3 Legal Decisions Every Founder Must Face
Why a strong legal foundation can prove to be an indispensable asset from inception to exit.
It really does seem impossible to make 500 million friends without making a few enemies. The adage, popularized by the film The Social Network, returned to relevance last week as Snap Inc. (Snapchat’s parent company) filed an S-1, revealing the company’s intentions to pursue what could be the most-hyped public offering of the year.
Disclosed documents revealed that a third founder, Reggie Brown, had been pushed out of the company during its first few months. An independent source alleged that it was Brown who vocalized the idea of “an app where pictures could disappear.” Eventually, Brown would extract a settlement of $157.500 million for his early contributions.
Many entrepreneurs, seeking to avoid the burdens of legal fees, avoid retaining counsel until the emergence of a tangible predicament. However, countless stories prove the opposite approach to be more rational: a strong legal foundation can prove to be an indispensable asset from inception to exit.
I caught up with Jeff Laretto, an attorney at Wilson Sonsini Goodrich Rosati, the acclaimed Silicon Valley law firm known to have advised Apple in its IPO and Google since its inception. We discussed three distinct and pressing legal decisions that every founder must consider.
1. Forming your company: When, why and how?
The first legal question that often confronts founders is that of entity formation and timing. “You form a company in order to protect your personal assets,” explained Laretto. “As soon as you begin commercializing products and entering into agreements with third parties, you’re exposed to liabilities. By forming an entity, you can generally shield your personal assets from those liabilities.”
There is considerable debate regarding the best structure for your startup. According to Laretto, one core consideration is: “Do you want to be the next Facebook -- and thus have a pressing need for significant capital? If so, a c-corporation is distinctly advantageous. Corporations are the structures that are the most tax-amenable to venture capitalists -- and the body of law governing corporations is broadly understood and consistent.”
LLCs may be potentially tax-advantageous for some business, especially those that tend to have a small number of owners or for companies that will distribute operating profits regularly. However, LLCs are not ideal for institutional investment. “You can certainly sell membership units and create corporation-like economic and control structures through an LLC; however, you’ll need some fairly complex and costly documentation. In the long run, there may be significant legal costs associated with maintaining the company -- and the structure may deter some investors,” Laretto said.
2. Equity ownership: How do I think about the relationships with the earliest members of my team?
Equity allocation is one of the most challenging problems faced by young companies. “There’s no right way to do it necessarily; however, there are many bad ways to allocate equity,” Laretto emphasized.
“First off, the concept of equity ownership should be clearly documented from inception. Not doing so could cause a Snapchat-like issue. I also advise founders that, when allocating equity, they should consider roles on a go-forward basis, rather than focusing on what a founder has done to-date.”
Founders should include vesting clauses. Vesting refers to the concept of earning equity ownership over time (or after achieving specified performance metrics), and protects founders from one another if a partnership splits (like in the case of Snap).
Technology companies often vest stock on a monthly basis over a four-year period, usually with a twelve-month cliff, to protect against instances where employees quickly prove to be a bad fit.
Related: How to Structure a Single Member LLC
3. Scaling your team: Know how to abide by labor laws and protect your product.
“It is vital for founders to understand and comply with relevant labor laws” Laretto insisted “There are few areas of law that can be as tricky, and failing to pay current wages to employees in many states can lead to personal liability to founders. In other words, not only are your company’s assets at stake -- but a court can come after your house and other personal assets.”
“Furthermore, the law will ultimately determine whether someone is an employee or an independent contractor, not the piece of paper that you ask them to sign. The law clearly favors protecting employees.”
In terms of protecting the company’s intangible assets, “every employee should be equipped with a non-disclosure agreement and a basic proprietary rights agreement that transfers, without a doubt, all intellectual property to the company. Otherwise, the entity may prove un-fundable down the road,” Laretto said. Founders should note that, without a proper conveyance of intellectural property, the work that contractors develop (such as software) for any company remains owned by the individual contractor.
Laretto argues that documents assigning all intellectual property to the company (from service providers) is often more important than racing to get a patent on file (which can often even be a waste of resources for many early-stage companies). Instead, companies should focus their efforts on protecting their trade secrets and core ideas and beating their competitors to market.
As we witness the tales of Facebook, Oculus and Snap, one takeaway is clear. Founders should proactively tackle their fundamental legal decisions as they seek to build the next generation of American success stories. Who knows, maybe it actually is possible to make 500 million friends without making a few enemies.