Startup Law 101 Series – Mistakes Founders Make – Ill-Documented Relationships.
Nothing creates more grief for an early-stage startup than an ill-documented relationship that goes wrong. Failing to document properly is by far the most common mistake founders make when setting up their companies.
The problem is a natural one. Things are loose and informal at the start, and no one knows for sure that the company will have value. It often makes no sense to founders to invest in lawyers to document things at that stage.
It is also true that many founders do just fine dealing informally with one another while awaiting the stage at which they feel it necessary to do formal documentation. In my experience working with founders since 1984, I would say that most situations do come out fine even though the founders assume legal risk when they fail to document. But those that don’t can and do lead to serious problems and so the issue is an important one.
So what is the answer?
Well, the obviously safe course is to hire a lawyer early, set up your entity, do your founder grants, put the IP into the company, document your service relationships with the company, and concentrate on building value into your properly documented startup.
If you choose to assume the legal risks associated with ill-documented relationships during the early stage, here are some guidelines for those of you who are doing your first startups.
1. Fair-weather friends abound. Be careful with any relationship until it has been tested. Those who are fair-weather often will not hesitate to make opportunistic claims if the circumstances favor them. Don’t get caught on the short end of such claims – a lawsuit is often lethal to an early-stage startup and it may cost you dearly to settle such claims.
2. Don’t let people do “favors” for your company unless you really trust them. Someone working in exchange for a straight payment has little or no basis for a legal claim as long as the payment is made. Someone working for little or nothing, though, can claim that the work was done in exchange for promised equity in the company. The claim may be bogus, but you are inviting it in such cases. If you do have such an arrangement, document what it is about in some kind of writing. If IP is involved, see a business lawyer and make sure the IP will belong to the company (you need a “work-for-hire” contract in this case).
3. If you see obvious signs of bad character, get everything in the arrangement formally documented as soon as practicable. Better yet, jettison such relationships whenever possible, the sooner the better. Even iron-clad documentation will not help much in such cases. It might sound trivial to say it but I have marveled at the number of times I have seen founders look the other way in hopes that a troublesome person will add enough value to offset the risks he brings to the company. Occasionally, this might prove true, but count the cost. Many a company has been dashed against this rock and ruined.
Your biggest risks in ill-documented relationships are (1) that someone will claim an equity interest in your company that you never intended to give, or will claim a much larger one than you intended to offer, and (2) that someone will claim rights in your company’s IP that you never intended to give.
The flip side of all of the above can happen as well. What if you are asked to do work for a startup in exchange for equity and you slave away at it only to get the jarring news later that no such promise was ever made. Without documentation, you are likely stuck. Yes, you can bring a legal claim but, for most people, this is a losing direction.
Again, the best advice is to go to a good business lawyer and get things documented properly early in the process. If you can’t do that for some reason, at least use less formal mechanisms to make clear what is intended by your arrangements. A simple, signed letter of intent stating your general goals, for example, and reciting that no promises have been made about equity (or the converse, if that is the case) will at least help curtail the most flagrant claims. If you can’t get others to sign off on a writing, at least try to document your intentions through email exchanges and the like – these offer only the thinnest of protection but are better than nothing at all. Don’t rely on verbal assurances only. You will come to regret this in that significant minority of cases where the ill-documented relationship does indeed come back to bite.
Founders often make the mistake of waiting too long to set up their limited-liability entity. Review the guidelines above, get your questions straight, and work with a knowledgeable business lawyer to make the right choice as to timing.