The sea of legal online resources can serve to either navigate or drown a newbie entrepreneur. That why it’s invaluable to identify early on what you need in order to properly secure your precious cargo — from patenting your intellectual property correctly to documenting employee on-boards and exits.
It may seem excessively formal to hand someone a lengthy contract when you’re operating a business with just one or two people, especially if you’re working with friends or family, but it’s a worthwhile precaution to ensure your company is protected down the line.
“If everything always went as planned, you wouldn’t need contracts, but things almost never go as planned,” says Danielle Naftulin, a partner who focuses on startups at Cooley LLP, one of Silicon Valley’s leading law firms. As a firm, Cooley made headlines as an advisor to Snap Inc. (Snapchat’s parent company) when the social-media-app-turned-camera-company made its debut on the stock market after its IPO in February.
Naftulin says that following the rules at the outset will protect you from getting into trouble during a due diligence process and financial statement preparation, among other benefits, and signal an appropriate level of preparedness to investors if you plan to take on outside funding.
Know Where to Turn
While there are countless online resources to help nascent founders understand startup law, the piecemeal blogs and guides can create a false confidence. Those who plan to build a scalable startup — with multiple board members, investors, and dreams of an IPO or acquisition — need to safeguard their company from day one.
Small-business owners may misclassify themselves or underestimate the brand or product value of their business, and so a few hours reviewing the resources on sites such as Cooley Go can help an entrepreneur understand what kind of legal protection a business needs.
If you decide you need to work with a lawyer (which Naftulin strongly recommends), be wary of who you select as your counsel, because not everyone specializes in startup formation; nor is every lawyer aware of just how much they don’t understand about the field.
“I passed the bar, but that doesn’t mean I can handle divorce cases or real estate transactions. That’s why we have teams of attorneys who specialize in nearly every aspect of a startup’s needs,” Naftulin says.
The Startup, With Slow-Downs
I personally learned that not all lawyers are equally qualified in 2015, when I set out to create a social media app that aimed to connect users based on their aspirations rather than their existing social networks. My founder and I built an app for Apple’s operating system, raised a small seed round, and spent months on our pitch deck.
We quickly learned from our developer that we needed to incorporate our company before we could be reviewed for launch in the app store. That sent us on a weeklong goose chase, as we sought advice from well-meaning friends who gave us a variety of recommendations and referrals. Finding a lawyer to help incorporate us seemed like a straightforward task, but I was surprised to find that even friends who’d been chief technology officers at startups accepted by Y Combinator — arguably the best startup incubator in the tech ecosystem — didn’t understand startup formation.
I then turned to friends with MBAs who suggested I needed an LLC and introduced me to a lawyer who wanted to charge us just under $10,000 for the service. But after some research, I realized that LLCs might not be the right option for us.
I read that Snap’s founder Evan Spiegel had come from a family of lawyers and was extremely careful in following best practices during the formation of his company. Thirty minutes of Googling later, I found that Spiegel had worked with Cooley, so I contacted the law firm by email. Naftulin got back to me within a day, and we spoke for an hour about the kind of company I’d hope build. She suggested we form neither an LLC nor an S corp but a C corp, which would enable us to take on funding more seamlessly. I realized that Naftulin was the sort of person I needed on our team, and my founder and I felt secure in dealing with investors and new employees from that point onward.
Carefully choosing the right way to incorporate is one of those basic issues Cooley’s counsel helps their clients with. “Beyond that, there are too many permutations of how things can go wrong. Most founders want to do things cheaply, but they underestimate the longer term price of cutting corners,” says Naftulin.
Spending a bit of money on legal advice and following through signals trustworthiness — not only to investors who can see right through what Naftulin jokingly refers to as “goofiness” but also to experienced employees and potential board advisors.
“It also says something when you’re represented by a firm like Cooley,” she says.
Traps in the Road
Whether or not you opt to work with an attorney, Naftulin outlines a number of the most common errors that startups should watch out for:
1) Waiting a long time to form your entity.
This can be an issue regardless of the type of entity you ultimately select. According to Naftulin, the longer you wait to get your entity formed, the messier it can become (and the more costly to untangle the mess; plus there can be tax implications for founders). One issue that arises is a lack of clarity around who is supposed to own what percentage of the company — if someone leaves before you document, you can be in a bit of a pickle.
“You never want people coming out of the woodwork later on claiming they’re entitled to a chunk of your company. If things are muddy it’s harder to protect the company,” says Naftulin. To avoid this, you’ll want to document how much equity employees have, when they begin vesting, and when they’ve resigned or have been let go. Setting your company through an attorney sets you up with the legal documents to reward those who are truly part of the company and draw clear boundaries that are harder to argue with later.
Additionally, getting advice early about the type of entity can save a lot of headaches down the road. For example, many venture funds will not be able to invest in an LLC — if you know you want to take venture money, it may be more efficient to start with a C corp than to start with an LLC and later convert.
2) Not paying employees.
Contrary to popular belief, it isn’t legal to not pay employees. This applies even if the employee is willing to work for free or if you decide to call them a contractor, volunteer, or intern. Sweat equity — or “sweaquity” — doesn’t cut it in the government’s eyes. (And calling someone a contractor doesn’t make them one.)
There appears to have been a recent uptick in states doing audits of this issue, and companies can face penalties if they’re discovered flouting this law. It can also come back to bite you in the pocket if you fire an employee who then chooses to sue you for back wages. “You usually start out as friends — or at least as people who trust each other,” Naftulin says, “but if things go south in a relationship, people can look for alternative ways to be compensated, and this can be one of those ways.”
3) Failing to patent or properly assign intellectual property to the company.
“Fast forward two years after you’ve been working on a startup and you’ll find there are dozens of ownership issues with the IP if the team hasn’t been working with a law firm and carefully minding its p’s and q’s,” says Naftulin. Commonly, if not working with a law firm, founders may not assign their rights in the foundational technology to the company and/or do not sign an invention assignment agreement. Failing to properly assign the rights to the company may result in the company having no legal claim to the foundational technology, which is a big issue.
If an individual leaves and wants to make a claim that the company is without rights, the company may have a steep uphill battle. Keep in mind that intellectual and other property rights are much broader than “patent” rights — the business plan, website/url, and social media handles should all be appropriately assigned. Investors typically want ownership of rights tidy, so securing these rights as you go rather than after the fact generally is the most effective, and the least costly, way to proceed.
4) Equating websites with trademarks or corporate names.
Just because a URL is available and you’ve registered your website under a certain name doesn’t mean you own the trademark to that name, or that the name is even legally available. If you grow into a profitable or high-profile company and don’t spend the time and money to have trademark analysis of your company or product name, you may be facing higher costs to acquire your own name from another party, settle a dispute, or to rebrand with a cleaner, more protectable name.
Just like the captain navigating a vessel in uncharted waters, every founder needs help from an experienced first mate to look out for icebergs and storms on the horizon. The good news is that experienced attorneys have thought out and created preventative measures against the potentially disastrous scenarios after the industry witnessed a number of high profile cases like the Facebook vs. Winklevoss lawsuit — a landmark case in which Mark Zuckerberg was sued by two of his Harvard alumni who believed they had a hand in creating the company early on and wanted a fistful of the profits after its maturation.
While not everyone will create the next Facebook or Snap, you should be honest with yourself if that’s your ambition and prepare yourself accordingly.
And How Did My Story End?
We did finally get our product approved in Apple’s app store and even had a significant number of downloads before burning through runway needed to pay our developer. Ultimately, two larger competitors made headway, and my cofounder who owned the majority share decided to pivot. So it goes.
I’m now pursuing a new product in the hardware space — and happily. The experience with Cooley gave me a Silicon Valley education that’s fortified my understanding of startups and empowered me with the knowledge I needed to help ensure my current company can protect its IP and our founding team.
“Big picture: there are lots of DIY tools for people who think they don’t want active advice from an attorney who want to go forward on their own,” says Naftulin. “For our part, we work with complex company structures, and that’s not clerical work. It’s something that takes a lot of thought.”