Startups face a multitude of decisions: some have to be made at the outset and many along the way. Having experienced legal counsel assist with making those decisions at the start can go a long way to ensure that the decisions made down-the-line are in furtherance of achieving the company’s goals, rather than fixing issues that could have been avoided if properly addressed during the earliest stages. Below is a list of ten considerations we, as startup lawyers, feel that every entrepreneur needs to carefully evaluate when launching a startup.
1. Entity Selection
The first decision for any entrepreneur with a new business idea is to select the type of business entity to form in order to run the business, limit liability and achieve desired tax treatment. Corporations and LLCs are the typical options, though not the only ones. Experienced corporate counsel can outline the pros and cons of the various options and help entrepreneurs choose the best entity structure for their startups.
2. Selecting State of Incorporation/Forming
Many founders might think that geographic location would dictate where they should incorporate. However, most startups, especially those with an eye on raising capital (either now or later), should utilize their legal counsel to understand the benefits of forming in a state like Delaware versus their home state. Fortunately for many Texas startups, there are numerous similarities between the Texas and Delaware laws that govern corporations and limited liability companies (LLCs). If founders do incorporate in a state outside of the state where their startup’s principal place of business is located, they need to be sure to register to do business as a foreign entity in the state where the principal place of business is located and may need to consider tax implications.
3. Founders Agreement & Vesting Schedule
At the outset (and hopefully throughout the startups life-cycle), all the founders are fully committed and devoted to spending the necessary time to turn their startup into the best company possible. Unfortunately, as tends to be the case, some founders end up being more committed than others and if not properly accounted for initially, it can be a nightmare to remove an absentee founder. However, one way to ensure commitment from all founders and to mitigate against the risks if things change is to enter into an operating agreement (founder’s agreement) defining the relationship between the founders. Typically, this includes a vesting schedule for the founders’ equity, voting rights, lock-up provisions, veto rights on company sale and provisions for removal of a founder. Furthermore, many investors will insist that the founders’ equity be subject to a vesting schedule before making an investment and if one already exists, investors are more likely to accept it than negotiate for implementation of a different schedule.
4. Debt or Equity Financing
Startups looking to raise have a multitude of avenues through which they can raise funds. The first question founders need to answer is should the company issue debt, like a convertible promissory note, or should the company issue preferred equity (e.g. stock) to investors? Understanding the pros and cons of the various types of fundraising methods is crucial in making the right decision for a startup because the fundraising method chosen will have implications throughout the entire life-cycle of the company.
5. Securities Laws Compliance
Many entrepreneurs may think that they can take money from family and friends without triggering any securities laws issues. The thinking is that “these people want to support my business, help me grow and they fully understand the risks.” However, even a friends and family raise requires compliance with both federal and state securities laws. It is imperative that entrepreneurs utilize legal counsel to ensure compliance with securities laws, regardless of how they raise their money and from whom they raise it.
6. Employee Compensation – Equity Compensation Plans
An option or equity compensation plan is a great way for a startup to attract and retain skilled employees, especially when cash on-hand to pay salaries is limited. Implementing an incentive mechanism is a complicated process that has both tax implications and requires compliance with securities laws. Experienced legal counsel can assist with creating a plan that enables companies to retain their key contributors.
7. Intellectual Property Protection
A company’s intellectual property is one of the most precious assets it has. This is especially true with startups who are pioneering new products and concepts. Startups are well-served to have experienced intellectual property attorneys that can advise them on securing, protecting and monetizing their patents, trademarks, service marks, copyrights and trade secrets. Startups should not forget the importance of structuring agreements with employees and service providers to ensure that intellectual property produced for the company stays with the company. In the event of infringement or disputes, these steps will help the company.
8. Investor Due Diligence
This may not seem significant to a first-time entrepreneur eager to close a round of funding for their startup, but given the level of research investors conduct on potential investments in startups, it only makes sense that founders take the same approach with potential investors. Founders should understand the industry experience their potential investors have and ensure that these are the right long-term partners to help the founders’ vision for the startup become a reality. Founders need to determine whether they want passive money or active money.
9. Business Contracts
10. Legal Counsel
Expenses are a big concern for any business, especially a startup where the founders have often bootstrapped their idea to prove its concept and may have incorporated themselves or used a national doc-in-a-box company to provide them with the basic documents needed for formation. However, as outlined above, good legal counsel is integral to a startup’s success and is not something to be brushed aside to do later down the line when there is more money. Seek attorneys that will work to structure an engagement that makes sense for both parties. Set budgets and have your counsel prioritize your legal needs, which can be handled as your funds allow. An experienced startup lawyer is a good place to start.