There are thousands of start-ups out there trying to make it big with a game-changing idea. But, it’s only the ones with sound execution that can turn that idea into a success story. Often, businesses simply need to take one step back and incorporate a bit of extra planning to avoid common mistakes that can derail their business.
From our daily interaction with countless early-stage founders and entrepreneurs, we have pinpointed the four biggest legal mistakes a start-up can make, and how you can leapfrog these common stumbling blocks.
1. Failing to incorporate the right legal entity or even completely neglecting it
Don’t send your clients invoices with the details of your personal bank account you opened back in 1999. Set up the right legal entity and open a business bank account as soon as possible.
In South Africa there are quite a few types of legal entities to choose from, but anything other than a private limited liability company (the so-called ‘PTY’ limited) and investors start feeling ill at ease. So, if you’re looking to raise venture capital soon, a private limited liability company is the way to go.
Another benefit of a private limited liability company is that you only risk losing the money you’ve put into the company. It is seen as a separate entity from you and so your personal assets, including your bank account, car, and house, will remain secure.
2. Failing to formalise the founder’s relationship
Possibly the most important first step in a new start-up, other than registering your company, is formalising the relationship between the founders. Sometimes due to the eagerness to get started, founders don’t stop to think carefully enough about the following four key principles:
- Commitment: the success of the business you have embarked on will take commitment from each of the founders. Define it! How can each of you be sure that all the founders are committed? What do the founders need to bring to the party?
- Control: Avoid disputes by asking these questions early on. How are the big decisions taken by the company? Who really has the power to make these decisions? Who really controls the company?
- Economics: who owns the company, and in what proportions? Then, how can the founders get the value created by the business – how are the profits of the company distributed to the founders and when can the founders sell their shares?
- Funding: how will the company initially be funded – loans from founders? Working for a low salary, or no salary at all? Or possibly Angel funding?
3. Failing to negotiate and consider proper vesting mechanisms for founder shares
How would you feel if you are foregoing a higher paid job to work on your start-up and one of your co-founders leaves the company for a lucrative position, and gets to keep all of her or his equity after leaving? Not great, right!
Be upfront about what you expect from each other and how long you agree to be tied up to the company. In comes “Vesting”. Vesting is the process by which a founder receives the economic rights in the shares of the start-up over time.
A typical founder vesting schedule works like this: A Founder needs to be with the company for a minimum period of 12 months (called the “Cliff”) to receive 25% of his shares, and thereafter his remaining shares vests in equal percentages over a 36-month period. So, if a co-founder quits before the ‘Cliff’ /12 months, he or she leaves with nothing.
In practical terms, vesting protects founders from the risk that a co-founder will prematurely leave with his or her slice of the company, which he hasn’t ‘earned’ yet.
4. Failing to properly document employment relationships
Start-up founders often overlook the importance of intellectual property assignment and confidentiality agreements – falsely assuming that anything their employees create is owned by the start-up. This can create a whole host of problems which are likely to come up when an investor or buyer is conducting due diligence.
Protect your start-up’s intellectual property by requiring all employees to sign proper intellectual property assignment and confidentiality agreements at the very beginning of their employment. At minimum, these agreements should include language expressly stating the employee’s rights to the intellectual property that the employee creates during his or her employment. Furthermore, it should include a confidentiality provision, requiring the employee to keep the company’s proprietary information confidential.
These are only some of the issues to consider as you launch your start-up. And if you are in your second or third year of business, and realise you missed a few steps – rest assured that it’s not too late and it doesn’t have to be complicated. Find people with the right expertise to help you identify your legal gaps, so that you can get back to what is most important – building your business.
