Hear from startup lawyers on the top legal mistakes that new startups make – and how to avoid them
This is a DMZ guest blog by Konata Lake and Edward Fan of Torys LLP
As startup lawyers, we work with founders across all stages of growth — from incorporation, to raising the first funding round, to IPO’ing or being acquired. We provide strategic and legal advice to startups as they grow, giving market perspectives and connecting clients with the broader ecosystem, including VCs and other advisors.
Unsurprisingly, there are many legal issues that arise as your company scales. While it is your legal counsel’s job to help you navigate those obstacles, it is important to understand what may lie ahead. It is much cheaper and more time efficient to get things right at the outset rather than fixing expensive mistakes down the road.
Let’s walk through some of the most common legal issues that startups face, and how you can avoid them.
#1 – You don’t have the correct legal structure in place
A common question early-stage founders have is whether incorporating their company is worth the money—especially when they are bootstrapping, or in cases when funding is low. The general answer to this question is: yes, it is important to incorporate your startup as soon as possible.
When you incorporate your company, it will help ensure that all the work done is held in and owned by the corporation (reducing potential diligence issues later during funding rounds), and that the liability and risks of operating the business are with the corporation and not with you personally as founders.
For example, if you are hiring an employee or contractor, you will need to make sure that the IP they create rests with the company and that a formal agreement between the corporation and the employee accomplishes this. To enter into this kind of agreement, you need a corporation.
Another reason you should incorporate your startup early on is to better attract investment. VCs will expect your company to be incorporated on market standard terms, so being properly set up makes you much more appealing to investors.
When deciding the best legal structure, it is important to determine where you want to operate and whether you have any plans for expansion, as this will determine if you should be federally or provincially incorporated.
#2 – Your startup doesn’t own all its intellectual property (IP)
Not clearly showing that your company owns its IP can be a deal breaker for investors. A significant portion of your startup’s value comes from your IP, and so you should make sure you are the proper owner. This means that your company—not you, your co-founder, advisor or employees—should own all the intellectual property that it is developing, and this ownership should be fully documented.
Everyone who works for, advises or consults with your startup should sign an appropriate confidentiality and IP assignment agreement. As a founder, you are not exempt from this requirement: you will need to assign all IP, including any pre-incorporation IP, to the company.
If you started working on your company as a side gig while being employed elsewhere, it is important to ensure that your previous employer doesn’t have any claim over the IP you developed during that time.
Another mistake is not employing the correct IP protection strategy for the kind of tech you are building. For example, if you have a SaaS business, you are likely hyper-focused on protecting your source code, so you may keep parts of the code a trade secret. This differs significantly from what a D2C eCommerce business selling products through Shopify might consider, which would typically focus more on trademark protection of their brand and products.
#3 – You’re not documenting your equity distribution
One of the most common mistakes for founders, especially in the early days, is to promise equity to individuals or companies who are helping the company without properly documenting and tracking it. This can result in a misunderstanding of the company’s ownership should a liquidity event take place.
To avoid this, it is important to track the distribution of equity. Common documents used for this are employment agreements, board resolutions, and option grant agreements. Equity granted to employees, advisors and consultants is often subject to vesting. Vesting means that equity will be granted/released to stakeholders on a pre-determined schedule, rather than in a lump sum. If an employee leaves before their equity is fully vested, they forfeit any unvested equity back to the company.
#4 – You’re not properly mapping out founder shares
Founder shares need to be clearly documented. Don’t assume a 50/50 split or that a verbal agreement is enough. Unfortunately, disagreements among co-founders happen, including issues over ownership which can result in legal action. It is also important that vesting schedules are clearly documented and tracked, and that the recipients of the equity understand what the vesting requirements are. The standard vesting schedule for founder shares is four years with a one-year cliff. This means no shares vest for the first full year, 25% vest immediately following the one-year “cliff” period, and the remainder vest monthly or quarterly in equal installments until all the fourth anniversary of the vesting start date.
Documents that are often used to show issuance of founder shares include a board resolution authorizing issuance of shares, a share purchase agreement or payment for shares.
You should also keep in mind that any options issued to employees should be properly approved by your board of directors and issued under a formal option plan. All options should be broken down and documented in employment agreements and option grant agreements. The standard vesting schedule for employee options is the same as that for founder shares.
#5 – You’re not complying with securities law
Every bit of equity in your startup needs to be issued in accordance with a valid securities law exemption. This means that, depending on the relevant exemption, you may need to prepare and file certain reports with the securities commission or pay related fees.
Most startups rely on the “friends and family”, accredited investor or private issuer exemptions; however, it is important to have a solid understanding of what these exemptions entail.
#6 – You don’t consider how your first financing round can impact future rounds
You need to not only consider the legal and economic implications of your first financing round but also how the structure of that inaugural round can impact your ability to close future financings.
You should be focused on what rights are being granted to investors in these early-stage rounds, as mistakes can haunt a company going forward. For example, if you agree to a liquidation preference that is greater than 1x, or if you grant a preferred share class seniority over other preferred share classes, that is likely to be replicated in future rounds. Counsel with VC experience will help you avoid these pitfalls.
#7 – You’re complicating your cap table with multiple valuation caps
Adding a valuation cap is a common way to structure convertible securities (convertible notes and SAFEs). Under this structure, investors cannot get less ownership than what’s calculated by taking their investment amount and dividing it by the valuation cap. However, having multiple valuation caps complicates your cap table.
That is because of a combination of unfair economic treatment of investors and the nuances of corporate law. Your counsel should advise you on how to avoid this issue, or how to resolve it if it’s already happened.
# 8 – You’re not fully complying with employment laws
One of the most common diligence issues we come across is the misclassification of contractors as employees. The contractor versus employee distinction is based on several factors, including the nature of the working relationship, the level of control the contractor/employee has, and ownership of tools and equipment.
Misclassifying contractors as employees will make you liable to the Canada Revenue Agency for failing to make the proper source deductions. In addition, you may become subject to claims from misclassified employees.