Why You Should Invest in a Lawyer for Your Startup: A Cautionary Tale

Jan 31, 2020

So you have a brilliant idea that addresses a true market opportunity and you’re eager to present it to the world…

Most founders immediately want to go on the offensive and jump into the fun stuff to get an edge over the market: verifying product-market fit, raising capital, hiring a team and figuring out a product development/marketing strategy, etc. It’s critical at this moment that founders stop and remember the words of an Alabama coaching legend…

“Offense sells tickets, but defense wins championships,”— Bear Bryant
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There are crucial steps to take to ensure your company is standing on a solid, defensible foundation that will protect your product, your company and probably most importantly, your own ass. Ignore these initial processes, and any successes you achieve could come crashing down without warning.

Founders often wear many hats, but when it comes to legal issues, startups almost always need to rely on external legal expertise. Between cryptic “Legalese” and high, difficult-to-predict costs, founders understandably dread engaging legal services, often to extreme detriment to the company. So when is the right time to bite the bullet and engage an attorney?

MYTH: You don’t need a lawyer until you start interacting with parties external to the company, such as selling to customers, building industry partnerships, sharing confidential data etc.

FACT: Consulting with an attorney prior to beginning any type of work in the company will allow you sidestep many pitfalls down the road.

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Meet Steve & Tony, two wide-eyed, first-time founders that buy into the myth that enlisting legal counsel can wait. Let’s say Steve and Tony have an idea and decide to form a company. They end up waiting until after the first quarter to engage an attorney because Tony thinks “lawyers are a drag, man” and Steve “just wants to get the ball rolling.”

Steve & Tony use the first week of the quarter to do the following:

  • Come up with a name for the company and begin building hype on social media.
  • Steve & Tony start documenting the idea. Steve even writes a few lines of code to start stubbing out the proof of concept.
  • The pair talk Tony’s rich ‘Uncle Carl’ into giving them $25,000 for a 25% ownership stake.
  • Steve & Tony decide that they will split the rest down the middle and create a simple document that states their partnership and equity split.
  • Steve purchases a URL and throws up a simple out-of-the-box website for the new company.

All of that seems like pretty innocuous stuff, right? What’s the worst that could happen? Well, what if…

  • Tony decides that he’s too busy to really focus on the “day-to-day” of a new company and disappears to Europe to “find himself” for 10 weeks.
  • An investment firm shows interest in your idea and would like to invest capital. Tony, who arrived back from his introspective journey two days ago decides that the shared strategy session and its outcome was really all his brainchild. He feels he is owed 75% of equity because he feels he contributed more to the idea. As the partnership agreement does not specify terms for ownership and is likely not legally binding, Steve is forced to take a much lower equity stake as to not deter the investor with “Founder Drama.”
  • The SEC determines that the manner in which Steve & Tony issued shares of ownership to Uncle Carl are in violation of securities law. They demand that Steve & Tony to refund $25,000 to Carl, despite the fact that they’ve already spent $20,000. They must also pay a $10,000 penalty.
  • The company website catches the eye of a litigious gentleman that holds a copyright to the newly-formed company name. He starts legal proceedings against the company for copyright infringement for $1,000,000 in damages. Remember, people can sue for anything so even if the company does not operate in the same domain, they now have a lawsuit on their hands from inadvertently “poking the bear.”
  • The investor, having discovered the lawsuit and and SEC violation as a part of their diligence, takes their offer for funding off the table.
  • Since they elected to form a generic general partnership to avoid the cost and hassle of setting up the company as a Limited Liability Corporation, Steve & Tony are personally liable for all debts and expenses. They now must pay cover the cost to Uncle Carl, the penalty to the SEC, and the legal expenses for defense of the copyright infringement lawsuit out of personal funds.
  • Uncle Carl covers all of Tony’s liabilities while Tony returns to Europe to focus on re-establishing inner peace. The company collapses along with Steve’s personal finances, sanity and general will to live.

Lawyer up!

Starting a business is a huge commitment. Entrepreneurs often fail to appreciate the significant amount of time, resources and energy needed to successfully start and grow a business. Steve could have avoided these issues by enlisting the assistance of an attorney at the beginning of his entrepreneurial journey. What makes this even more tragic, is that these basic steps are often extremely low-effort and as a corollary low-cost for a knowledgeable lawyer.

1) Define the founder relationship

The impact of Tony’s erratic behavior could have been largely mitigated with a simple Founders’ Agreement. The Founders’ Agreement should be created prior to legal formation of a financial entity and will set clear expectations for a variety of subjects moving forward, including equity allocation, duties & responsibilities, IP assignment and mechanisms to deal with departing founders. A lawyer can provide you with a solid templated to customize and review the final product to highlight any ambiguities or potential future pitfalls that could come back to bite you. Entrepreneur and speaker, Jiah Kim, provides more information on how to draft an iron-clad Founders’ Agreement in this article.

2) Name the company

There’s more to coming up with a name for your business than coming up with a word that describes what you do and randomly changing letters until it’s virtually unrecognizable. Legal counsel can assist in confirming the proposed company name does not infringe on an existing trademark and file the necessary documentation to protect your company name moving forward. Even in the event your company name needs to change, legal professionals can provide shortcuts that prevent the need to file for a completely new trademark. This guide can teach you everything you need to know about corporate company names.

3) Build a business entity

Choosing the right business entity is key to protecting the personal assets of founders and can save major logistical headaches once your company becomes profitable. If Steve had chosen an LLC instead of a Partnership, his personal assets would have been protected regardless of the performance of the company. A legal professional can make sure you understand the pros and cons of the various entity types, assist in filing formation paperwork and help you choose the right entity for your business. Here’s a comprehensive list of all the business structures that your company can follow. Once you understand what each one means, your lawyer can further assist you in making the right choice.

4) Specify investment terms

Even if you’re receiving capital from a close relationship you’ve known your entire life, a solid term sheet is critical for protection of the investor, the founder, their relationship and the investment. Investment regulations are notorious for being difficult to parse since investment terms can vary dramatically from term sheet to term sheet. Enlisting experienced legal counsel will help you navigate the vast regulatory landscape and can save you considerable time, money and possible liability. If you want to learn more, Nashville attorney Alexander Davie can help you further understand common investment structures for a seed or angel funding round. 

Jumpstart’s Refinery, including a proven curriculum and a vast network of Capital Partners, Advisors and Vendor partners, has everything you need to grow your company quickly and safely. 

Visit www.jsf.co if you’re interested in learning more about becoming a JSF portfolio company to leverage everything The Refinery has to offer.

Interested in becoming an Advisor, Vendor Partner or Capital Partner? Shoot me an email at Brian@jsf.co for more information.

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