There are certain issues that frequently arise when founders elect to incorporate their companies using a ‘DIY’ approach or a lawyer that is not experienced in representing startups. Thankfully, these mistakes are entirely preventable with basic, early-stage planning under the guidance of a corporate lawyer experienced in dealing with startups. Listed below are three of the most common mistakes that early-stage companies make and how they can be avoided.
Overly Complex Share Structure
It is common to see freshly incorporated companies with an overly complex share structure, such as a dual class share structure or multiple common and preferred share classes.
As a general guideline, investors in British Columbia and Canadian companies will expect for a startup to have a simple share structure. Creating a secondary class of non-voting common shares can create certain unintended consequences in edge cases, such as veto rights for the non-voting class, and preferred shares need not be introduced until substantial external capital is invested into the company, at which point the rights around such shares will be carefully negotiated.
For companies that implement a complex share structure at incorporation, the share structure will eventually need to be altered, which requires shareholder approval and adds unnecessary additional legal fees. However, this can easily be dealt with by incorporating the company with a single common share class, with additional share classes being added later if and when necessary.
Absence of Reverse Vesting Arrangements
At the inception of a company, “founder shares” are allocated amongst the founding team and are issued to them for nominal consideration. This is standard operating procedure, but certain additional measures should be adopted if there are multiple members of the founding team.
For instance, what happens if one of the co-founders prematurely leaves the company? It wouldn’t seem fair for this co-founder to maintain a substantial equity stake in the company without continuing to contribute to its growth, and this perceived unfairness could result in costly legal disputes. Additionally, depending on the size of his or her equity stake, this co-founder may hold the company hostage in future transactions by withholding consent or signatures to key matters such as completion of the sale of the company.
This scenario can be avoided by implementing a “reverse vesting” arrangement for the founder shares, where each of the founders will enter into an agreement with the company which says that if they depart from the company prior to the end of their vesting period, their “unvested” founder shares can be repurchased by the company for their original, nominal purchase price. Over the vesting period, the number of “unvested” founder shares will gradually decrease so long as the founder shareholder remains continuously engaged by the company. This allows the company to repurchase an appropriate proportion of the shares held by a co-founder that does not stick around until the end of their vesting period, which is typically three to four years with a one-year cliff.
Unclear Chain of Intellectual Property Ownership
Most of the value of a high-growth startup is typically rooted in its intellectual property. It is thus of utmost importance to a prospective investor or purchaser that their ownership interest in the company results in an ownership interest in the company’s intellectual property. In other words, the company itself must be the owner of its intellectual property.
Given that the founders, employees and contractors of the company are the ones who actually develop the company’s intellectual property, any of such persons could make a claim that they (as opposed to the company itself) have rights to and interests in the intellectual property. The standard approach to dealing with this issue is for such persons to formally assign to the company their rights to the intellectual property.
Not having these arrangements in place is a problem that is usually identified by a buyer or investor during transactional due diligence, often months or years after the time when the intellectual property assignment should have been signed. This can result in a transaction being delayed so that a company can obtain signatures from the necessary signatories, who may no longer be engaged by the company and may thus be difficult to locate. The fact that there is no guarantee that such signature can be obtained adds risk to the transaction. For this reason, intellectual property assignment should occur at the time of engagement of the employee or contractor.
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Navigating the startup process is challenging enough, and worrying about future legal issues is often not at top of mind for busy founders. It is recommended that you seek legal advice from an experienced startup lawyer at or prior to incorporation of your venture so that you can properly understand the impact of early decisions on your company.