5 Biggest Legal Mistakes That Startups Make Part 3

TL;DR

The five biggest legal mistakes startups make are choosing the wrong entity, failing to secure intellectual property ownership, neglecting vesting schedules, violating securities laws, and inadequately vetting investors. Corporate lawyer Scott Edward Walker recommends forming a corporation in Delaware because investors expect it and because it simplifies issuing equity to employees, co-founders, and future investors. Read on to understand these mistakes and which entity problems may still be fixable.

Transcript

name of this Workshop is the five biggest legal mistakes that startups make my name is Scott Edward Walker we're being filmed today so I'll wave to the camera here uh I didn't expect that so um I've done a couple of these workshops before and what I was going to do is come up with five new new mistakes but last night I kind of sat down I get calls ... Read More

Key Insights

• 😄 Startups should form as corporations in Delaware to align with investor expectations and ease future equity issuances.
• 🎮 Securing intellectual property ownership is crucial to avoid legal disputes and maintain control over the startup's assets.
• 🔬 Implementing vesting schedules ensures that equity is earned over time and protects against co-founders leaving without contributing to the startup's success.
• 🤨 Startups must comply with securities laws and ensure they are only raising funds from accredited investors to avoid legal complications.
• 🚂 Vetting investors and conducting due diligence helps startups find suitable partners who align with their goals and values.
• 🪜 Crowdfunding regulations, although intended to democratize startup funding, have added complexity and challenges for entrepreneurs.

Questions & Answers

Q: What are the five biggest legal mistakes that startups make?

Scott Edward Walker identifies choosing the wrong entity, failing to secure intellectual property ownership, neglecting vesting schedules, failing to comply with securities laws, and not properly vetting investors. He notes that some startup mistakes are fixable, while others can become “deadly mistakes” that cannot be fixed.

Q: Should a startup form an LLC or a corporation?

Walker recommends that startups form corporations rather than LLCs. He specifically advises forming a corporation in Delaware because that is what investors expect and it makes future equity issuance easier.

Q: Why does Scott Edward Walker recommend incorporating a startup in Delaware?

Walker gives two reasons: investors want startups to be Delaware corporations, and the structure makes it easier to issue equity. That equity may go to employees, co-founders, or future investors.

Q: Why can an LLC be a poor fit for a startup?

An LLC is a pass-through entity, meaning its profits and losses are allocated directly to its owners. Walker says venture capital firms and other investors do not invest in pass-through entities, so a successful LLC seeking investment may have to convert to a corporation anyway.

Q: Why are stock options more complicated for an LLC?

Walker says LLCs do not really issue stock options; they use what is called a profits interest. He describes profits interests as unfamiliar and complicated compared with issuing equity through a corporation.

Q: What documents are involved in forming an LLC?

Walker says an LLC basically involves two documents: a certificate or articles of formation and an operating agreement. He notes that an operating agreement can be about 80 or 90 pages and combines corporate-style provisions with a complicated tax layer.

Q: Are LLC tax advantages usually relevant to startups?

Walker says LLC flexibility around tax distributions and allocations is generally more relevant to hedge funds, private equity, and real estate. Startups commonly lose money for a number of years and put revenue or raised funds back into the company, making those LLC features less relevant.

Q: Can a startup fix the mistake of initially forming an LLC?

The existing guidance says a startup may dissolve the LLC and form a new corporation or convert the LLC into a corporation, depending on when the problem is discovered. The process can vary by state, and Walker warns that converting later can be expensive.

Summary & Key Takeaways

• The speaker, Scott Edward Walker, is a corporate lawyer specializing in startups and entrepreneurs.

• He shares the five most common legal mistakes he sees startups make in his practice.

• These mistakes include choosing the wrong entity, not securing intellectual property ownership, neglecting vesting schedules, failing to comply with securities laws, and not properly vetting investors.