How to avoid legal pitfalls when setting up a company

All you need to found a startup is a great idea and a great team, right? Wrong, says UK-based lawyer Tina Baker, founding partner at new startup-focused law firm JAG Shaw Baker. Caught up in the dizzy rush of launch, many founders fail to put in place the right legal provisions to protect their company as it grows. Here’s what she recommends.

With collaboration and relationships so key to a startup’s success, it’s critical that founders determine key relationships before they get started — both with each other and with other consultants and advisors that may assist them — so it’s clear what everyone expects from each other and who gets what rights. Unfortunately, people tend to postpone uncomfortable conversations and sometimes naïvely assume that they are legally protected when they aren’t.

This example may sound familiar…

Two people have an idea for a new mobile app and start a company, with a little of their own cash to get to prototype to show investors. They form the company – let’s call it JazzApples – and issue themselves 45 per cent of the shares each, without any restrictions. They then issue another 10 per cent in total to two developers in Estonia, let’s say, who have a particular expertise that they can’t afford to pay cash for. Verbal agreements are made but no contracts are signed.

The founders use what little cash they have left to pay branding experts for a killer logo, but they don’t sign a contract with the branding company either, assuming that if they pay cash for it, the logo belongs to JazzApples.

Nightmare scenario #1

One or both of the developers could disappear off the face of earth without providing the support agreed to or they could simply say they don’t have time to work on the project. One of the founders could become ill, get hit by a bus, fall in love with someone on the other side of the world, or even get a record deal and split with 45 per cent of the equity. The logo, meanwhile, belongs to the branding expert, who could then hold JazzApples ransom when it’s raising money.

Nightmare scenario #2

In a different scenario, let’s say that things have gone very well with the app’s development and the founders get an investment offer from an institutional seed fund. As part of the due diligence process, it discovers that JazzApples does not own any of its intellectual property. The founders can fairly easily assign the intellectual property they’ve created to JazzApples but the developers, realising how important a role they played in securing the funding round, now want cash or more shares before they’ll sign any contracts assigning JazzApples the rights to any intellectual property they have created.

These demands don’t go down well with the investors – they don’t want to see their money being used to pay for past services. And they won’t agree to suffer any further dilution, so the founders will need to transfer part of their stake to the developers if they’re seeking shares. Even if the founders are okay with that, the investors might not be – they tend to want to make sure founders hold a big enough stake to be incentivised to grow the business. To make matters worse, the branding company has now gone out of business, so JazzApples can’t get assignment of the logo.

Getting out of a sticky situation

What can founders do in these situations? Basically, nothing. If one of the founders has left, unless there are provisions to recapture some or all of her shares, the remaining founder will be stuck. If he needs to find a new cofounder he’ll end up having to share his equity and face the irritation of having a former partner out there with a big stake in the business and no interest in the outcome.

In the first scenario the founders could try suing the developers for not sticking to their oral agreement – if they can prove one existed. And what bootstrapping startup has the funds to institute proceedings on a multi-jurisdictional basis?

As for the logo, JazzApples may just need to pay for it twice, unless the branding expert is particularly generous and agrees to assign the rights after the fact.

In the second scenario, unless there was a clear intention for a rights assignment to be executed, attempting to sue the developers would be a worthless exercise. And getting the logo legally assigned from a bankrupt company may be impossible, meaning JazzApples would have to rebrand if it wanted to attract investment.

Vesting is not a dirty word

So what are the takeaways here? Although some founders think that “vesting” is a dirty word, it’s actually good to have expectations out in the open and to protect yourself in case things don’t go according to plan. It’s naïve to think that the honeymoon will last forever and that you will never fall out with your cofounders. By the same token, they may be unhappy and want to try something else.

In the US, it’s pretty standard that when startups incorporate that the founders enter into stock restriction agreements with four-year vesting provisions. Unfortunately, this isn’t so common in Europe. When a startup comes to me for advice on incorporating, I always tell them to include vesting provisions – they protect founders if something goes wrong and most investors will require them when closing funding rounds.

Vesting protects the company if more equity is needed to replace a departing founder; it also protects the investor, who essentially is investing in you and is counting on you to stay and execute the plan. The only way to ensure this protection is to penalise you by taking away your shares if you leave – or screw up!

As far as consultants and advisors are concerned, I wouldn’t recommend issuing them shares without some kind of vesting provisions being put in place (unless you are prepared to give away equity and get nothing in return).

All people who create intellectual property for the company should execute an assignment of the intellectual property prior to starting its development. If this is all being done pre-incorporation make sure that there is an assignment agreement with at least one of the founders, with a right to assign further.

This story originally appeared on VentureVillage. Copyright 2013