The tech startup community is booming. Each day, there is news of a famous investor buying into a new venture or college kids bringing another idea into reality in their college dorm room. With such potential for upward mobility in the startup scene, it is easy to forget just how volatile the business of starting a business can really be and how important it is to make sure the fundamental legal matters are well covered.
Selim Day, J.D., an attorney with Wilson Sonsini Goodrich & Rosati, (the exclusive legal sponsor of General Assembly,) shared some insights into how best to navigate through the pitfalls and intricacies. Who knows? With a solid idea and these tips in mind, you might just be on your way to becoming the next Zuckerberg.
1. People Matter.
When creating a tech startup, people are key. Lawyers spend a lot of time proposing and negotiating legal documents, but the bottom line is that building strong relationships is the best way to avoid legal trouble down the road. Build a team of people you know and trust, who share your vision and are willing to commit themselves to the enterprise. Consider people with diverse skills that complement each other. Fill your critical needs first, but remember that a technology startup without a technically-inclined individual on board will have a harder time raising financing than one with that individual. Be flexible and surround yourself with people who can adapt. If at some point you realize that the company needs to change its direction, you want to be surrounded by people who will be helpful and constructive in making the necessary adjustments.
2. IP is Critical.
Intellectual property in a technology startup is critical. Startup founders should make sure that all IP they develop is assigned to the company and that anybody else who performs any work for or with the company assigns and transfers ownership of that intellectual property to the company. If, for example, a founder has a friend or an intern help write some source code, one can ask- does that source code belong to the friend/intern or to the company? If this is not clearly defined, then problems can arise. As a young startup it’s easy to be lax about these things, but these types of issues seem to arise at the absolute worst times – on the eve of a sale, financing, or IPO – and can bring an important transaction to a grinding halt. There is a very fine balance that a startup’s founder must strike - though it might seem somewhat conservative or even awkward to hand out paperwork to friends/interns, when intellectual property is concerned, it is always a good idea.
3. Choose the Right Legal Entity for You.
The choice of the legal form of a startup has tax consequences. Which entity is right for you is dependent on long-term goals and strategy. You must understand the business expectations for your company. Do you want to build a business and then sell the business or take it public (what can be referred to as the “exit model”)? Do you want to build a business and live off of the cash flows of the business for the foreseeable future (what can be referred to as the “income model”)? Research the issue to get a full grasp on the differences between entities such as an LLC and a C-Corp. Also, consult with a lawyer. One thing to keep in mind is that venture capitalists in the technology sector will not typically invest in LLCs. In short, do your homework and make sure to pick the model that is right for you. Also, once you decide, make sure you form the entity correctly. This is one area you really need to get right.
4. Model out your Equity.
Prepare a model to forecast how much equity the founders will continue to own after a series of equity financings. Make some assumptions on the amount of each equity raise and the amount of dilution that will occur. You should do this prior to each round of financing so that you have a good understanding of how much of the company you will own at the time of a sale of the company or an IPO. You want to make sure you get a meaningful payout when the company is successful, and adjust your financing strategy if necessary.
5. Value your Investors.
In considering term sheets from investors, consider intangible aspects of your potential investors in addition to the valuation of your company in their term sheets. Investors can add significant value to you as a founder and to the company. This value-add proposition differs for each company and with each investor. Traditional technology venture capitalists have a long, rich experience in providing value-added advice on how to build a successful company. You should give significant credit to a VC with a proven track record. Strategic investors (typically another company operating a business in your vertical) may provide industry expertise which, depending on your business, could be critical. In the case of a strategic investor, you should understand the reason for their investment in your company and ensure that their goals are aligned with yours. In short, don’t just look at valuation in choosing an investor. Look at your investor as your partner and consider the value proposition to you and your company in partnering with that investor.
6. Be Open Minded with your Investors.
Be receptive to your investors. They are your partners. They may have different views than you, but their contributions to building value in your company could be invaluable. An investor can frequently bring a fresh look on an issue or on the direction of your company. Take the time to listen and think about their input. Moreover, it is important to maintain a good working relationship with your investors and to treat them fairly. Goodwill developed with your investors could be very beneficial down the road.
7. Get a Lawyer Early on in the Process.
Speak to a lawyer knowledgeable in technology startups early in the process. The actions you take in the early days are important because they could impact your ability to raise financing or consummate an exit transaction – a sale of the company or an IPO. If you work with a lawyer from the start then you’ll be better informed when making decisions. Even if you are not yet ready to dive into the business planning, consulting with an attorney knowledgeable in technology startups can only help. Make sure you also discuss tax issues with your lawyer. Along with forming the entity correctly, this is an area you want to make sure you fully understand.