Thinking of finally launching that startup in this year? You’d be in for a ride even if the next 12 months weren’t shaping up to be as change-filled as it appears they might. Crowdfunding laws are evolving, and the regulatory landscape is already shifting as the Trump Administration gets underway.
Fast Company asked startup expert and lawyer Christina Oshan, cofounder and managing member of the J+O Firm in Brooklyn, for tips on forming a company, financing, and other things you may not have thought of—but will definitely need to if you’re getting a business off the ground in 2017.
What do startups need to do to set themselves up for success?
One of the most important things is actually forming the company, which is something startup founders sometimes forget to do. I always think of the scene in Silicon Valley where he gets his first investor check and he goes to the bank and says, “I want to deposit this,” and the bank says, “You don’t have a company.” That’s something we’ll often see with founders. They’ll think about trademarking their name, or they’ll think about setting up their website before actually setting up the entity.
Similarly, founders should remember to issue stock to themselves. Something that’s really important is when you first start the company, the company is obviously worth nothing, so issuing your shares for nothing is an even exchange. But as soon as you start the company, you’re inherently building value every single day.
So if, for example, you go on LegalZoom to form a corporation but don’t actually take the steps to issue the stock to yourself, you’ll be heads down building the IP, and then you get your first check valuing you at however many million dollars. All of a sudden you’ve set a price tag for what the company is worth. If you go to issue (stock to) yourself then, and if you don’t pay equal value for those shares, you’re going to have a hefty tax bill.
For example, if an investor says, “I’m going to value the company at $10 million,” and you’re saying right now that you own 100% of it but you haven’t issued yourself any shares, then now your company is worth $10 million. If you receive shares that are worth $10 million, then you need to pay taxes on $10 million, unless you pay equal value for them.
Another important thing to consider is who you’re starting the company with. It’s a deep relationship that you’re forming. While things are great in the beginning, things come up. For example, one of your cofounders might decide that they can’t devote as much energy or time as they expected. Or they actually need to make a salary, they need to go get another job. So vesting is key—if someone decides to leave and not devote all of their time or any of their time, there should be a vesting schedule put in place so that they’re not walking away with 50% of the company.
Are there any other errors you see startups making?
Another thing you’ll see a lot of times is that as people are hiring or engaging service providers to provide little pieces of the business—for instance, if they work with an app development company—they’ll forget to put an agreement in place that actually assigns the work that those individuals are doing over to the company. Or they’ll make promises of equity grants or incentives, and they don’t take the steps to grant that. Or they’ll promise percentages of the company, which is a mistake.
It’s really important to always promise a number of shares versus a percentage because 5% before raising financing is a lot less than 5% after raising financing. If you don’t get around to actually doing the grant until post-financing, then all of the sudden you’ve given away a lot more of the company than you initially intended.
What about crowdfunding?
Everyone is anticipating that there will be a lot more of it in 2017. Founders should understand the implications of raising funds with unaccredited investors.
When VCs are investing, there is an inherent risk and time frame that they’re expecting for the investment that they’re making, and they understand what goes along with it. Whereas if you’re raising with a non-accredited investor, they’re going to be less tolerant to risk, and there will also be a tightened disclosure obligation that the founders might not be ready to undertake.
In addition, there are limits on the amount the non-accredited investors can invest in the company, so you’re starting to look at a larger number of stockholders. Once the cap table starts to get bigger, there are inherent issues that come along with that. For example, if the company’s exit opportunity ends up being an acquisition, they’re going to have to go out to the stockholders and get consent to close the transaction.
Subsequent rounds of financing dictate how much consent you will need from stockholders, but often the acquirer will require a high percentage of stockholder consent to move forward with the deal—upwards of 90%. So if you have hundreds of stockholders that you need to sign a consent, it’s often like herding cats to get people to sign something. All of a sudden that can really impact your ability to close a transaction.
When should startups patent ideas and file for trademarks?
It very much depends. For trademarks, you should always start with a trademark search when you’re thinking about what name you want to go to market with. The first and foremost thing should be, “Is there anyone else that’s out there that’s doing it with this name?” —not only because it will affect your ability to get a trademark, but it will also help you avoid a potential problem down the road.
If someone comes to you and says you have to stop using their trademark, you’ll have to rename everything. Founders become very attached to their names, and they would like to fight it, and that might be a misuse of time and effort that could have been avoided at the beginning. At a bare minimum, founders should always be thinking about a trademark immediately.
With a patent, if they’re thinking that an idea could potentially be patented, they should talk to a lawyer first to see if there’s a chance they could get one. It is very rare that I see that the things our clients are working on are the right fit for a patent application.
Is there anything startups should be watching out for with the Trump administration?
I think it remains to be seen. I think everyone is adopting a “wait and see” approach because we don’t really know what he’s going to do.
Aside from the political climate, there is a bigger move [by startups] to focus on the amount of money that you actually need, rather than the amount of money that you can raise. That goes back to founders understanding their cap table, and how much they’re giving away (to their stakeholders). Something that you’ll see early-stage founders do is issue convertible notes for friends and family, and they’ll put a valuation cap in there that is lower than they should.
If they’ve (the friends and family) invest $1 million at a $3 million valuation cap, you just let one-third of the company walk out the door, and you haven’t even brought on subsequent investors, you haven’t hired your team. [You need to] understand exactly how much of the pie you’re giving away as those early funds come in.