3 Legal Mistakes That Can Cost You Your Startup
Not all legal mistakes are created equal. Many are inconsequential. When you realize you’ve done something wrong, you can right it as easily as flicking dust off your shoulder.
However, there are a few that are unforgiving. You may be riding high in all respects – traction, fundraising, team… and then you get a call from your lawyer, and your dream comes crashing down.
Unremarkable at first glance, the matters behind these mistakes don’t so much as get a second thought from founders, who act on a whim and move on. That mistake, however, festers as time goes on and by the time it’s caught, it’s usually too late.
But the most painful part is this: while these mistakes are insanely expensive (if at all possible) to fix once made, they could have been avoided so easily with just the right awareness.
This post is about some of those mistakes and the hope that 10 minutes of your time will help save your dream.
1. Not having founder vesting
The Story
You and your co-founder shake hands, split the equity, and you’re ready to take on the world. But things are off to a bumpy start, as things usually are with startups.
One month passes. Three months. A half year goes by.
And then you get a call from your co-founder: “Hey, can we chat?”
The startup life isn’t for him. He misses his corporate job – the one that he couldn’t wait to be done with. At least it provided stability and peace of mind, he reasons. His words fly over your head; you know where this is going.
“I want to call it quits.”
“Well, hey, you gotta do what you gotta do,” you force yourself to say out of decorum. “Just hand back your stock, and we’ll do a clean break.”
“Hand back my stock? Why? I started this company”, he retorts.
“Yeah, but you’re quitting. Why should you keep 40%?”, you try hard to keep your cool.
“What do you mean? I came up with the name!”
“You’re kidding me, right? 40%, for a stupid name?!”
Seems like this conflict isn’t going to resolve itself anytime soon.
The Prevention
We wouldn’t be here if the founders’ stock was subject to a vesting schedule. A vesting schedule is a timeline according to which the stock becomes the founder’s (or any equity recipient’s) full property. If the founder leaves the company “early” – that is, before the vesting schedule timeline has fully run its course – then part of the founder’s stock will go back to the company.
The concept here is that the founder earns their stock over a period of time – and not all on day one. A four-year vesting schedule, with a one-year cliff, is customary. This means that the founder’s stock will become the founder’s full property in four years. If they leave in two years (half the time), they must return half of their stock to the company. However, if they leave before one year – they get nothing (hence, the “cliff”).
In our story above, if the founders’ stock was subject to a four-year vesting schedule with a one-year cliff, then the quitting founder would have had to return all of his stock, because he was leaving before one year was up.
The Cure
Since the founders don’t have a vesting schedule, the resolution will involve some sort of settlement. The two founders would have to negotiate a fair break, which would likely result in the quitting founder getting paid a sum of money to relinquish some or all of his shares.
If the founders don’t come to agreement, then the quitting founders stock will be “dead equity”, making the company largely unattractive for investors – which, ultimately, may mean game over for this company.
To learn more about this problem, check out the blog post Dead equity makes your company uninvestable.
2. Not filing your 83(b) election
The Story
You’ve been building like crazy, heads-down, for a couple years now. You’ve got an all-star team. Your traction is growing at a healthy pace. You’re hitting all the right KPIs.
It’s time to raise your first institutional round – your Series Seed.
You talk with dozens of VCs, get a whole bunch of rejections, and then finally, finally, land a term sheet from a handful of funds – including your favorite VC, which is giving you the valuation you were looking for: $20,000,000.
Time to level-up!
You hire a startup lawyer to help you with the round. They negotiate the term sheet, you sign it, and then they ask you to share your legal documents so they can prepare you for due diligence.
The next day you get a call.
“Hey, I couldn’t find your 83(b) election. Could you send it over when you get a chance?”
“My what?”
“Your, umm… 83(b) election?”
“Never heard of it.”
“You sure? Look through your documents again, please.”
There’s a long silence while you browse your files once again. You can hear your attorney’s breath shaking with anxiety.
“Nope, I sent you everything I have,” you finally add. “Should I be worried?”
You can feel that you should be worried. Probably very worried.
The Prevention
The 83(b) election is a tax filing that kicks in whenever you get stock that is subject to vesting (yep, that vesting – the one we covered in the previous point). Whenever you get the stock, you have 30 calendar days to make this filing to the IRS – hard rule, no exceptions. And had you made this filing, this problem wouldn’t have arisen.
But… what’s the problem? Sit back for a moment and read the following Income Tax 101 crash course.
As a founder, you’re getting stock for your work – you’re putting in effort and getting paid stock. So, just like your salary would be taxed, so too would the value of your stock be taxed.
The question is – the value of your stock as of when?
The default rule is that the value of your stock is determined as it vests. So, if your stock is subject to vesting over four years, about one-fourth of that stock will vest in any given year, and you’ll have to pay tax on that one-fourth at the value at which it vests.
Now, in a high-growth startup, the value of your stock will ideally go up. And when you get a term sheet, that value will instantly skyrocket the moment you get that term sheet.
See where this is going?
If you own, say, 40% of a company that is valued at $20,000,000 (your term sheet’s valuation), then your stock is worth $8,000,000. A quarter of that – or $2,000,000 – will vest that year. At a 40% income tax rate, your tax liability on the vesting stock that year would be $800,000.
That’s a big number. A very big number.
This is where the 83(b) election is so critical. Had you filed the 83(b) election, your tax liability would have been determined not as the stock vests, but as of the date it’s granted. Since stock is worth less than a penny when it’s granted in an early stage start-up, if you had filed your 83(b) election, your entire tax liability may have been an entire $10 or so.
The Cure
Sadly, once you get a term sheet, your options are severely limited to, essentially, three:
- Find $800k to pay your tax bill
- Convince your investors that some of their investment be used for your personal tax bill (spoiler: they’re not going to agree)
- Kill the deal
If you don’t have a term sheet yet, you may have more latitude. Get in touch with a qualified startup attorney asap.
If you’d like to learn more about 83(b) elections – and, better yet, file it online – check out file83b.com. Startup Stack members get a special deal here.
3. Not assigning IP to the company
The Story
Another founder break-up story here. You and your co-founder have a falling out. Divergence of vision, of priorities, of what color to use as your brand. And so, they leave.
“Good riddance,” you think. You can build this company without them. And you go on to pick up the broken pieces of your company, put them back together, and get things rolling again.
Fast forward five years, and you’ve bootstrapped your company to $10M in annual revenue. You and your early team are getting paid handsome dividends. Things are looking up and up.
Then one day, you get served with a demand letter. It’s on behalf of your ex-founder. They are claiming 10% of the business.
“What?! That’s ridiculous!”, you tell your lawyer during the meeting. “Their stock was subject to vesting, and they weren't past the cliff. They forfeited everything they had fair and square. What’s this all about?!”
(look at you flaunting your legal awareness 👏👏👏)
“Right… but they never signed an IP assignment”, your lawyer responds matter-of-factly. He has his CYA – he wasn’t your lawyer when you started the company.
“A what?!”
“An Intellectual Property assignment, basically agreeing that the company owns all of the rights toward their work. They’re now claiming that they still own the code they wrote for the company and the company has been using it illegally all this time. They’re offering to call it a day by giving them 10% of the business.”
And you thought this conflict was well behind you…
The Prevention
You can’t see it, you can’t touch it, but your IP – or intellectual property – is potentially worth billions. In a high-growth tech startup, it’s one of your most prized assets, and you want to make sure you have all the rights you need to make commercial use of it (in other words, to run your business and make money).
That’s where IP assignments come into play. An IP assignment provides that any work that a service provider – such as an employee, a contractor, or an advisor – does for the company belongs to the company. IP can take many different forms here: it can be the code that your engineers write, the UI/UX that your designers create, the marketing campaigns that you run, the inventions that your researchers invent.
Having an IP assignment with everyone who does any non-insignificant work for your company is, thus, critical. Otherwise, someone who did work for your company and never assigned the rights to that work can later come around and cause trouble. “This is my property”, they will claim, “and you can’t use it.” At best, that’s a legal headache for you. At worst, it’s a showstopper for your business.
In this story, the company was bootstrapping, so they never really found out that they had made this mistake back in the day until the ex-founder came forth with the claim. In a venture-backed startup, however, this mistake would first come to light in due diligence for a financing round. All investors want to make sure that the company they’re investing in owns or possesses the IP it needs to run its business. If you can’t produce the necessary documents providing this, you’re likely not going to get funded.
The Cure
As is normally the case with legal claims, the resolution lies somewhere along the lines of settlement. The company should be willing to give up something of value – cash, stock, etc. – in return for the ex-founder’s consent to drop the claim. The lack of this consent will cause delays in fundraising, which gives the ex-founder leverage in the negotiation. On the flipside, the ex-founder should be equally aware that unless they’re cooperative, the company may soon plummet in value, defeating the purpose of the claim in the first place.
To learn more about this problem, check out the blog post No IP assignment? No investment.
Conclusion
Legal isn’t fun. Sometimes, it can be downright scary. And on top of it all – with all the moving parts in a startup – it’s rarely top of mind for founders.
That said, with basic legal awareness, you can avoid making some of the most unforgiving mistakes in the startup journey – mistakes that would wipe out all the gains you made through the years.
After all, as they say, an ounce of prevention is worth a pound of cure.
Stepan Khzrtian is a former corporate lawyer with 10+ years of experience helping 100s of founders navigate the legal journey across all stages of the startup lifecycle, from incorporation to exit. He quit his private practice to start Corpora (use code STARTUPSTACK10 for 10% off all of Corpora's services) and help founders raise money faster by automating the legal backend. Connect with him on LinkedIn.
