Startup Law 101 Series – Common Mistakes That Founders Make – Ill-Documented Relationships

Nothing creates more grief for an early-stage startup than an ill-documented relationship that goes wrong. This 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 what is being done 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 the vast majority of situations do come out fine even though the founders assume legal risk when they fail to document.

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 risk associated with ill-documented relationships, 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 through adversity. And those who are fair-weather 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 will therefore cost you dearly to settle up 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.
  3. Watch out especially for those who quarrel constantly, or who always insist upon their own way, or who abuse others even in little ways – you will not be immune from such treatment if it is in the basic character of a person to act this way. In such cases, at the very least, 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 contracts will not help you when you deal with an inveterate abuser.

Your biggest risks in ill-documented relationships is (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.

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 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. Don’t rely on verbal assurances only. You will come to regret in that minority of cases where the ill-documented relationship will indeed come back to bite.