Common mistakes founders make – a lawyers’ point of view
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There is a ton of noise on how to succeed in making fail-proof start-ups or nailing the elevator pitch. What doesn’t find much mention is mistakes founders make for lack of a legal budget. As a lawyer I will obviously say that there is just no substitute for proper legal advice, but I also recognise that “legals” can be a pain point for bootstrapped start-ups. This article suggests a few legal DIYs which might avoid a few costly mistakes early in start-up life.
Create a legally binding relationship with your co-founder. The truth is, unless a founder has a very large social circle of highly skilled people, a set of co-founders are likely to be people who do not know each other in-depth. Add to that the inevitability of beginner mistakes, you have the start-up etching nervously at the precipice of a board room dispute even before it has gained momentum.
Founders need to consider not just the creative genius or business flair of their co-founders but also how persistent they would be when times are tough, or what it might cost the company if they decided to part ways. Founders would help themselves by openly discussing time commitment expectations, salaries, and who will be taking responsibilities when giving warranties to investors. If there are no written service agreements with vesting provisions at the outset, when things start going belly-up, co-founder disagreements can become a huge drain on the company’s time, resources and momentum. Establishing a vesting period can help protect the company from deadweight founders: this is where shares are only received over a specified period, and if someone leaves before their time (or is removed for reason) they lose that ownership.
Protect your intellectual property (IP). It is crucial for a tech start-up to invest in protecting the IP it owns, and avoid infringing IP rights of third parties. Equally investors or purchasers will become nervous if you are over-reliant on third party IP – as termination of that licence would then be disastrous.
Where the primary innovation is software, copyright is likely to protect the code itself automatically – but that won’t prevent someone copying the functionality. That means being first to market is often more important. For more complex projects, patents for inventions related to such software can be important. Sophisticated investors will appreciate that use of some “open source software” (where the usually proprietary source code can be not only used but amended) is a great way of rapid code development. But it does come with risks: some “copyleft” open source licences can have an unexpected impact on a start-up’s proprietary code, so use it with care.
Equally critical is creating a protectable brand. Just a name won’t be protectable if it only describes what you do. One should also search the publicly available trade mark register, but that won’t give you complete certainty that you’re free to use the brand.
Adopt company-friendly documents. One mistake founders make is taking a one-box-fits-all solution to legal documents they replicate from other start-ups, without investing much of their own thinking. Agreed there is no need to reinvent the wheel but always at least ask your lawyer if they can help you adopt good standard forms within a budgeted fee. Think about implementing a house-style employment contract, IP assignment deed, customer T&Cs for B2B/B2C SaaS products. Data heavy businesses (such as machine learning/artificial intelligence) engrossed in cleaning or trading data should consider data protection laws carefully. If you are co-founding various companies it is imperative that you apportion your time/value legally through a co-operation deed or a similar agreement, to avoid potential conflicts – should one company exit before the other. None of this is wasted cost as it garners investor confidence, which is key to success.
Familiarise yourself with key legal jargon. Terms like statutory books, share capital, nominal value, premium, option shares, vesting, convertible debt, warranties, reserved matters, transfer restrictions, tag-along, drag-along etc. should become comfortable territory to every start-up founder. For example, often founders do not fully understand the terms or potential impact of convertible loan notes until they convert in a priced round. I’ve seen it happen way too many times where a company gets excited because they have more interest than they originally anticipated. When it comes time for their Series A, the founders are surprised to see the dilution at the conversion, or how many different share classes with varying rights have been inadvertently created. Before signing a document, familiarity with terms entrenched in business documents would prevent future costs undoing any such mistakes.
Prepare your cap table early on. In the beginning a capitalisation table is a simple spreadsheet but it will become more complex as the company grows with investment and hires people. An unevolved cap table is a mistake. This table is at the core of determining the runway, who is owed what shares/voting power, how much equity dilution is acceptable by offering option shares to new hires. Keeping good cap table hygiene from the start reduces legal costs too, as you save spending on trying to retrace your steps on how you got to where you are when receiving investment.
Other tips to save legal costs are, check if the start-up will be regulated (e.g. fin-techs are regulated by the FCA). Raising SEIS/EIS money from friends and family may have tax implications don’t over promise until you have understood these. If you have employees then understand their and your rights (especially now in the context of Covid and furloughing schemes).
That said, sometimes things will not go as planned, which is where a more streamlined effort instead of mindless hustling will reap rewards. Don’t cut corners on legal costs as you may end up making bad decisions for the longer run, instead hire a good lawyer, you will find many city firms willing to accommodate discounts to match a start-up’s budget. I conclude with what I oft say to my clients, avoid being penny wise, pound foolish.
Mumuksha Singh is a corporate lawyer at international law firm CMS in London. She is tuned in to London’s start-up pulse and reachable on CMS’ equIP programme.