The venture capital process is daunting to many entrepreneurs, particularly those with limited business experience or exposure to the legal regime governing business. Mistakes, disorganization, or unnecessary complexity in your startup can frighten off investors, be costly to clean up, and run you afoul of the law. However, understanding a few simple principles can keep your company running smoothly and facilitate the financing process. While your attorneys and other professional consultants will have additional advice, following are several pitfalls entrepreneurs may encounter as they progress from formation to financing.
1. Keep It Simple. Investors prefer to work with familiar structures, so avoid complicated or uncommon structures for your startup. Unless compelling tax or other reasons lead you to form a limited liability company, the most common start-up structure is a “C corporation.” In fact, if you don’t start as one, a subsequent investor may force you to convert into a C corporation. This structure works well with stock option plans and is unencumbered by many restrictions that limit other entity forms. Similarly, keep your other organizational documents (bylaws, stock option plan, board resolutions, etc.) as simple and standard as possible.
2. Paper the Equity. Settle ownership allocations among you and your co-founders, and memorialize them with stock purchase agreements. All co-founders also should consider entering into a shareholder agreement that provides, among other things, that if one co-founder (1) resigns, the others can repurchase her stock at its original cost, or (2) tries to sell her stock, the others (or the company) have a right of first refusal on the transfer. This avoids the potentially ugly scenario in which a big block of company shares sits in the hands of a retired founder or stranger. Founders frequently ignore this at the outset only to regret it later when relations sour between them.
3. Keep It Clean and Organized. Keep a well-organized, comprehensive set of corporate records. For a C corporation, that generally means (1) a minute book, containing all of the company’s board and shareholder resolutions and its charter documents; (2) a stock transfer ledger with copies of all stock certificates and details on each issuance or subsequent transfer; (3) a complete capitalization table; and (4) a diligence packet, with all other company agreements, arrangements and documents. Investors and their lawyers almost always “diligence” a company before investing and will want to see all of these materials. If you cannot provide accurate, up-to-date records in response to a diligence request, the lawyers will spend time and money ensuring that everything is correct and, if necessary, cleaning up inaccuracies. In some circumstances, the deal might even fall apart.
4. Don’t Wait to Talk to Your Lawyer. A good lawyer can prevent a bad deal. All too often a founder eagerly meets with investors, cuts a deal, then hands the resulting term sheet to her lawyer to paper the deal. While this could be the founder’s first financing, many investors are experienced, savvy, and have negotiated countless investments, so by the time the term sheet is completed, it may be too late to undo one-sided terms. If brought in early enough, a lawyer can offer invaluable counsel on critical provisions as well as what’s “market,” or standard, for each provision. The same applies to negotiating employment and severance agreements, stock option plans, licensing agreements, finder agreements, and almost every other arrangement.
5. Stay Involved. After you enlist the help of a lawyer, stay involved and help move the deal forward. Your lawyer and the investor’s may unnecessarily spend time and money posturing against each other with standard negotiation tactics, trying to win issues or points that don’t concern you. Keep current on outstanding issues and, if necessary, arrange a conference call with you, the investor, and your respective lawyers to help speed the process.
6. Beware the Law. Your attorneys should provide a primer on the statutes that you will likely encounter when running a startup. For example, you will need to register in every state in which you conduct business. If your company is a C corporation, every contract, lease, or other arrangement entered in connection with the business should be in the name of the company, not you individually. In addition, the issuance of stock and options (and perhaps debt) must comply with federal and state securities laws. Consult with an attorney before offering or issuing any securities (even “founder’s stock” or securities issued to consultants and service providers). As your company grows, it may trip other legal requirements, particularly in the area of employment and labor law.
7. Dealing with Investors. Investors may take a large piece of the company, thereby extracting a heavy price for the risk they bear when investing in a startup. They also may impose vesting, transfer or other restrictions on your stock; take control of your board of directors or shuffle certain officers or employees; force accrued salaries to be forgiven; change the business model; and, in general, impose a level of disclosure and accountability to which you are unaccustomed. Conversely, investors bring invaluable business advice, relationships, credibility, and cash. Consequently, you should think about your specific goals and needs before seeking outside funding.
8. Duties of the Board. As the founder of a startup, you will likely wear several hats: director, officer and shareholder. Of these, the “director” position carries the most power and responsibility. Ultimate control over a corporation resides with its board of directors, which determines the company’s management policies. The directors cannot delegate this authority, and they have a fiduciary duty to constantly act responsibly, with care, diligence and in the best interests of their shareholders. Certain corporate activities, such as the sale of stock, require board of director approval. In addition, as a director you must avoid activities competitive with the company and follow certain procedures when engaging in transactions with the company (for example, personally making a loan to or from the company).
9. Protect the Company’s Rights. Aside from your management team, your startup’s most valuable asset may be its intellectual property including its technology and brand and investors will be particularly concerned with what measures you have taken to protect these proprietary rights. Early on, you should register a web domain name, complete a trademark search, file your trademarks and service marks, and apply for patents covering your technology and (potentially) your business processes. Each additional protection you implement will help to push your company’s valuation higher.
10. Stay Prepared and Flexible. Finally, it is crucial to be self-critical to assess the limitations of your management team and business model, keep them both tightly and aggressively focused, and stand ready to make changes. By thoroughly understanding your customer, your market, and your competitors both existing and potential you can anticipate the questions investors will pose and be prepared to answer them.
Robert Haymer is a partner and Eric Zabinski is an associate in O’Melveny & Myers’ Century City office.