#02 ~ Clean up on aisle 4? Not if you're smart!
Why start-ups should consult lawyers early and often.
When we think of lawyers, we think of messes. We think of the courtroom drama television shows where a noble public defender is trying to keep the prosecutor from putting some unfortunate soul behind bars. Or the media headlines of John Bob celebrity going to court to fight for custody of his kids. So, when we think of lawyers, we don’t just think of messes, we think of lawyers cleaning up those messes.
And this is a big problem, especially for start-ups.
Contrary to popular belief, where lawyers really add value is not in cleaning up messes, it is in making sure that no mess is ever made. For start-ups, that means laying a firm legal foundation.
Laying a sturdy foundation
Have you ever built a house? If so, you likely know that the first step is pouring the foundation. However, this isn’t a simple process; a cement truck doesn’t just show up one day and pour it. There are lots of steps that go into laying a foundation! Things like picking the site, checking the soil, choosing the type of foundation, surveying the land, digging the trenches, and lots more!
But, what happens if you skip some of those steps? What if instead of testing the soil, you just give it your best guess? And instead of considering which type of foundation suits your house, you just pick the simplest one? What if instead of surveying the land you just give it your best guess? The short answer is: bad things will happen. You might end up with a basement you didn’t want, a foundation that isn’t sturdy, or even a house built on someone else’s land.
None of these outcomes are ideal, so smart builders minimize the risk of negative outcomes like these by being thoughtful and thorough in their preparation of each house’s foundation. They understand that only headaches can come from a poorly-planned foundation.
Unfortunately, many start-ups approach the legal foundation of their start-ups like 10-year-old boys building a fort in the backyard. They simply start building walls and a roof, throw some carpet down and call it good. Then, a few weeks later, a rainstorm hits, and suddenly, as they watch the small creek flowing through the middle of their house, they realize that maybe they should have considered building some sort of barrier between the dirt and the floor. They begin to think that maybe it would be nice if the walls were connected to the ground in some way. And hey, maybe it would be nice if the fort was level!
Start-ups often get caught up in the excitement of building the house and sloppily throw some concrete down in an attempt to quickly prepare a foundation so that they can move on to bigger and better things. And when start-ups do this, it’s only a matter of time before the problems start trickling up through the foundation’s cracks. It’s at this point that they’re forced to approach lawyers as mess cleaners instead of mess preventers.
How can start-ups avoid this? The answer is simple: Consult a lawyer early and often.
Specifically, lawyers can be helpful to start-ups in 3 key areas: company formation, intellectual property protection, and contract drafting.
Company Formation.
A lawyer’s job is to travel to the future and identify potential problems that the start-up may face. They explore the different timelines and the potential paths which the start-up may travel down. Then, they return back to present day and help their client plan for and prevent potential future messes.
A common pitfall for start-ups is improper company formation, and it’s easy to see why. Start-ups often begin on a whim. A start-up can go from an idea being chatted about over dinner and drinks, to a full-on Delaware C Corp in a matter of hours. When founders get excited, they do as the all-powerful Mark Zuckerberg says and “move fast and break things.” Unfortunately, what often gets broken in this process is not their competitors’ will to survive, but the company’s chance at smoothly avoiding future problems.
Poorly drafted shareholder agreements, choosing the wrong business entity and state of incorporation, or improperly allocating founders’ equity can severely handcuff start-ups. Start-ups may be left with deadweight on the cap table, may be forced to convert their company to a corporation in a different state, or may have to amend shareholder agreements. Sometimes these problems are fixable. Sometimes they’re not. But these problems are ALWAYS a hassle for start-ups and ALWAYS add resistance to the start-up’s achievement of their ultimate goals.
For example, consider a start-up formed by 3 friends–one was salesy, one was techy, and one was friendly. The salesy one helped build the sales funnel and drive clients to the product. The techy one built the product and ensured that the customers’ problems were being solved. The friendly one was… friendly. He got the coffees and kept company morale high, but after a while grew disinterested in the start-up and moved on to other work. No problem, right? Wrong. You see, salesy, techy, and friendly forgot to establish a vesting schedule–instead of earning their shares in the company over the standard four year time period, friendly got all of his equity up front. Then he walked away with 33% of the company. Now, the start-up has 33% of the company tied up in a shareholder who is no longer contributing. This is called dead equity, and most investors aren’t willing to invest in a company with that much dead equity. A mistake like this can be crippling. If this start-up would have consulted a lawyer before they incorporated the company, the lawyer would have helped them avoid this mistake. Remember: consult a lawyer early and often.
Intellectual property
Typically, start-ups are built on a key idea or invention, created by one of the founders, that solves a problem that their customers have. This is likely intellectual property of some sort. Unfortunately, start-ups often don’t have a firm grasp on what their intellectual property is and how to protect it. This is another important area where lawyers help start-ups.
Many problems can arise for start-ups in relation to intellectual property, the first of which is a start-up being founded on someone else’s intellectual property.
Often, tech employees sign employment contracts that include what is typically called an “intellectual property assignment clause.” These clauses generally assign any intellectual property created by the employee, sometimes even if created outside of work, to the employer. As such, it’s possible that a start-up founder comes up with an idea while employed by Company X, leaves to start a company, and is subsequently sued by Company X for intellectual property theft. This is clearly a less than ideal situation for start-ups. Consulting a lawyer early on can help prevent start-up founders from finding themselves without a salary, running a start-up without any unique intellectual property to build upon.
Another problem can arise when start-ups seek to raise funding from venture investors. Assuming that there are no issues with the intellectual property ownership as previously mentioned, there can also be an issue when the owner of the intellectual property doesn’t assign it to the start-up early on.
Imagine this: you find yourself 6 months into building your start-up and you are attempting to raise a seed round. Investor X says, “I’m interested in investing $X million into your company.” You jump for joy, but are quickly interrupted by investor X saying “But first, let me have my lawyer do some due diligence.” A key piece of this due diligence is ensuring that the start-up’s “intellectual property ducks” are in a row. If a founder owns the IP that the start-up is based on, no prudent investor will close the deal. It’s asking for a lawsuit. And the major problem is that the founder has all the leverage. They can hold the IP hostage and force the start-up to buy it from them. A lawyer can help make sure that this never happens.
Finally, the lawyer can help the start-ups protect their intellectual property from competitors. There are four types of intellectual property: patents, trademarks, copyrights, and trade secrets. Each of these has different requirements for securing and protecting, along with different durations. If not careful, start-ups can easily lose their intellectual property protection. For example, trade secrets are an interesting type of intellectual property; you can’t register them and as soon as they lose their secrecy, you lose them. Start-ups need to be careful when pitching investors that they don’t divulge trade secrets. Lawyers can help start-ups prepare for pitches and ensure that their trade secrets are kept safe.
Contracts
Lawyers can add clarity to deals by drafting clear contracts.
Business, at its core, is some combination of interaction between different parties (B2B, B2C, C2C, C2B). Anytime you have an interaction like this, you have an opportunity for a mess to be made. Consider the following example, from outside the world of start-ups:
Recently, my friend Mike told me how a guy named Paul, who he had hired to plow his field, had taken advantage of him. Mike and Paul had agreed on a price and then Paul plowed the field. Lo and behold, as Paul plowed the field, he damaged his plow. Since Paul damaged it while plowing Mike’s field, he charged Mike for the damage, which was upwards of $30,000. At that point, Mike had a choice to make: hire an attorney to help him resolve the dispute or pay the $30,000 and move on. Ultimately, he decided to pay and move on, which was probably the right choice, because oftentimes, the only person that makes any money in a dispute like that is the lawyer.
But, what would have happened if Mike had called an attorney before he finalized the deal with Paul the plower? The attorney could have drafted a simple contract, outlining that Mike wouldn’t be responsible for any broken equipment. Then, Mike would have had clear evidence of the agreement and Paul would have very little leverage to ask Mike to pay for the broken equipment.
Lawyers can also help ensure that parties to contracts understand what they’re agreeing to.
Consider the story of another friend, Norman, who works in the tech industry. He was recently hired at an early-stage start-up for a role that included a significant equity package. Norman was a bit smarter than Mike, because Norman understood one important thing: messes are easier to prevent than to clean up. When Norman received his employment contract from his new employer, instead of signing it, he sent it to a lawyer who reviewed the contract with him. The lawyer simply read the contract with Norman and explained the clauses to him as he went along. When they reached the provision outlining the equity compensation, he explained it and asked Norman if the numbers were correct. Norman said he didn’t know, so he called his soon-to-be employer and said “Hey, can you explain this number to me?” The employer reviewed the provision and responded that it looked like they had improperly calculated his equity compensation and would need to send over a new contract with the correct numbers.
What if Norman had signed the original contract? Maybe nothing. Would it have gotten fixed eventually? Maybe. But, it would have been a mess in need of cleaning up and it would have been a hassle. Here, 30 minutes of a lawyer’s time prevented a mess later on that could have potentially cost Norman a significant amount of money.
Hiring the right lawyer
At this point, I hope I’ve convinced you to approach lawyers as mess preventers instead of mess cleaners. Just as important as hiring a lawyer though, is hiring the right lawyer. Unfortunately, there are far too many dishonest and incompetent lawyers in the legal field, so start-ups should be wary of hiring just anyone with a law degree.
Here are two good methods start-ups can use to hire a lawyer:
First, hire a flat-fee business attorney.
Most attorneys charge their clients an hourly rate. Personally, I find this practice incredibly unethical. The incentives are completely misaligned. The lawyer is incentivized to work slowly so that they can bill more, while the client is incentivized to avoid lawyers and keep information from them because they want to pay as little as possible.
Fortunately, there is a better way. There are many lawyers that will charge a flat fee, i.e. I will do X and it will cost $Y. This allows start-ups to know upfront what their cost will be and allows the lawyer to prioritize efficiency, instead of billable hours. A lawyer that can tell you a price upfront, is often a lawyer that you can trust not to drag their feet and overbill you.
Another more interesting method for hiring a lawyer is to hire a part-time general counsel.
Find yourself an attorney that is willing to offer you 5 hours of their time per week in exchange for salary–proportional to their time commitment of course–and equity. This aligns the lawyer’s interests very closely with the start-up’s because as an employee and shareholder of the start-up, they are highly incentivized to help the start-up succeed. This means they’ll likely be more conscious of not wasting the start-up’s time and money, and will have significantly more skin in the game. Learn more about hiring a part-time GC here.
Takeaway
Succeeding as a start-up is already incredibly difficult. Don’t set up your start-up for failure in an attempt to save money in the short term. Find a lawyer you trust and let them help you lay a sturdy legal foundation for your start-up.
When your company IPO’s, you’ll be glad you did.
*DISCLAIMER: I’m not a lawyer and this is not legal advice. Full disclaimer here.*