Founders are encouraged, incentivized and pressured to begin transacting with customers as quickly as possible to drive growth and revenue. But making legal mistakes early in the game can create costly liabilities down the road.
That’s why we invited James Alonso from Magnolia Law and Adam Zagaris from Moonshot Legal to join us at TechCrunch Early Stage to give us a 360 overview of the legal side of running a startup. We’ve shared highlights from their presentations below, along with a video of the entire panel discussion.
Corporate law 101 for startup founders
James Alonso gave us a presentation on company formation and getting funding. Maybe you’ve already created your startup, but if you’re still working on your own and don’t have any clients or employees yet, these tips are essential before you get your startup off the ground.
When you’re setting up a new company, it forces you to have a discussion about capital structure — who owns shares, how many shares and what kind of shares. There isn’t a single way to design a company on this front and we’ll look at some options later in this article. And because you’re starting a startup, you want to structure your company in a way that makes future financing easy.
Setting up a company also lets you put your IP in a single entity that you’re sharing with other shareholders. “One of the key things you’re doing when you’re forming a company is assigning the IP related to that company into a single entity that holds it all,” Alonso said.
Control of a company
There are many misconceptions about the control of a company. In a traditional company, there are three groups of people: officers (CEO, CTO, etc.), a board of directors and stockholders.
You might think that the most important group in this list is officers — but it’s the complete opposite. “This is a cascade, the ultimate authority in the company are the stockholders because your stockholders elect the board members. And the board’s main job, other than having bimonthly meetings and talking about the company a lot, is choosing who is the CEO, appointing the officers,” Alonso said. If you only have issued common shares between you and your co-founder, the person who has more than 50% of shares can elect the board, and the board elects the CEO.
It’s really, really hard to actually implement a true 50/50 split among co-founders James Alonso
This seems obvious when you think about headlines covering late-stage startups. Board members decide to replace the CEO because they’ve been doing a poor job, or stockholders think a company is not managed properly so they get together to attract enough voting power to replace board members.
“As a result, it’s really, really hard to actually implement a true 50/50 split among co-founders as people often request,” Alonso said. It’s easier to talk about it from day one and design the company so that one of the founders has more shares (i.e., more voting power on the board and eventually more power as an operating officer).
That’s the right time to think about vesting as well. It protects the most committed co-founder to make sure everybody remains on the same page. Four-year vesting with a one-year cliff is pretty standard.
Issuing shares
Most startups only issue common stock. Some companies choose to create founders preferred stock. Even fewer companies choose to create dual-class stock with more voting power for some shareholders (Zuckerberg-style stock).
“There’s been a lot of ink spilled about different tax advantages you can get by adopting some founders preferred stock. It helps in a limited case when you’re doing a secondary sale down the line to sell some of your shares to investor,” Alonso said. “It’s something that any lawyer should be able to implement for you if you want to do it but it does add a little bit of work to the formation. I’d say one in five companies that we have worked with have asked for that.”
When you create a company, you authorize shares and then you issue a portion of those shares to the co-founders.
Deciding how many shares to authorize doesn’t really matter. It’s an arbitrary number and the value of each share is going to go up and down with your company’s valuation. You don’t want to create a company with 10 shares as each share is going to be worth a lot of money and it’ll look funny in a term sheet.
“It’s calculated based on conventions to get you to a normal-looking price per share,” Alonso said. But it can be 10 million, 20 million or a number around this range.
Similarly, deciding how many shares to issue is arbitrary. As long as you keep the right ratio between co-founders and you keep an excess buffer of unissued shares, you’re fine.
The goal here is to create a boring company. You don’t want anything to stand out when a VC firm looks at your legal documents. You don’t want to slow down processes with complicated legal terms.
“When we get to Sequoia writing you a term sheet or lawyers at Hooli reviewing paperwork, I want their eyes to glaze over and say ‘Yes, this looks normal, this is good, this is a normal company, no mistake has been made.’ Nobody has ever achieved a huge exit because of innovation on their corporate formation legal work,” Alonso said.
Overall, you should pay around $2,000 for company formation. Don’t overpay for that process as a good lawyer is not going to charge a lot of money for that process. They expect more work down the road.
And that’s it from James Alonso. You can watch his full presentation at the bottom of this post.
Drawing up your first contract
Adam Zagaris followed up with a presentation about the other side of the coin — commercial contracts and managing transactions. It’s also incredibly important to have the right framework in your head when you’re entering contract negotiation.
“Commercial contract is a very broad topic. It ranges anywhere from customer agreements, to vendor agreements, nondisclosure agreements, marketing deals and affiliate deals, engaging contractors, etc. It’s a very broad topic,” Zagaris said. “What I thought I would do here is try to provide you with a general framework to think about commercial contracts.”
The primary issue for startup companies on the commercial contract side is getting customer deals done when you’re sitting across the table from a larger party Adam Zagaris
But, as a startup, chances are you’re going to sell your product to much bigger organizations. They have huge teams of lawyers and they generally want to come up with a perfect contract. You probably just want to sign a contract that is good enough as it’ll take a lot less time.
“The primary issue for startup companies on the commercial contract side is getting customer deals done when you’re sitting across the table from a larger party,” Zagaris said.
There are six things that you need to think about when you’re approaching customer deals with larger organizations: goals, leverage, business terms, legal terms, risk tolerance and customer contracting processes.
Determining goals and your leverage
There are many motivations behind a deal and you should never forget about your own motivation. “Determine what is my overarching goal in getting this done. It’ll inform how you approach the deal,” Zagaris said.
You could be doing this deal to get revenue but it could also be a proof of concept. It could also be a strategic deal — cross-licensing for instance. Or maybe you’re just trying to close a small deal in order to get your foot in the door and close bigger deals down the road.
“For example, if something is a 30-day evaluation or a proof of concept, you may likely not negotiate that deal as hard as you’d negotiate a broader long-term relationship,” Zagaris said.
You’re entering a long process and you have to identify your main point of contact and change your message based on that. It’s not the same thing when you’re talking to the IT department or the sales department. And you have to understand the personal motivations of the person you’re interacting with — maybe they have a spending budget, maybe the CEO already said that they need your product.
Legal and business terms
Without going into industry-specific cases, there are some do’s and don’ts. In general, you want to avoid over-lawyering to get deals done. But don’t forget that you usually have less leverage.
“Determine what are the terms and conditions that I must have, what are the terms and conditions that are nice to have. To that, I apply a 25% rule. When you’re negotiating in a position with less leverage with a larger organization you won’t get everything you want. So the goal is to make a prudent markup of any legal and business terms and conditions. Always overmark an agreement, always ask for 25% more than what you really want,” Zagaris said
Some of the business terms you have to think about are fees and payments, termination rights, limitations on business (noncompete agreements), deliverables and milestones, service levels, information security and insurance requirements.
“One practice tip that I would say is that when you’re starting out and you’re working on software or a SaaS company … if you’re providing some sort of product or service that has support and maintenance involved, come up with your own support and maintenance terms, come up with your own service level documentation,” Zagaris said. “Work with your attorney on that, you’ll find that it pays off in spades. Why? Because if you don’t have your own support terms and service levels, your customers will come to you and ask you to agree to their support terms and their service levels, which will inevitably be long documentation that is very difficult to comply with.”
As an entrepreneur, you should decide early on what kind of risk tolerance you want in an agreement. You’ll have to negotiate limitations on liability. You may have to pay some indemnity if your customer is sued. Once you understand your risk tolerance, you can negotiate the most important terms and get the deal done.
As you can see, it can become complicated really quickly. So you want to make sure you don’t end up in a corner. You might not be able to solve all those issues without a lawyer, but now you know the issues that surface often when you’re signing a contract.
If you want to learn more, watch the full presentations from James Alonso and Adam Zagaris:
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