I began the post mortem and quickly realized that one of our glaring mistakes was lack of legal structure. Looking back, my co-founders and I preferred focusing on what was easiest for us — the code. The legal ins and outs were tricky, and we delayed them until it was absolutely necessary (and too late!) Never again; I decided it was time to educate myself. I sought counsel with my friend Idan Bar-Dov. Idan is a lawyer who specializes in startups and if Suits was real, this guy would be Harvey.
In this post, we try to demystify complex legal terms and clarify key issues usually encountered when starting your own company.
Just so we’re clear: This post is intended for informational purposes only and does not constitute legal advice.
Ha! I know what you’re thinking! “I know what a company is dude … get to the goood stuff”.
Though we intuitively understand what a company is, its legal definition is quite different from what we know.
There are different kinds of companies. However, in the context of the startup world, when someone says “I just started my own company”, it usually means that they have incorporated a private for-profit organization. In other words, it’s a privately-operated legal entity intended for financial gain.
Legally speaking, a company is independent. It can enter into agreements, assume obligations, and be held accountable for its actions. Incorporators may share a great deal of interest with their company, but legally they are not the company. The employees, founders, board members, and even the CEO are all a part of the company, but combined do not equate the company itself.
Nevertheless, companies are run by people. Like a ship, steered by the captain and crew, companies are lead by their Board of Directors and operated by the people who control the “Company Organs”. These include shareholders, directors, officers etc., who affect the decision-making processes at their different capacities.
They’re on a boat
Founders are usually the individuals who “give birth” to the company. They fill out the paperwork, pay the incorporation fee and sign the relevant documents.
In this context remember the following rule of thumb:
No Registration = No Incorporation!
Namely, your Company registration must be approved by the state.
The main benefit of incorporating is gaining a distinction between individual and company — a.k.a. a “corporate veil”. As separate legal entities, companies are accountable for their debts and obligations, as opposed to the individuals who operate them. In other words, each individual’s contribution marks the limit of their potential financial risk. Hence the term “limited liability company”.
However, the veil’s protection is not absolute. In certain cases individuals may be held personally accountable for their actions. For example, when using a company for fraud, illegal actions, or to circumvent existing obligations. A recent example of this is Benchmark Capital suing former Uber CEO Travis Kalanick.
Crash course definition: equity = holdings, owning a chunk of the company.
Two co-founders splitting equity
When founders say equity they usually refer to shares. This is the company’s “currency”, which entitles its holders to certain privileges, such as financials, control, and information rights.
There is no gold standard in dividing equity between co-founders, it’s subject to your discretion. I believe that founders should be equal partners. Idan thinks that equity should reflect skill and contribution (Y Combinator has researched this extensively, you can read more here).
Once equity has been issued, a founder’s reason of departure won’t matter much. They are already an equity owner — it’s theirs, no turning back.
Such a departure may generate “dead equity”. Shares which are held by a founder who is no longer involved with the company. This creates an involvement-equity mismatch, which has negative impact, especially on the company’s fundraising front.
The solution is defining the founders’ relationship upfront, by entering into a Founders Agreement. A departure case must be addressed before it occurs, preferably even before incorporating. Think of a founders agreement like a prenup, which obviously should be signed before getting married.
Equity-wise, it is customary to include a “vesting schedule”, which determines the founders equity eligibility. The purpose of a vesting arrangement is to incentivize founders to remain engaged with the company and diminish any involvement-equity mismatch.
A standard time-based vesting schedule will specify that if a founder leaves before date X, then he will give-up Y equity. For example, in a linear 3 years vesting schedule, if a founder leaves after 1 year, then he gets to keep ⅓ of his shares, and has transfer the other ⅔ to the remaining founders. It’s a quid pro quo arrangement: work = equity.
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