5 founder mistakes that keep your lawyer up at night
1. Giving away board seats to convertible note holder investors
Finding the right partner to invest in your business out of the gate is paramount to the success of a start-up (particularly) through its infancy stage. If your initial investors are conditioning their participation in your “friends and family” bridge round on receipt of a board seat, that should serve as a red flag. Your venture’s earliest investors, if experienced, should understand the fact that the founding team requires a maximum amount of flexibility at the board level as the company is coming out of inception and through its bridge financing. Adding an outside investor influence is more appropriate at the time of the company’s initial equity financing. Disrupting that equilibrium beforehand can cause problems for founders (too many cooks in the kitchen) and most importantly, may slow the company’s ability to achieve desired growth (forcing founders to chase after partially committed investors). And don’t buy the “but we want to help more than just giving you capital” argument. If that’s the case, set up a quarterly scheduled call or coffee meeting.
2. Issuing founders convertible note
Common Stock should be held by founders/management/employees and preferred stock should be held by investors. Any disruption of that fact inevitably introduces complexity as it relates to establishing an appropriate and unbiased governance structure of a company. For founders who have dedicated significant $ resources before outside capital becomes available, there is a temptation to “honor” that debt and roll it into the first convertible note round. The terms of that convertible note round, however, will undoubtedly have a conversion mechanism whereby investment in the convertible note ultimately converts into the preferred stock sold to investors in the initial equity round. Suggestion: instead of piggybacking the founder’s loan through that convertible note instrument, founders should consider documenting their loan instead as a straight promissory note (without a conversion feature) that would get repaid at some future trigger date.
3. Not getting assignment of IP agreements from contributors out of the gate
This is one I see too often. At the time of engaging lawyers to legally form an entity that will house a product that you and your 2 other co-founders have been dedicating time to over the last 3 months, you get asked by your attorney to have everyone who has contributed to the IP of the company in the prior 3 months to execute an assignment of IP agreement. The problem: there was a 4th individual who was a part of the early conception stage but disappeared on you last week because they disagreed with the direction of the product build. Now they won’t answer your emails. The takeaway: if you are leaning on the contributions of individuals other than yourself out of the gate, immediately forming the legal entity and putting all the IP created in the company is paramount to not finding yourself in this situation.
4. Spending too much time coming up with special vesting arrangements for co-founders
You are not only an incredibly intelligent individual but you are brave enough to put everything on the line to pursue an idea you feel passionate about. That fact is what gets me up in the morning to work and why I love my job so much. BUT, nothing is more frustrating that seeing you divert your efforts and intelligence away from building your company to instead coming up with novel vesting schedule schemes for you and your co-founders. 9 out of 10 times it will end up being a waste of the company’s money and time. Stick to what you do really well. Building companies. Not unique vesting schedules.
5. Not filing 83(b)s
And… I saved the best for last. You go through the incorporation process with your lawyers. You form your entity, you finalize equity documents and then you are off to the races building your company. You are feeling really good until you find out that your lawyer (and most likely their paralegal or junior associate) becomes complacent and fails to file or remind you to file your 83(b) election for the un-vested equity you received at incorporation. This is the ultimate mistake you and your lawyer can make out of the gate. If a founder does not make an 83(b) election, in any taxable year in which equity vests, the founder will be required to include in his/her gross income as ordinary income the delta between the fair market value of the equity at the time such equity vests and the price he/she paid for the equity. As a result, income that likely would have been taxable at capital gain rates upon sale if the founder had made an 83(b) election would be taxable at ordinary income rates upon vesting. Yikes.