Founders must get these legal issues right, in order for their Company to have the best chance of success:
1. Divide the pie correctly. Too many Founders divide the start-up equity immediately, quickly and equally (because, after all, “equal is fair”). Research shows that Founders who take their time with the decision and don’t feel compelled to allocate immediately, and above all, don’t necessarily allocate equally, fare better. Not all Founders are equal – each will bring different contributions to the business. Equal allocation almost always leaves one Founder (or more) feeling cheated — working hard while the others get a free ride.
2. Vesting, vesting, vesting. No matter how the Founders divide equity, they must “earn it” through a vesting schedule. That is, if you are a one-third owner, you’re not a full one-third owner unless you have worked for the start-up for at least, say, four years (four year vesting with a one year cliff is very common). Leave early, quit, get fired, die, become disabled, job relocation, etc. and you leave part of your equity with the Company.
3. Protect the IP. Each Founder, every employee, and every contractor must sign an invention rights agreement (which provides that any concept the Founder, employee or contractor develops that is related to the Company’s business belongs to the Company (including “work for hire” language for copyrights and patent assignments for patentable ideas). Consider non-competes as well.
4. Who owns what? Keeping an up-to-date cap table (or capitalization table) is essential. The cap table is a chart (or, most often, an excel spreadsheet) which lists every equity owner (common stock, Preferred Series A, Series B, etc.), option holder, warrant holder, convertible note holder, etc. and how many shares they own (or could own on exercise). The final column is their fully diluted percentage ownership of the Company. Having an up-to-date cap table is key to tracking all of the promises of equity that have been made and the ultimate percentage that each holder has in the Company (which is important for voting rights as well as payout upon sale or exit of the Company).
5. Pre-money value: higher is not always better. If the Company plans to attract investor capital the concept of “pre-money value” is important. “Pre-money value” is the value of the Company prior to the investors funding, which determines what percentage of the Company the investor will own after funding. The higher the pre-money, the less equity is given up to the investor. Sounds like a good thing, right? Not always. If the Company will need successive rounds of funding, the goal is to raise each round at a progressively higher pre-money value. If the Company doesn’t reach a milestone, the next round may be at a lower pre-money than the last (a “down round”). “Down rounds” are painful. Lots of blood – including from the Founders. Don’t be seduced by a funding offer with an inappropriately high pre-money.
6. Hire a Good Lawyer. This is a specialized area, and your counsel should be a specialist. Enough said.
For further information regarding these matters, please contact Mr. Bruder at 248.619.2596 or via email.