Startup Founders: 10 Common Mistakes from a Legal Standpoint and How to Avoid Them
Launching a startup is undoubtedly a risky endeavour. According to the latest data, 9 out of 10 startups fail, while the success percentage for first-time founders is about 18%. This blog aims to identify 10 of the most common mistakes startup founders make, from a legal perspective, and offer some steps to avoid them while getting ready for funding or an exit when the opportunity arises.
- Delaying the Incorporation of a New Company
Many startup founders often begin working on a new idea without formally incorporating a new company, or while utilizing the resources of an existing company. Forming a new company (NewCo) is crucial as it provides liability protection for founders, with some limited exceptions.
A common mistake arises when founders delay the incorporation process until after creating intellectual property (IP). It is important to recognize that if such IP is intended to be considered an asset of the NewCo, founders must transfer it from either themselves personally, from a third-party developer or other entity, or from their existing company, if applicable, to the NewCo. While a simple IP Assignment Agreement could suffice for this transfer, if the IP holds significant value or is tied to a revenue stream, a proper Asset Transfer Agreement becomes necessary.
Procrastinating on this step, especially as the value of these assets increases, poses a risk. The longer a founder waits and the higher the value of these assets, the higher the risk that the Canada Revenue Agency may view the transfer as having occurred at a fair market value which might be higher than $0, or the nominal amount the founder would typically aim to transfer the assets for, resulting in imposed taxes on the transaction. To prevent this, startups should incorporate as soon as possible, but if that is not feasible, and they have reached the stage described here, then they should consider transferring the assets to a NewCo on tax-deferred basis by filing the appropriate election under section 85 of the Income Tax Act. This strategy delays tax payment until the NewCo’s shares or assets are sold during an exit.
- Underestimating Ongoing Maintenance Requirements
After incorporating, startup founders often underestimate the importance of annual or recurring maintenance requirements. Companies that don’t file their annual report can be administratively dissolved, which creates extra work to revive the company. The annual report allows companies to confirm certain information or report any changes, namely about the directors or the registered office address. In addition to filing the annual report, companies need to hold their annual meeting of their directors and shareholders to approve financials, reappoint directors, waive audit requirements, etc. This can be done also through written resolutions that need to be signed by all directors and shareholders.
For companies that have many directors and shareholders, it is often the case that they cannot reach one or more directors or shareholders, either because they cannot secure their signature due to a dispute or disagreement or because they sometimes simply disappear. In this case, the company has to hold the annual meetings by providing notice to directors and shareholders in accordance with the company’s by-laws or the governing statute. The law has recently changed in Ontario to allow these meetings to be held online. For companies that don’t follow the proper steps, there is always a risk that the shareholders or directors who didn’t attend or weren’t properly notified can dispute the legality of the decisions taken during such meetings. That is why it is important that the founders are aware of the procedures contained in their by-laws and other restrictions in their minute book documents and update such documents to reflect the latest legislative updates.
Federal companies are also required starting January 2024 to file a report of Individuals with Significant Control. There are discussions that other jurisdictions, such as Ontario and British Columbia will follow the same approach.
- Adopting an Inappropriate Share Structure
Often founders use their accountants to incorporate their company. The risk of doing so for startups with high-growth potential that wish to attract investors is that the Articles of Incorporation are unnecessarily overcomplicated. The Articles in these cases often contain classes of preferred shares that are not utilized but anticipate that the founder may need such class in the future for tax planning purposes.
If your intention is to go through one or multiple funding rounds and/or attract team members through equity compensation, the best share structure is two classes of common shares, one voting for the founders, and one non-voting for key team members you wish to incentivize through an Option Plan. A common question founders ask is if their Articles of Incorporation need to include classes of preferred shares for future investors. The simple answer to this is that sophisticated investors in an equity round will ask for specific rights, so it is pointless to try to predict what those rights will be, since it is common for startups to amend their Articles to include such new classes of shares based on what they negotiate with investors during that specific round.
- Issuing Unrestricted Shares to Co-Founders
Another common mistake startups make is to issue unrestricted shares to co-founders. Companies usually issue shares to their original shareholders at a nominal value since the company presumably does not have any value at the time of incorporation. For startup founders, it is presumed that the founder will work toward creating value for the company, thereby increasing the value of their shares. Issuing unrestricted shares to co-founders, however, exposes the startup to the risk that one or more co-founders will either not pull their weight or simply leave the company holding a significant portion of the company’s equity without actually earning it. In essence, such founders benefit from the increase in value of the company from the efforts of the remaining founders.
To protect the remaining founders, but also to anticipate such concerns from future investors, the company should consider issuing shares to co-founders on a reverse vesting schedule. A typical vesting schedule has a 4-year term with a one-year cliff. Essentially, if a co-founder leaves within the first year, none of their shares have vested so the company has the right to redeem and cancel the shares simply by providing notice to the founder. Similarly, if the founder leaves after two years, the company can cancel the unvested shares for the remaining two years. This approach is different from issuing options, which again can vest over a similar period, but once fully vested, the Optionholder has to exercise their options and purchase the shares.
- Not Having Founder Agreements in Place
Founders carry the heaviest load when it comes to the growth of a company but often do so based on an oral understanding of what their obligations are or often don’t define what their responsibilities are. A Founder Agreement contains important provisions to hold founders accountable by clearly outlining their responsibilities and the consequences of their failure to deliver. This allows the company to terminate them, thereby stopping the vesting of their shares, provided that they have been issued restricted shares, if the founder is not meeting their obligations.
The Founder Agreement also covers important considerations, including providing for the assignment to the company of any IP created by the founder in relation to the business, preserves confidentiality, and imposes non-solicitation obligations. Additionally, it can address certain corporate law scenarios, such as obliging the founder to resign as director and officer (if they hold such positions) if the respective Founder Agreement is terminated. It is important to note that the termination of a founder, especially if the founder is also a director and/or officer of the company, is approved by the board of directors or the shareholders, so co-founders need to be advised of the quorum requirements and other risks on a case-by-case basis to exercise such termination rights. Finally, these agreements should be read in tandem with any shareholder or other agreements that may offer some shareholders, who are also founders, board nomination or other rights.
- Neglecting Entering into a Shareholder Agreement
Many startups are bootstrapped, so founders don’t allocate an appropriate budget for the essential agreements. A common example is the Shareholders’ Agreement which helps anticipate certain points of disagreements among shareholders. Startups often remember too late to have such an agreement in place, usually when a shareholder dispute has arisen, at which point only a court can mandate the transfer of the shares of a shareholder.
Shareholder Agreements can help founders, who are typically shareholders, consider their intention in certain scenarios before they occur, such us the right of first refusal offered to existing shareholders if a shareholder wants to sell their shares to a third party, a tag-along right for other shareholders to benefit from a (partial) sale of a shareholder’s shares, or a drag-along to ensure that minority shareholders don’t hold up an exit deal. Such shareholders’ agreements can also offer director nomination rights to certain shareholders, but they can also limit the rights of directors or require additional shareholder approval, subject to certain jurisdictions, such as British Columbia. Note also that a Unanimous Shareholders Agreement is a creature of statute applying to future shareholders even if they don’t execute it. It is important to understand the differences and any jurisdictional limitations.
For high-growth startups that wish to secure equity financing, Canadian investors may be more familiar with the Canadian Venture Capital & Private Equity Association (CVCA) – or, for US investors, the National Venture Capital Association (NVCA) – model documents, including the Shareholders’ Agreement, which takes the form of three documents, (i) the Voting Agreement, (ii) the Right of First Refusal and Co-Sale Agreement, and (iii) the Shareholder Rights Agreement or Investor Rights Agreement. Founders need to familiarize themselves with these documents and how these agreements play out given the company’s specific situation.
- Underestimating the Importance of Agreements with Team Members
Having appropriate agreements with team members is important for many reasons, including to clearly assign any IP created by such team members to the company, outlining the parties’ obligations and termination rights, as well having the typical non-compete and non-solicitation covenants. Some examples include Employment Agreements, Independent Contractor or Service Agreements, Advisor Agreements, and IP Assignment Agreements. IP assignment is very important as future Investors and potential buyers will want to see a clear chain of ownership of the assets of the company to solidify its value.
Founders often find templates online to minimize costs. While the risk may be lower for certain types of agreements, in cases where the category of key members is statutorily protected, such as employees, it is important to have such agreements reviewed periodically to incorporate recent changes in the respective laws and to avoid a court decision imposing (often much higher) common law standards.
- Disclosing Company Confidential Information Without an NDA
While it may seem counter-intuitive, many founders seeking financing or discussing with a potential buyer may casually disclose confidential information of the company or show their platform and any existing customer lists through a screen-share. Some founders bring up trust or the fear of overcomplicating things and disincentivizing a potential interested party as deterrent from presenting an NDA.
It is an absolute must that you don’t share any confidential information of the company without an NDA and that you understand the different types and obligations flowing from such agreements. For example, a Mutual NDA (MNDA) creates equal obligations for both parties to preserve the confidentiality of the other party’s disclosure. This is used in cases where both parties are expected to share confidential information, such as when the parties are contemplating an acqui-hire, where founders are expected to be compensated through cash plus conversion shares or options in the buyer’s company, etc. Another significant point to remember about NDAs is that they are usually entered into in anticipation of the parties signing a definitive agreement, which will include its own confidentiality obligations and terminate the NDA. Therefore, it is important for startups to understand any ongoing obligations arising from an NDA if the parties do not end up closing the deal.
- Granting Options Without an Option Plan
Many founders at the early stages of a company promise new team members a percentage of the company’s equity, which often translates to overcompensation. There are plenty of resources online that show statistics of the percentage of equity offered to early employees or contractors. However, it is important for the company to understand the value of the services offered and the valuation of the company based on comparables or a revenue multiple to better calculate the number of options that should be granted in each case. These considerations are also important for the company when coming up with the exercise price for such options.
To better anticipate dilution, companies should consider adopting an Option Plan which will provide for the specifics of the Optionholders’ entitlement, and the company’s right to cancel the options. A typical Option Plan for early-stage companies reserves around 5-15% of the company’s equity and grants Optionholders non-voting shares. However, each company may have different talent acquisition strategies and may allocate a larger or smaller percentage to their Option pool.
- Lack of Understanding of How Convertible Debt Affects the Cap Table
Prior to an equity round, startups typically raise funds through convertible debt, including Convertible Promissory Notes (Note) or Simple Agreements for Future Equity (SAFE). SAFEs can be considered more pro-company since they do not include a maturity date to pressure the founder to either pay the initial amount plus interest or convert it to equity. Companies usually use the Y Combinator SAFE form that offers two options: (i) discount or (ii) valuation cap. It is important to note that these Y Combinator forms are pro-investor. Even more so, startups are presented with variations of such form of agreements from accelerators that add more complexity into the conversion mechanism. It is therefore imperative for startups to understand how these documents affect future dilution because it may disincentivize future investors or lead founders to get more diluted than what is necessary.
Another important factor is a Side Letter with additional rights that some investors may negotiate. Such Side Letter may include preemptive rights, a favoured nation clause, information rights, board observer or board nomination rights, etc. Startup founders should understand how these rights will affect their cap table by modeling out the most likely scenarios of their upcoming round but also how such Side Letter will affect their decision making or reporting obligations.
There are additional things to consider when startups are raising capital in an equity round or undergoing an exit. Stay tuned for our next blog that discusses those considerations. Starting a business is challenging, but with determination, perseverance, and the right knowledge of the associated risks, you can increase your chances of success.
Our firm offers services under a Startup Program to anticipate many of these risks and guide startups. Our Startup Program also offers startups a discount for additional services within the first year of signing up. To learn more, see here or email Yonida Koukio at ykoukio@oziellaw.ca or Allan Oziel at aoziel@oziellaw.ca.
