10 Shortcuts Entrepreneurs Should Not Take When Starting a Company
By Robert Giachetti and Mark Higgins
Congratulations - you have done it! You had an idea, you built a product, you figured out how you want to go to market, and you created a company. With that tedious process complete, you are ready to find your first customer, iron the bugs out of your product, and start making money.
With your attention so focused on the challenges on getting your business up and running, it is tempting to lose sight of the long-term goal of enhancing the value of your business at every opportunity. Whether you wish to take your business public, sell to an interested acquirer, or attract bigger and better investment dollars, the actions you take to solve today’s issue can have a material effect on the value of your business in the future. We see it all the time - a client starts a business, does well, and is preparing to exit or finally take on an important investor, when suddenly issues start showing up in diligence. Decisions that the client made in the early days of the business suddenly become a hindrance to getting the deal done.
In this post, we point out ten shortcuts that we have seen entrepreneurs take and we explain why you do not want to go down that same path. These “You don’t want to do that” scenarios have caused deals to stall or fall apart, have caused the parties to renegotiate the economics of the transaction, or have resulted in the entrepreneur carrying additional liability he or she would not otherwise need to worry about.
Shortcut #1: I can be the accountant! Too often, entrepreneurs will maintain their own financial records without any outside assistance, which, in addition to being daunting and tedious, can result in errors that misrepresent the business.
What we recommend: Hire an accountant. The heart of your business is making money and maintaining updated financial statements is important for any transaction. Potential investors and buyers require empirical data regarding your business’ financial health. Well-kept financial statements give such investors and buyers some comfort that they are buying what they think they are buying. Hiring an accounting firm to assist with preparing your business’ financial statements and other accounting needs from the beginning has practical and legal benefits, but engaging one of the “Big Four” accounting firms is not necessary, especially at this early stage. Smaller, local accounting firms are usually more cost-effective and produce a similar work-product for companies at this earlier stage. Your legal counsel will usually have good contacts they can recommend.
Shortcut #2: Granting equity with a handshake. You are probably either a sole founder or part of a small team of co-founders. As your business is quickly growing, you want to properly incentivize your team, new hires, advisors, consultants and the like by giving them a (small) share of the pie with an issuance or grant of equity. Given the rapid pace of business, you leave such issuances and grants to be memorialized by a handshake and a promise to follow up with paperwork in the future.
What we recommend: Document all equity issuances. Did you agree on three percent with a lapsing repurchase right? Was the recipient going to pay with a promissory note? Did you get board and shareholder approval to make good on the handshake? Is the issuance exempt from securities regulations? All of these potential concerns can be alleviated by consulting with your legal counsel in an effort to put the issuance in writing. This has the benefit of making sure that the legal requirements for an equity issuance are met, which gives both you and the recipient clarity on what your handshake was about and ensures that you can deliver what was promised. Otherwise, ambiguity and uncertainty can develop, which can potentially lead to a lawsuit over the terms of the equity grant and even an invalid issuance. A potential investor or buyer will insist that any such ambiguity or uncertainty be resolved before a transaction closes so that the recipient of the equity will not have an opportunity to cause problems (like claiming a bigger stake). Take care of the paperwork now.
Shortcut #3: We can prepare or update the cap table later. Similar to the previous shortcut, uncertainty surrounding equity issuances can cause headaches at the most inopportune times. Each time you grant equity, while you file away the paperwork, you move on to the next task, forgetting to update your capitalization table.
What we recommend: Keep track of the number of shares, options and other equity incentives issued. Options and other equity incentives are usually governed by plans that limit the aggregate number that can be issued. If you start to run against this limit, you run the risk of issuing equity incentives that are over the limit, and therefore potentially invalid. Fixing this issue down the line can have negative tax consequences for equity incentive holders which can lead to disputes. By properly tracking all issuances you can increase the limits under your plan before it becomes an issue.
Shortcut #4. Valuations? Not worth the cost. While your business is still emerging, you may feel like it has nothing more than a name and some gumption with a small dollar value. When you issue options to your employees, you may also feel like the exercise price for such options (or the “strike price”) should be minimal and some nominal value. You finish the paperwork, document the issuance, and go back to working on the dream of the big payday.
What we recommend: Hire an independent valuation firm. For a large variety of reasons, your business (and its stock) is probably worth more than nothing, and such value is discernible (at least to a degree). With that information, your employee’s options can be issued with a strike price that accurately reflects their fair market value. Why is this important? Taxes. If the strike price is not reflective of the fair market value at the time the options are granted, it can have adverse tax consequences. Your legal counsel can guide you through the proper valuation process and 409A valuation safe harbors.
Shortcut #5: I will keep the files in my email server. While making a diligent effort to produce all of the correct documentation and get all of it signed, you decide that the easiest place to maintain such documentation in in your email server, as it is always readily accessible.
What we recommend: Maintain your files in either a data room or in a format from which it is easy to create a data room. Those agreements and other documents you have been “filing” in your email server deserve a better home. In any major transaction, the other party will most likely require your business to create a data room containing requested diligence materials. The data room is essentially a central repository of all the relevant information about your business, which should be organized based on the different legal and financial aspects of your business (e.g. corporate, employment/HR, tax, accounting, material agreements, IP, etc.). Setting up and maintaining a data room in the early stages of your business will keep you organized and save you time and money during the diligence period of a transaction. Moreover, data room providers have flexible fee structures that make creating and maintaining a data room affordable to early stage companies - your legal counsel will usually have good contacts they can recommend. Also, do not forget to keep the documents in the data room themselves current (e.g. contact information for shareholders should always be up-to-date)!
Shortcut #6: The board decided, move on. In your business’ early stages when the board is small and most members of the team have a formal role, it is tempting to get the board’s consensus on an action and then go act, leaving the deliberation and approval undocumented. If the business’ board meets in-person, major decisions can be made quickly and agilely through a quick meeting, leaving no record other than calendar invitations.
What we recommend: Keep records of shareholder and board meetings. What was decided? Who decided it? What was discussed or deliberated? Keeping an accurate record of board and shareholder meetings helps limit any uncertainty or ambiguity in the future. You can appoint a secretary to transcribe meetings or record the session and condense it to minutes shortly thereafter. Also it is important to keep in mind any notice and quorum requirements in your business’ governing documents, because if these requirements are not followed, there is a risk that your board or shareholder actions may be invalid.
Shortcut #7: Who was Jim? Remember that small team you started the business with so long ago? Wasn’t Jim the Treasurer and CFO? When did he leave again? Was it mid-June? He is gone so it does not matter and you move on.
What we recommend: Memorialize changes of officers and directors. The comings and goings of officers and directors can often be hectic, but do not forget to properly document such changes, including with resignation letters and board or shareholder consents (as applicable). Providing a proper trail of who constituted the board and officers of your business can show a potential investor or buyer during a due diligence process that you take the time to maintain accurate business records, while also mitigating the risk of invalid board actions. You should also consult with your employment counsel regarding whether you should seek releases from such departing individuals.
Shortcut #8: We don’t need the employee to sign all of those forms! In the rush of those first days and months, as your business is bringing on its first advisors, consultants, and employees, handling multiple legal agreements to a new member of the team may seem like overkill when you are not even sure your business will survive to next week. You decide to wait to get some breathing room and deal with it down the line.
What we recommend: Have all consultants, advisors, and employees sign confidentiality and invention assignment agreements. These form agreements, while seemingly unnecessary at this early stage, are crucial in maintaining the confidentiality and validity of your business’ proprietary information and assuring that any intellectual property (or “IP”) created by such individuals is owned by your business (and not them). Strategic partners and buyers often look to a business’ IP in making their decision to acquire or invest. It is far easier to show that there is no question as to the company’s ownership of its intellectual property with forms of such agreements executed by all consultants, advisors, and employees, than having to provide comfort to an investor or buyer with indemnification relating to the same. Your employment counsel can prepare a form agreement that will work for all employees to sign at the beginning of their employment.
Shortcut #9. I like the sound of that one. Let’s be Gaagle. You have done it. You have created a disrupting product, and it is going to change the world. Now, your marketing side will give it the right name, even if it is off the top of your head!
What we recommend: Consult your IP counsel regarding brands and material trademarks. IP is a large part of a business’ value. You want to protect your business’ own IP and make sure that you are not infringing on anyone else’s IP. Competitors can bring lawsuits claiming misappropriation of their IP even if you do not think you are stealing their ideas. Further, descriptive or suggestive marks may not be as protectable as you want. Your IP counsel can search existing marks as well as properly register and protect your new marks.
Shortcut #10. “I think we can take this section out of the contract”. You want to engage a new supplier for your business. You have the business terms nailed down and you are ready to sign an agreement and move on, so you take a form contract that your business used in the past, change the names and a few of the business terms, and sign it.
What we recommend: Consult with your counsel regarding significant changes to contracts. What may seem like an insignificant change in an effort to save on legal fees could have significant unanticipated legal consequences. If you are not sure, ask your legal counsel. Forms of contracts are prepared for clients to protect them as best possible. Deviating from a known form of contract may risk losing those protections. Your attorney will be able to analyze and present the risks of your decisions succinctly to help you make the best decision for the business.
At Mintz, we help clients start their businesses and then we help them make sure that they capture every cent of value that they can. Retaining the maximum value of your business requires constant maintenance and attention to seemingly thankless tasks. A quick call or email today and a focus on maintaining good records can save you heartache as you near the finish line of that big transaction.