Top Ten Legal Mistakes Made by Entrepreneurs
"I've heard many war stories," says Harvard Business School associate professor Connie Bagley, reflecting on conversations with former students who have started business ventures. To prepare current students for the HBS Business Plan Contest, Bagley gives a seminar in which she shares these war stories with the prospective entrepreneurs, in the form of a list of "top ten" legal mistakes often made by the unsuspecting. In addition, Bagley teaches the second year elective course, "Legal Aspects of Entrepreneurship," which covers the waterfront of issues typically faced by entrepreneurs in starting and running a business, including securities and intellectual property law issues.
Bagley's teaching and research focus on legal aspects of entrepreneurship and corporate governance. Before coming to HBS in 2000, she taught at Stanford Business School, and prior to that she was a corporate securities partner in the San Francisco office of the law firm of Bingham McCutchen. She is author or coauthor of several textbooks, including the just-published second edition of The Entrepreneur's Guide to Business Law.
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Bagley recently met with Harvard Business School's New Business magazine, and talked about the legal issues commonly faced by entrepreneurs, as well as her thoughts on how to successfully deal with them.
In Bagley's view, there is a tendency on the part of many entrepreneurs to think that the lawyers can handle the legal issues and to delegate too much to the attorney.
"While the language of the law can be intimidating, the concepts are usually quite straightforward," she says. "Lawyers tend to be risk averse, and if you delegate to them you will usually stay out of legal trouble but can often compromise your business objectives. My goal for the course—and for the coaching I give entrepreneurs—is to give them sufficient comfort with the legal concepts to feel confident in driving the process, to understand the ways in which the law is a constraint, but also the ways in which it is a tool that can help you create and capture value."
# 10: Failing to incorporate early enough.
One problem that arises here is the so-called "forgotten founder": a partner involved in starting the venture subsequently drops out. When the venture gets financing or is ready to go public, this partner returns, perhaps with an inflated view of what his or her contribution was, demanding equity. This problem can be eliminated by incorporating early and issuing shares to the founders, subject to vesting. As partial consideration for their shares, each founder should be required to assign to the new corporation all inventions and works related to the company's proposed business.
Incorporating early—before significant value has been created and well in advance of any financing event that establishes an implicit value for the shares—also helps prevent potential tax problems for "cheap stock." Incorporating too late, and issuing inexpensive stock to the founders at the same time that much more expensive stock is being sold to investors, can create tax problems when the IRS argues that the difference in stock price is actually income to the entrepreneur.
# 9: Issuing founder shares without vesting.
Simply put, vesting protects the members of the founding team who take the venture forward. If people remain on the team and are productive, their shares will vest. If they leave earlier, that stock can be retrieved and given to whoever is brought in to replace them.
#8: Hiring a lawyer not experienced in dealing with entrepreneurs and venture capitalists.
Many venture capitalists say that they often rate the judgment of entrepreneurs by their choice of legal counsel. Lawyers who have no experience working with entrepreneurs and venture capitalists will most likely focus on the wrong things while failing to recognize some of the more subtle potential traps. It's better to hire someone who has played the game, who knows what's standard and what isn't, and who will get the deal negotiated and closed promptly.
#7: Failing to make a timely Section 83 (b) election.
If the advice in #9 is followed, then shares will be issued, subject to vesting, to the founders as well as new employees. If stock is acquired and it's subject to what the IRS calls a substantial risk of forfeiture, then the IRS doesn't view the purchase as being closed until that risk goes away. When the stock vests, that risk evaporates, so the IRS considers the deal closed. The IRS then calculates the difference between the price paid at the outset and the fair market value at that later date, then taxes this difference as ordinary income. An 83 (b) election allows the tax computation to be made based on the value at the time the shares are issued, which is often pennies per share.
# 6: Negotiating venture capital financing based solely on the valuation.
Valuation is not the only thing one should consider when selecting a venture capitalist or when negotiating the deal. There are many other ways for venture capitalists to get compensated if they end up paying a high price for shares. These include requiring participating preferred with a high cumulative dividend, redemption rights exercisable after only several years, and ratchet anti-dilution protection with no cap.
One must ask, what's the reputation of this firm? Do they have a history of standing by the entrepreneur if the entrepreneur stumbles? Do they have good contacts in the industry? In trying to build alliances, do they know the big players? A no-name firm offering the highest valuation is often not the best source of equity.
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