenance, and overtime work compensation. It also lays down child labor standards along with other regulations for health and safety, workplace harassment, and discrimination.

Non-compliance with any of these laws can lead to fines and penalties, which are other legal pitfalls when structuring a company. Investors are likely to examine the company’s operations during the due diligence to ensure that it follows the rules.

Legal Pitfalls When Structuring A Company – It’s Crucial to Avoid Them

Setting by a company involves myriad legal connotations that founders are typically unaware of. Getting legal advice is crucial from the time you come up with an innovative concept and develop the IP for it.

From converting the idea into a market-ready product and testing it on customers to hiring talent and bootstrapping–every step involves legal compliance. At the onset, it’s easy to ignore these issues, but once the company is ready for fundraising, the problems start.

Investors are likely to go over every aspect of the company from inception to operations with a fine-toothed comb. They need assurance that their investment is secure and capable of generating rich returns.

Legal issues they unearth will make them rethink their decisions to offer capital and any other kind of backing. You may have to accept negotiations for less favorable terms and conditions to raise funding effectively.

This is why it’s critical to structure the company per federal and state regulations. That’s how you’ll ensure long-term success.

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