I’ve seen my fair share of entrepreneurial mistakes over the years. And not all of them had to do with building the right product or assembling the right team. Just a few days ago, I was reading a story about an entrepreneur that decided to jump on a project with a friend.
They co-founded a startup with equal equity and then onboarded a third person, who would angel invest in the project. He worked every day for nine months, doing all kinds of jobs — planning and designing the app, recruiting, preparing sales pitches for clients, etc.
The startup was growing rapidly, and they were gaining some traction.
One day, he noticed that the angel investor had registered the company in his own name. Then it occurred to him, he did not have his name on anything except matters related to sales and admin.
When he told his friend, he replied everything was fine. Eventually, everything would be on paper. Unsatisfied with the reply, our entrepreneur insisted he wanted clarity on his role in the company. And he asked to have everything in writing.
Eventually, the investor agreed to sit down and talk with him. However, he refused to settle for equal distribution of shares. The conversation ended on a sour note.
The following day, his friend called telling him he was out. For his nine months of work, they offered to pay three months as an intern and the rest as a decent salary. When he asked his friend to keep his word, he simply shrugged, saying he was not liable in the absence of a written agreement.
The lesson here is clear:
“Get a startup lawyer to help you put everything in writing – even if your co-founders are your friends.”
This is just one example of what could go wrong without decent legal advice.
As a startup founder, before you know it you’ll need to: Incorporate your startup; create contracts; Issue equity; protect your intellectual property (IP); draw up investment agreements.
To help you avoid some of these costly mistakes, our team reached out to Ryan Shaening Pokrasso, the Founder of SPZ Legal, a boutique law firm specialized in legal counselling for startups.
In our conversation, he shared the importance of onboarding the right startup lawyer for your business, as well as tips on how to go about filling this crucial startup role.
Expert Interview with Startup Lawyer, Ryan Pokrasso
Q: Ryan, let’s start with the basics.
Let’s assume I’m an entrepreneur with experience in my industry. I’ve seen this problem or inefficiency that I can solve and I want to jump out of the corporate world and build a startup. When should I start seeking legal advice?
A: Different people have different tolerance for risk, so it’s up to every entrepreneur and how they approach it.
The best practice, though, is once you start having understandings with other people – like co-founders, for example. That’s a good time to start documenting your understandings – and the best person to do that is a lawyer who specializes in startups.
One of the biggest pitfalls and issues that I see with entrepreneurs and startups is when they assume they’re on the same page with other people.
They often assume they have an understanding and agreement about how something’s going to work and it is often the case that they didn’t have the same understanding.
I think this issue happens a lot when people start businesses with friends – but not exclusively.
I started my law firm with friends so I know what it’s like to work with friends.
You hear a lot that friends and business shouldn’t be mixed. However, my experience is that friends can make awesome business partners.
“You just have to be absolutely intentional when it comes to communication and ensuring you’re absolutely on the same page instead of just assuming.”
The best way to do that is to use contracts.
Contracts literally put you on the same page. There’s a written agreement on what:
- The expectations are for each other.
- Each person is going to do.
- Compensation they will receive for doing that.
So, once you start having those understandings, it’s the right time to get a lawyer to start documenting it properly.
Then when you’re ready to start having people develop intellectual property (IP) for you you should start seeking legal help. You’ll need to incorporate because you need a business there to hold that IP.
Another time to bring in a startup lawyer would be when you’re ready to start working in any sort of public way. Again, you want to incorporate before you start working with the public.
There’s a lot of good online services for incorporating a business. That being said, if you use one of these automated services and you don’t fully understand the documentation sent by the service you should have a startup lawyer explain it to you as well.
Related: 7 Traits to Consider if You Want to Find the Perfect Co-founder
Q: We work with a lot of entrepreneurs and we usually advise them to start speaking with potential hires, investors, lawyers, any stakeholder you can think of as soon as possible.
Even the decision of which country you start in can determine the success of the business. But for sure there are some services and automated platforms for this. I believe, however, if I had a doubt I’d seek someone out from the get-go.
So moving on from that, what are some of the biggest risks for entrepreneurs who don’t seek out a startup lawyer from the get-go?
A: Let me start with an example.
I had a client come to us about three years into starting their business. They worked with an automated service to incorporate their business. They’d grown to a few million $ in revenue so they were a real business at that point.
Then they came to us and said:
“Hey, now we’ve gained some traction and we’re doing well so we’d like you to review the documents that we used to start the business.”
So we did. It turned out that they didn’t properly execute some of their legal documents. Essentially, they never had anybody who worked on the company assign IP rights to the company.
More than that:
“They’d never issued stock in the company to themselves or anyone else, so they didn’t even own their company.”
Fortunately, on the IP front, the company had good relationships with the people that had done work for them and they were able to get agreements to assign the IP.
That being said, they still had to pay some money to do that – because they didn’t have any leverage. The people who had done the work owned all the IP so could pretty much name their price.
As for issuing stock, there are huge tax implications of issuing stock to yourself when the company is already worth a lot. You have to issue stock at fair market value or recognize tax on it.
When a company is brand new, you can justify issuing stock for next to nothing, but when the company has millions in revenue you can’t do that anymore.
Essentially, it became very expensive for them to buy back their IP and issue that stock. Luckily they could afford it and had the right relationships to do it successfully.
That’s just one example of seeking out a startup lawyer too late and being reckless with it.
“Issuing equity and assigning IP are two of the core legal factors to consider when it comes to building your startup.”
In addition to that, you need to properly document the relationships you and others have with your business.
Let’s take another example, I’ve seen people engage a software developer for their business and the extent of the agreement is an email chain.
This makes it very vague in terms of what your rights are. You’re in a place where you’ve got all these questions like:
- Who owns/is entitled to what
- How will disputes be resolved
- What’s the timeline for getting things done
The list goes on.
I had another client who came to us after operating for a while (without a startup lawyer, or any kind of legal party) and they told me:
“We’ve spent $80k on software development and now this person is developing their own business with our idea.”
So I asked them to show me the agreement they have in place to resolve the issue. The response was:
“What agreement?”
At which point, from a legal standpoint, issues become difficult to resolve.
All of this to say, it’s vital that you’re using contracts and setting up your company in good standing. And don’t forget the basic things too. I’ve had clients so focused, down in the weeds of building their product, that they’ve forgotten to pay taxes.
This leads me to an important point:
“If you’re going to start a company you need to make sure you’re ready to actually run the company, not just build a product. And if you’re not doing that you should bring in someone who will do that for you.”
The most effective teams have that. You have the person down in the trenches working on the product. Then you have the other person who’s great on the business side. And yeah, you get people that can do both but it’s a lot to carry alone. Having people with different skillsets is important.
Essentially, if you or your co-founders don’t have the expertise then hire someone to do it. Hire software developers if you’re not a developer. Bring in lawyers if you’re not a lawyer.
Related: How to Build a Startup? CTO, Freelancers, Agency?
By definition, entrepreneurs are people who like to do things themselves. First and foremost, they don’t want to work for someone else – they want to build their own thing.
But learning how to delegate is vital. Take legal aspects. There are some things about the legal process that are mundane and not overly difficult that we can do in about an hour.
And yes as an entrepreneur you probably could figure it out on your own. But it will take you weeks and you may do it incorrectly – whereas I can do it in an hour and do it right.
All of this to say, as an entrepreneur your time is better-used building your business and bringing the vision to life.
Q: Let’s say, as a founder, despite the advice you’ve given, I decided to go about building my startup without a lawyer. What crucial moments are there where I absolutely MUST have legal counselling?
A: One of the most critical moments is when you’re bringing on investors or otherwise issuing equity to anyone beyond the founding team. You’re making promises to other people and it’s important that you do that in a way that’s respectful to them.
When it comes to investors, it is possible to bring them on board without counsel but it’s foolish and could expose you to, in a worst-case scenario, criminal liability.
In the US for example, when you’re issuing securities to people if you don’t make proper disclosures to them about the risks of your business you can be liable for securities fraud. Not to mention that disclosing the risk is simply the right thing to do.
The more sophisticated investor will have the ability to look out for their own interest. However, if you’re bringing on money from friends and family you should be using a startup lawyer as well to ensure that you’re following the right processes.
Again, a worst-case scenario is you can break relationships with friends and family if you don’t follow the correct process.
This is the case not just anytime investment is involved, but also when you’re issuing equity to workers. Again, they’re investing their time and effort out of a promise that you’re going to compensate them partially through equity. If the equity isn’t issued properly it can cause huge problems for them, including significant tax issues.
“Issuing equity in compliance with the law is not just about being a good entrepreneur following best practices, it’s about being a respectful person.”
Q: Before I reached out to you, I talked to some entrepreneurs to discuss their concerns when it comes to startup legal issues. So my next few questions will be around that, starting with:
When signing paperwork to form a startup, which legal points should be tackled to ensure that the entrepreneur is protected?
A: When founding a company you should make sure that all your co-founders have vesting in their equity. This way it’s impossible for a co-founder with 40% of the company to leave, taking their chunk of the company with them.
So vesting is critical. Next is assigning IP to the company and ensuring that all the work product that’s developed is owned by the company, not the individuals.
The other critical aspect is making sure that your equity is properly granted. There are other things you need to look at like ensuring the paperwork is compliant with the law where you’re operating.
Q: And when it comes to raising money, what should I as an entrepreneur be careful with?
A: That depends a lot on the stage of investment.
If this is your first round with friends and family it’s normally done through a SAFE (simple agreement for future equity) or convertible note. In this case, making sure you don’t set a valuation cap or discount that’s too generous.
It’s good to be generous because people who invest early should get rewarded for doing so and taking the risk early but if you give people a 70% discount then when the next round happens your venture capitalist is gonna say, “This person’s getting way too much for the 10k they put in, you’re asking me for a million and I’m going to end up with the same equity as them.”
This is obviously an exaggeration but the point is:
“Don’t give terms that are overly favourable. I recommend sticking with the market ranges in this case.”
If you’re working with convertible notes, make sure the maturity date is set long enough out to where you’ll actually be able to raise a future round before that note matures.
With convertible notes, if the maturity date hits, and you haven’t raised a round to convert the note into equity, the investor can require that you repay it. And in the worst-case scenario, this could bankrupt your company.
It’s not common for an investor to do that, that’s not the point of their investment. However, if the relationship sours that gives them a lot of leverage and they could do that, and it has happened before.
Those are some of the key aspects to watch out for when it comes to early investment. For later-stage investments, there are a lot of issues to consider. One important one is to make sure that the liquidation preference isn’t too generous.
The standard in the US is doing what’s known as a 1x non-participating liquidation preference. If an investor asks for anything else other than that like a 2x or participating liquidation preference that’s not good – you should push back on that.
Then there are the more obvious business terms. Making sure you’re getting the valuation you deserve, things like that.
Another important legal issue is to make sure that you’re not giving out of the ordinary blocking rights. You want to retain enough autonomy so that you can make business decisions without going to the investor every time you want to change something.
Q: When entrepreneurs outsource, or partner with a third-party entity like a software development company, what should they be careful with?
A: The biggest one is making sure you own or have a very broad exclusive license to IP that’s unique to your business.
Another point is to make sure that you’re not getting tied into an exclusive arrangement. You want the ability to go and work with others if you’re not happy with the relationship. More than this, you need to ensure you can get out of the contract if you’re not happy.
The worst would be a long, exclusive relationship with a third-party partner, which wouldn’t make any sense and is very rare to see. Make sure you have flexibility in the contract.
The next thing you have to do is ensure that compensation (regardless of whether it’s equity or cash) is earned based on satisfactory performance and completion of deliverables.
Those are the core things to be careful of. If you wanted to go further into the weeds then we should mention making sure that the software developer provides assurance that they have the rights to use the code they’re providing you with, that’s a big one.
Related: 10+ Reasons Why Outsourcing Software Development Fails
Q: One thing I’ve talked about often with entrepreneurs is when they dive into the details of a deal with a startup lawyer it can often result in a lot of time and effort that gets in the way of a startup’s growth what’s your take on that?
A: That’s interesting, our approach is we definitely like to follow the entrepreneur’s tolerance for risk. If they’re the type who is happy to take that sort of risk I’m not gonna say don’t sign that contract. I will, however, make sure that they’re informed of all the risks.
Our role is to make sure our clients are informed of the risk and that they fully understand the risks so that they can make an educated decision.
I see a lot with law firms where they do things and over-lawyer things to the point that it really gets in the way of sales.
A startup isn’t going anywhere if it isn’t making any sales. So when you’re working with an early-stage startup you need to adjust the way you give advice so that the core legal best practices are covered without destroying every deal that comes across their desk.
Q: Are there any other common legal pitfalls and nightmares you can think of?
A: One that’s common and is a big challenge to deal with is employment laws. When startups are brand new and they don’t have any money to pay anybody then it’s difficult to classify them as employees.
If you aren’t able to pay people an appropriate wage then you can run into lawsuits around misclassification. It’s very easy to file a misclassification claim; you don’t even need a lawyer; you can fill out an online form in many jurisdictions.
Those claims are common and it’s something that can be a big issue. So compliance with employment law is a big focus point.
Next is making sure that the contracts that you use are appropriately addressed to a situation. So if you are running a business that’s consumer-facing and you don’t have proper terms of use, then a disgruntled user could bring up a claim. So make sure you have that in place – especially if you’re public-facing.
The next one is less of a legal point but it’s an important one.
“The biggest risk for your startup is not being a good communicator.”
Lack of communication can leave you with a lot of legal claims.
Make sure that you’re communicating timelines and milestones with the people you work with. Some people will try to include it all in the contract, and while that’s important it’s also critical that everybody is communicating well outside of contracts.
This will overall result in a better relationship where you don’t have to ever enforce a contract.
Q: Let’s move onto the road to finding the right legal partner. How should entrepreneurs go about finding the right legal counsel?
A: Speaking to people in your network about their experiences is the best thing to do as an entrepreneur. People that can speak to your experience and the experience of the lawyer will be very beneficial.
If I’m an entrepreneur looking for a lawyer I want to speak to other entrepreneurs in my network to find out who they work with and how it’s gone. Make sure you feel that the lawyer you’re talking to has experience in the area you’re going to be working in.
A big point, ensure they’re transparent when it comes to billing. One of the biggest complaints people have about the legal industry is that they’re constantly hit with invoices they didn’t expect.
It happens all the time. We try to be as transparent as possible. After all, we’re supposed to be trusted advisors, and how can they trust us if we’re just going to hit them with a $10k bill they don’t expect when we invoice them.
Having fair communication around billing is absolutely critical.
Q: What questions should an entrepreneur ask a prospective lawyer?
A: Ask about the experience the startup lawyer has to make sure it fits your business idea and the industry you’re tackling.
Make sure they have the capacity to tackle the timelines you’re expecting. In addition, make sure their fee fits your budget.
Other than that, if I was an entrepreneur looking for a startup lawyer I would start asking them some specific legal questions and make sure they had the answers right away.
For example, if I am building a US company that will be seeking outside capital from angel investors and VCs, I would ask the attorney if they do venture capital financings and how they go about such work.
If my company will collect data from individuals in the EU, I would want to know that the attorney understands complex data protection laws governing such collection and transfer of data.
It would give me that extra confidence if they can answer real questions as opposed to just talking abstractly about incorporating and the like.
Q: What’s the best model for early-stage entrepreneurs? Should I look into a long-term contract with a startup lawyer, pay per need, etc.?
A: It depends on the business and how much you want to work with your startup lawyer. Some of our clients see us as part of their team and I’m in touch with them almost every day. Others I speak with once every six months.
So it really ranges depending on their approach. It’s interesting because the entrepreneurs who are the most cost-conscious and concerned about legal costs are also the ones who need the most legal advice.
They’re the inexperienced entrepreneurs who’re trying to save money on everything and they don’t talk to lawyers very much. And when they do it’s a very rushed conversation, but they also don’t understand things so they need to take that extra time to gain legal advice.
You rely on outside advice for a reason so making sure you engage them every time a legal issue comes up it’s a good way to approach it.
“Ultimately if you run your business with trust and delegation it will result in an improved ability to scale and grow.”
Q: Is there anything else you think could be useful for a first-time founder looking to understand the legal side of building a startup?
A: Not really, for me, the biggest thing is communicating clearly among your team and partners, like lawyers and investors, etc. Secondly, you have to trust everyone that you’re working with.
Q: Are there any resources you can recommend for entrepreneurs?
A: It’s an old book that’s completely outdated but the general concepts still apply. It’s called The E-Myth Revisited: Why Most Small Businesses Don’t Work and What to Do About It.
The idea in that book is that if you’re building a business you should build it as if you’re going to franchise it – even if you never intend to. By doing that you essentially are building processes for everything and that allows you to effectively delegate.
As I said, it’s from the early nineties so the examples that they give are outdated. It doesn’t have as much to do with tech and more contemporary things. But it’s a quick read and it’s something that really helped us out when we started our law firm.
It gives you a framework to think about things. Like, imagine if you were going to franchise your business, you would need to have processes and methodologies for how to do everything.
Once you have that you can effectively delegate everything.
Thanks, Ryan…
… For taking the time out of your busy schedule to speak with me.
If I had to choose one thing to take away from my conversation with Ryan it’s this:
While in the excitement of building a new company, directing the time and money to a startup lawyer may not be high up on your to-do list, it should be.
After all, there’s no point in building an innovative product that gets adopted by your users if a lawsuit could mean you lose your shirt (or worse, your company) in the process.
Thanks for reading.
This article was originally published here.
