Common Legal Pitfalls of Startups and Emerging Companies
Due to business demands posed by product development, the hiring of suitable candidates, and capital needs, good “legal hygiene” and corporate governance may not always be top-of-mind for startups and emerging companies. At MT>Ventures, a division of McCarthy Tetrault LLP, we pride ourselves as being the external “in-house legal counsel” for our clients to assist them on their legal and non-legal needs at all stages of their lifecycles. Having spoken to hundreds of startups and advised emerging companies ranging in the pre-seed stage to the Series B stage, we have compiled below a list of five common legal pitfalls to avoid as you go from the founding of the company to exit.
1. Failing to incorporate your business
Some founders operate on the belief that incorporation is just an additional legal cost that can be handled at a later point in time. As a result, they continue to kick the proverbial can down the road. While there are certainly downsides to incorporating “too early” – for example, a corporation is more expensive to operate than a sole proprietorship – it is often beneficial for revenue-generating businesses to incorporate sooner rather than later, in order to tap into the suite of benefits available to companies. Not only can incorporated businesses benefit from potential tax advantages (remember to always check with your tax advisors), founders can also shield their personal assets from unlimited liability, a protection not otherwise available to sole proprietorships. Moreover, a corporation has greater access to capital, as they can issue securities and generally borrow money at lower rates than individuals. Most importantly, as your business continues to grow and develop, incorporation is often necessary to obtaining third party funding from venture capital firms and other institutional investors.
2. Failing to enter into a shareholders’ agreement
Co-founders may balk at the idea that they may one day face a conflict they would not be able to resolve collegially. These founders may be surprised to find out that, according to Noam Wasserman, best-selling author of The Founder’s Dilemma and Harvard Business School professor, 65% of high-potential startups fail due to co-founder conflicts. Combined with the fact that time is always of the essence for small businesses, this is why a shareholders’ agreement is important to help co-founders manage disagreements – or worse, indecision and bottlenecks – that may arise in the future. A shareholders’ agreement (or even just a founders’ agreement between your co-founders) sets out the decision-making process to be followed for a variety of potential future events, including an exit, divestment, fundraising, termination, dispute, death, divorce or disability. It also helps business partners understand their rights and obligations relative to one another, such as each owner’s financial and management rights. By clarifying these rights and obligations upfront, a shareholders’ agreement provides co-founders with a “playbook” for navigating through unforeseen problems, and ultimately helps to promote the efficient and orderly operations of a business.
3. Neglecting your minute books
Launching a successful startup requires a founder’s undivided time and attention. With founders already working around the clock to launch their next product, onboard new customers or seek out new partners, the management of a company’s minute books and corporate records often falls through the cracks. We sympathize with founders, and are here to help. At MT>Ventures, we can act as our clients’ corporate secretary by maintaining, updating and managing minute books and corporate records on their behalf. While neglecting your minute books is certainly not the end of the world (it’s not uncommon for companies to catch-up on all the missing pieces at the time of their first major financing), taking a retroactive approach to minute book management will likely wind up costing your business more in legal fees in the long-run.
4. Failing to have your intellectual property assigned to the company
For many startups and emerging companies, the most valuable asset is not registerable intellectual property, but rather trade secrets that the business rely on to sustain a competitive advantage. This may include core innovations, algorithms and data. In order to protect your trade secrets from improper disclosure, a confidentiality and proprietary rights agreement should be entered into with all of your founders, employees, contractors and service providers to ensure that all inventions are transferred to the company. For companies seeking to attract third party funding, venture capital firms and institutional investors will almost certainly require that the company own all of its proprietary intellectual property. By entering into confidentiality and proprietary rights agreements and employing appropriate security measures, you can help safeguard the secrecy of your trade secrets and mitigate against the risk of a departing founder or other personnel taking any of the company’s proprietary information with them.
5. Choosing the wrong investors
We understand that the process of seeking out potential investors can be overwhelming. With the cash runway breathing down your neck, especially after one too many business rejections, it is easy to become discouraged and jump at the first opportunity for a cash infusion. Founders must be careful about which investors they choose. Although this investment may provide short-term liquidity, an investor who is the wrong fit can hurt your company exponentially in the long-term by way of disagreements, conflicts or a much dreaded early divorce. This, however, begs the question: what makes an investor a wrong fit? There are many factors to consider. As a starting point, it is important to ensure that your vision, goals and objectives for the company are aligned, including any short-term financial or operational milestones, and the manners in which the company’s performance will be measured against those milestones. A potential investor with a less-than-perfect attitude can often be managed. However, if they bring little else to the table aside from cash, are unclear about their financial goals or their conviction to your business, or you notice they are dragging their feet in the diligence process, these may be “red flags” that indicate the potential investor is not the one for you. Ultimately, a good investor is someone that provides strategic value by compensating for existing gaps in your business, whether they are skill gaps, relative lack of industry experience, an under-developed network or otherwise. Joining a local technology startup accelerator, incubator or similar community can help founders become more familiarized with the investment ecosystem available to them. To facilitate a smooth and orderly closing, we also recommend founders iron out all of the material legal and financial terms of the investment at the term sheet negotiation stage early-on.
Entrepreneurship and building a successful business is not easy. At MT>Ventures, we bring a combination of legal and entrepreneurial expertise to help you navigate the potential pitfalls you may encounter. If you found this information helpful and would like to discuss anything in greater detail with us, please e-mail MT>Ventures at [email protected].
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