If you’re a first-time entrepreneur, the law can feel daunting. You may have read or heard about scary stories in which startups (and the dreams of their founders) failed due to legal mishaps. The good news is that most such mishaps can be avoided if entrepreneurs keep in mind legal considerations at two important stages of growth: incorporation (the very beginning) and fundraising (when startups rapidly scale).
Incorporation
Entrepreneurs tend to underestimate the importance of getting the corporate structure right from the start because changing it afterward could lead to extra legal costs, disputes between the founders, and confusion for potential investors. Here are some things that you should take note of:
- Where should you incorporate it? Most law firms would recommend incorporating in Delaware as opposed to New York. Delaware corporate laws are transparent, organized, and favorable towards entrepreneurs in the face of lawsuits and other disputes. Startups that register in Delaware enjoy the benefits of laws that are easy to read and interpret (and most importantly, that make sense).
- What type of corporation is best? Investors tend to prefer C corporations (C corps) for several reasons. First, the shares of C corps can be easily transferred, making it simple for investors to enter and exit a startup. Second, C corps are taxed for their own revenue, and investors only have to pay income tax on the dividends they receive from their shares. Certain other structures, such as partnerships, require taxes on company revenue to be paid out by the partners, which can prove very costly for investors.
- Share structuring. First-time co-founders tend to divide up the shares amongst themselves equally, which can lead to fights in the long run. Over time, it’ll be clear that not all roles are equal – some co-founders will inevitably work many more hours than others. It’s important to think of how shares should be distributed from the start, such as how vesting plans would work out.
- Shareholding agreements. To build on the previous point of managing relationships between co-founders, startups should have shareholder agreements in place at the time of incorporation. These agreements outline dispute resolution mechanisms when certain events happen, such as when a minority shareholder wants out, whether existing shareholders will maintain their percentage ownership in the event of new issues, and what happens if the startup fails or is sold.
- Intellectual property. Finally, make sure that your technology or ideas are protected by patents, copyrights, or trademarks!
Fundraising
The second important stage that involves a lot of legal documents is when startups begin to fundraise. At this stage, entrepreneurs need to navigate relationships with investors carefully or risk feeling like they’re meeting an ex they want to avoid at every board meeting. In order to successfully scale a startup, entrepreneurs need to be on the same page as investors on the goals and strategic plan of the company. Consider the following tips when building your pitch deck and executive summary:
- How do you find the right investors? If you’re an early-stage startup, you may be tempted to say “yes” to every offer of investment you get. After all, money is running out, you need to pay your staff (and yourselves), and you’re constantly doubting your decision to take the risk of entrepreneurship rather than working at a stable job. Even in these moments, you need to make sure that there is alignment between the investors and the founding team. You need to have the same vision for the startup, good communication, and mutual respect in the event of a dispute. If you have a bad relationship or can’t agree on the key points, then you may end up in a power struggle that will be detrimental to the startup’s growth.
- Should you use SAFEs? Because SAFEs are standardized, they make everyone feel good, especially entrepreneurs who want to feel protected without paying hefty legal fees. In the past, SAFEs were firmly on the side of entrepreneurs, but in recent years, they tend to make life just slightly easier for investors. Read all the clauses before using a SAFE to make sure that every one of them helps you.
Navigating New York’s Legal Landscape
The right legal strategy can make all the difference to the success of a startup. Well-protected entrepreneurs can focus all their time and energy on growing the business instead of disputes. Keep the tips above in mind as you take your startup to the next level.
