5 Mistakes to Avoid When Forming Your Startup

Starting a new company can be a daunting task. One filled with apprehension and enough shot nerves to make you pull your hair out. However, there are ways to avoid some of the problems startups encounter by taking a few steps up front in order to avoid problems down the road. Here are five common mistakes you should avoid when forming your startup.

Mistake #1 - Incorporating before determining equity splits

A mistake many founders make at the very beginning is forming a company the moment they have the idea to start a business. After all, it's super cheap and quick online (more about that in Mistake #5) so why not go ahead and get that part done first? While that's not necessarily a terrible approach to take, what many founders fail to realize, and what many online services fail to explain, is that there is a whole suite of documents that must be put in place after the company is formed. Many of the online incorporation services simply do not provide anything other than the incorporation and a set of generic cookie cutter bylaws. A problem arises when the company has been up and running for a while and one founder decides to step away, or one founder wants to break away from the other one, is that founder who leaves owed stock? How many shares? How much work was put in before they walked away or were pushed out?

These questions can be avoided by following all the normal post incorporation steps after that initial filing is done. Assign shares to the founders based upon a predetermined decision you've made and be sure it is set up on a vesting arrangement.

Speaking of vesting...

Mistake #2 - Issuing stock to founders without having a vesting arrangement.

I've discussed vesting before, but it is worth mentioning again....and again....and again, because so many founders still get this wrong. Everyone involved in the company should always be on a vesting schedule based upon them maintaining their work relationship with the company. Most businesses fail within the first few years. Most startups fail, period. For the ones that don't fail and that actually go on to make money, many of the initial members leave the company for various reasons - some of which are very good reasons that have to do with needing a more reliable income or having health related issues. While there are plenty of valid reasons for someone to leave a company, there are very few valid reasons for someone to leave a company a few months in and keep all the shares of stock they were assigned at the very beginning. I had two situations recently that illustrate the importance of this point.

In one case, a set of founders decided nobody would be on a vesting arrangement because they all trusted each other. One left after less than a year and kept 20% of the company. The others continued working on the project and couldn't understand why they couldn't compel him to give his shares back. In another situation, the same thing happened, but in this case the exiting founder was on a vesting schedule. While it was annoying to have to give him 1/4 of his shares even though he was leaving, the remaining founders were grateful they didn't lose even more of the company; and in the end, he earned the shares that he was able to keep based upon the amount of time he worked there, so the company definitely got something out of the short-lived arrangement.

Mistake #3 - Failing to assign intellectual property to the company.

I see this one less and less since tech companies are always in the news and startups are part of regular business discussions now, but it still comes up. Certain intellectual property that gets developed vests the ownership in the creator in the absence of any arrangement. For example, copyright rests with the creator of the work who then has the ability to license or sell that ownership right to someone else. Other types of intellectual property must have the rights established by governing bodies, but it doesn't change the fact that in most scenarios the maker of the thing is the owner of the thing. In a "work for hire" situation, the employer becomes the owner automatically. However, when you are the owner, you aren't necessarily your own employee for a work for hire situation. There are plenty of arguments that can be made regarding who gets ownership in a common law or statutory dispute, but it's so much easier and cleaner to just execute an IP assignment or transfer agreement. In that case, you're making an agreement between yourself and the company that anything you create while doing tasks for the company is automatically owned by the company. I'm oversimplifying a bit, but that's the essential nature of these types of agreements.

Why would something like this matter? If the company is the creator of a super popular app, that app is what gives the company value. It's what brings in money. It's what investors will look at to determine how much a company is worth and how much they're willing to invest. But this only applies if the company actually owns the app and all the IP that went into it - the design, the UX, the UI, the code in the programming, name, logo, etc. Without all of those pieces being owned by the company, all the company really is at that point is a name on the wall and a rented office space in the back of some building.

Mistake #4 - Registering as an LLC instead of a Corporation

I know this one might ruffle feathers, but in the startup world there are very few occasions where a company will actually want to be structured as a limited liability company instead of a corporation. If you plan on either taking minimal or no investment, or you don't plan on giving out ownership in the company to too many people then it's honestly perfectly fine to organize as an LLC. You'll make your accounting life way easier and have almost no corporate governance hoops to ever jump through. But...if you're a startup then you will most likely be looking for investors over multiple rounds of financing and you will most likely plan on offering options to employees or contractors to incentivize them to work for you when you don't have the money to pay market salaries. Don't get me wrong - it is entirely possible to do both of these things as an LLC. It's just really, really clumsy and difficult to do; especially if you have to do it many times over.

When you're a corporation, your investors only need to see a few standardized documents in order to know that everything is in order before investing. When you want to give out equity to employees, there are quick processes in place to issue options easily. Nobody wants to pay their attorney $3,500 to review and negotiate changes to a 55 page operating agreement. So, therefore, investors simply won't invest in an LLC. What happens? You have to convert from an LLC to a corporation and that costs much more than setting up a corporation from the beginning.

Which leads to...

Mistake #5 - Using an online service to set up your company

Don't get me wrong, the actual process of forming a company in Delaware (or any state, really) is super easy and simple. You literally just fax over a form that lists the company's name, number of shares, and some other basic information. Pay your fee and, voila! Instant corporation. But that's only part of the process.

Did you choose the right state of incorporation? Did you choose the right corporate entity? (See Mistake #4 above) Are you incorporating late and already have an investor putting in money for preferred shares and you could've included that in your charter while incorporating, but you didn't so now you have to pay extra and waste time? Do you want to have a separate class of shares for founders? Did you select the appropriate number of shares to put in place from day 1?

These are all questions that a lawyer will lead you down the path of answering while consulting with you. That's part of what you're paying for.

Additionally, there's the post incorporation paperwork that covers vesting of stock, assigning intellectual property, officially adopting the bylaws and appointing the board of directors, etc.

When you use an online service to incorporate, you will quite often not get the post incorporation paperwork. You will almost never get an actual attorney who can give legal advice on whether or not you can do a typical setup or have special circumstances that require something a little different. So you can pay some online service $400-500 and they'll file the piece of paper that you could've filed yourself, and have nothing else done. Or you could pay a few hundred dollars more and have someone guide you through the process, answer questions, customize things for your unique needs and plans for the future - all while establishing a relationship with a person you'll need to rely on many times during the life of your company.

What next?

If you're ready to get your company started, shoot me an email and let's talk about how I can help you get set up and living your entrepreneur dream.

Don't miss these stories: