CHECKLIST AND SUMMARY OF STARTUP LEGAL STUFF: SIMPLIFYING THE LAW
As a startup attorney in Houston, Texas and Dallas, Texas, I've run into many entrepreneurs AND investors in the oil & gas and tech startup world that don't look at the whole picture of a business and don't have an overarching understanding of what is going on.
Screw that.
That's not the way we do things.
Always--ALWAYS--have an eye for the big, overarching picture.
To be fair, it's not really even the fault of these individuals. No one really tells them this stuff in a simplified, system-level manner.
So that's what I'm going to do in this article.
I'm going to lay it all out right here.
Here's how it works. A startup is a business. And ANY business has these four phases:
PHASE 1. COMPANY FORMATION: the startup (i.e., company) is formed
PHASE 2. COMPANY GROWTH AND OPERATIONS: the company does business and grows
PHASE 3. COMPANY FINANCING: the company raises money for itself
PHASE 4. COMPANY END GAME: the company has a liquidity event or IPO
A company will go back and forth between Phase 2 and Phase 3. After a certain point, the company is just raising money and growing and raising more money and growing even more.
Understand the simplicity of this process and where you are on it--because this is really what's happening on a fundamental level. Everything else is the details. Of course details matter. But understand the big picture first.
Below is the sequence of how these four phases play out.
Total time for the sequence is 8+ years:
1. PHASE 1: COMPANY FORMATION--SORT OUT YOUR EMPLOYMENT CONFLICTS
Your prior or current employer CAN prevent you from working on your startup. They CAN say that whatever thing you're building for your startup belongs to them. Even prior to formally creating your startup, you need to make sure that working on your startup will not conflict with any previous or current employer.
Key Points and checkpoints:
___ a. Check the contracts between you and your employer
Be certain that there are no restrictions or issues before and while you are employed elsewhere; this includes issues such as non-compete agreements, misappropriation of trade secrets, and no-moonlighting agreements. Yes, you need to sort this out BEFORE working on your startup. Some of this is very state specific. The rules in Texas are different than other states. Other states are different from other states.
Check here for more information.
___ b. Don't breach duties you may have regardless of contracts
Even if there are no contracts in place between you and your employer, make sure you don't breach any particular duties. Check here for more information.
2. PHASE 1: COMPANY FORMATION--ADDRESS PRE-INCORPORATION IP ISSUES
Intellectual property or IP is the stuff that you and your company creates. This includes patents, copyrights, trademarks, trade secrets etc. Who does this IP belong to? You? The startup? Your previous employer? Some third-party? Ownership of IP is a crucial area of concern with businesses. These issues need to be addressed even BEFORE the startup gets officially created.
Key Points and checklist:
___ a. Make sure IP is not owned by a third party
Make sure the intellectual property that you've created or will create will not belong to some other entity such as your prior or current employer. You don't want that employer to own the IP that you will deploy into your own startup. If you want to know how to destroy your startup on day 1, that will do it. So here's what to do--you need to look at the contracts and relationship between you/the founders and each person's previous/current employers. See here for more information.
___ b. Transfer any IP created prior to incorporation to the startup
People often work on their project before formally incorporating. This stuff is considered intellectual property. IP should not be owned by an individual in the company. Execute agreements that specify that any IP created by an individual (even you) working for the company-to-be is transferred over to the company after the company is formed. It's not sufficient that the IP belongs to a founder of the company on an individual basis. If something happens to that individual that holds the IP, the company can be screwed.
___ c. Assign IP created after incorporation to the startup
Any employment agreements or similar between the startup and employees of the startup need to be clear that any IP created belongs and is assigned to the startup.
3. PHASE 1: COMPANY FORMATION--DECIDE INITIAL OWNERSHIP STRUCTURE OF THE STARTUP
You and your co-founder(s) need to decide who will own what in the company and what your respective roles will be. This can be a shitty, but necessary conversation. You will also need to figure out what the structure of the company will initially look like and how it will be managed (a pre-incorporation agreement.)
Key Points and checklist:
___ a. Decide roles of the founders of the startup
Who is going to do what in the company? What will each person take on?
___ b. Split the startup company ownership pie properly
Entrepreneurs frequently want to split the company up evenly with a 50-50 split or a 25-25-25-25 or whatever depending on the number of people on the team.
Stop that.
Figure out what actually makes sense depending on the roles everyone will play. If it's going to be even, that's fine. But make sure that the reasoning makes sense. EVERYTHING that my best clients--investors or entrepreneurs--do has reason behind it.
___ c. Decide on a vesting schedule for founders
Vesting is a way of giving slow ownership of something instead of outright and upfront. A typical vesting schedule allows for founders to receive their entire share of the company after 4 years instead of all outright on day 1. Instead of giving you 1,000 shares of the company on day 1, you get 250 every year for 4 years. It incentivizes you and your co-founders to stick around. This way, if someone leaves the company on Day 2 after forming the company, they don't run off with half of the company.
This is not theory.
I know people who this has happened to.
And it fucking sucks for those left holding the remains of the company.
4. PHASE 1: COMPANY FORMATION--INCORPORATION
This is the part where the startup company actually gets created. This is a legal process where filings are made with the Secretary of State to actually create the entity that will be your startup. The company does not need to be formally established in the same state as where the company will operate. In fact it may be very advantageous to start it in some other non-residential state. There are many different types of company structures you can decide from such as an LLC or C-Corp. These entity types have different types of ways that ownership of the company is represented (such as "stock" or "member interests") and other differences.
Get this stuff right from the get go. I've had to fix these issues for people. Believe me--it's much less painful (and a lot cheaper) to do it right from the beginning than it is to correct it later.
Key Points and checklist:
___ a. Incorporate as early as possible
___ b. Incorporate as a C-Corp in Delaware or your home state
___ c. Authorize 10,000,000 shares of common stock at a low par value of $0.001 or $0.0001 or even $0.00001.
___ d. Issue common stock to founder; Preferred stock is for investors--don't worry about preferred now
___ e. Founders pay for their shares
___ f. Vest shares
___ g. File an 83(b) election
___ h. Have all supplementary documentation (corporate governance) clear, polished, and on point
___ i. Follow this list and make sure you cover all of your bases: Link
5. PHASE 2: COMPANY GROWTH & OPERATIONS--RUN THE COMPANY
This is where shit gets real.
This is the make it or break it phase. This is where you will find out if all of your ideas, product, etc. are actually worth the hype you built up in your head.
You don't need to tell me. I know that you've built up that hype. And actually, if you haven't then you probably shouldn't be doing this. That's okay. Some people should be involved in this industry; some shouldn't--and that's all right.
Any way, if you're going to do this, this is where you work on developing, building, marketing, and selling your product.
A host of legal issues will arise while operating the company. This includes IP issues, contracts, contractual disputes, taxes, leases, etc.
Key Points and checklist:
___ a. Work your ass off for your startup and be on the top of your game. Remember what I said--don't be complacent. Complacency is the absolute worst thing that can happen.
Check here for help on issues you will face in this phase.
6. PHASE 2: COMPANY GROWTH & OPERATIONS--HIRE PEOPLE
You will need to hire people in order to help operate the startup.
Key Points and checklist:
___ a. Follow the law. Don't be naive.
Abide by employment laws and IRS regulations. A lot of this is also state specific, such as for the state of Texas. This is not the area you try to outsmart others or "hack" the system. Click here to understand how to hire people.
___ b. Give incentive to those in the startup
Properly incentivize employees with pay and/or stock options in the startup. Read the articles in Phase 2 to help you on this.
7. PHASE 3: COMPANY FINANCING--FUND THE STARTUP (BOOTSTRAP AND FRIENDS & FAMILY)
During this stage, the company is still young and just getting started. The company may need money just to get rolling.
Initial funding will be self-funding by the founders or funding by friends and family.
I've seen many individuals do this step improperly only to cause more problems later. Just because you may be dealing with friends and family whom you've always dealt with casually doesn't mean to be casual with business related matters. You're operating a business now.
Now is not the time to be amateur. Be polished. Be on top of your game.
Key Points and checklist:
___ a. Make sure any investors are accredited
This is true even friends and family. This relates to securities law. An accredited investor is one that according to the SEC has a certain amount of income or other accreditation that allows for investing in certain types of private companies. Just because some one is a friend or family does not mean they are automatically accredited.
___ b. Use loans to receive small amounts of money from friends and family for your the startup
The terms should be gentle. Startups are risky enterprises. F&F should be aware of this. They may never see their money again.
___ c. Use a convertible note to receive substantial money from friends and family
If friends and family are giving a notable about money of money (e.g., $100,000) use a convertible note. IF YOUR FRIEND OR FAMILY MEMBER IS NOT ACCREDITED--DON'T ALLOW THEM TO INVEST. They can, however, give you a loan if they are not accredited (a loan is not an investment.)
___ d. Don't get excessively diluted during financing rounds
Always watch out how much equity you are dishing out. Minimize dilution. Read this article on dilution for more information.
___ e. Shoot for flexibility with your startup company
At this stage--and unless you've done this before--you still don't know what the hell you're doing. Be careful about how you receive money at this stage. Focus on flexibility. You don't want terms with family and friends to be so stringent that it dissuades future investors to invest in the company. So what do you do? Keep the terms gentle. Don't allow for excessive preemptive rights.
8. PHASE 3: COMPANY FINANCING--GET SEED FUNDING (ANGEL INVESTING)
Grow the company by getting more funding. This is usually done with angel investors and takes the form of seed investments.
Key Points and checklist:
___ a. Get seed funding in the shape of a convertible note or a Series Seed priced round.
___ b. Use this checklist for a convertible note. Link.
___ c. Use this checklist for a series seed priced round. Link.
9. PHASE 3: COMPANY FINANCING--GET VENTURE CAPITAL FUNDING
Venture capitalists invest in early stage companies that have high growth potential. They are looking for returns of at least three to five times their investment.
Key Points and checklist:
___ a. Pay attention to money & control terms of a financing deal
Pay attention and keep your eye on the monetary aspect of the deal as well as control of the company. These are the two most important areas to keep in mind.
10. PHASE 4: COMPANY END GAME--HAVE A LIQUIDITY EVENT OR IPO
The end game is reached typically by another company purchasing the startup (an M&A event) or an initial public offering.
Investors are always looking for an exit strategy. This is what founders and investors want. It's how investors get their return on their investment (they get to sell their shares of the company that have increased in value.)
Key Points and checklist:
___ a. Set up to succeed with or to exit the startup company
The best thing to do is to set up and grow the corporation in such a way as to make the desired end game feasible and structured favorably to all parties. By following all of the above properly, you set yourself up to reach this level of success.