How Faulty Documentation Can Derail Your Startup

Are you a lawyer to startups, an aspiring entrepreneur or counsel to venture capital funds? If so, you probably have high hopes for your startup, sensing promise in its products and management team. However savvy the CEO and however dazzling the product, your startup can crash, or at least can cause major headaches for you, by doing the following, so steer clear!

1.         Self-Drafting

You wouldn’t save a few dollars by doing surgery on yourself; you’d leave complex medical procedures to a doctor with years of education and practice. Nor would you do complex home renovations by yourself. However, plenty of non-lawyers in startups engage in the risky practice of “self-drafting”: preparing complex legal documents themselves. The results can be catastrophic, with legal expenses that far outweigh what it would have cost to have a lawyer draft documents right the first time, and delayed transactions that put a company’s finances at risk.

For example, some startups issue equity to advisors and employees by self-drafting stock option documents. The result? Documents that contain imprecise descriptions of the equity issued, equity valuations that lack adequate support and wrong dates. The risk? IRS audits and penalties, claims by equityholders for larger amounts of stock than intended and frustrated investors.

Other startups self-draft complex agreements specifying how relationships between founders should be governed. The result? Documents with unclear language that is open to dispute, sometimes resulting in expensive claims by one founder against another if there is a falling out.

2.         Side Deals

Venture capital investors make investments that have consistent structures, with terms varying only within a range of acceptability. If you’re tempted to strike a deal with someone such as a key advisor or employee or customer, particularly involving your startup’s equity or intellectual property, think twice, since the deal might not fit in the framework with which venture capital investors will be comfortable.

For example, if you promise an advisor the right to maintain his or her percentage of equity ownership in your company or if you promise a business partner the exclusive right to use some intellectual property, the results can be costly. Before engaging in side deals or promising equity or specific equity terms to anyone, call a lawyer and ask how venture capitalists will respond in the future.

3.         Sloppy and Missing Paperwork

When a venture capital fund is ready to invest, a key part of its process before funding is due diligence; it and its counsel will want to see, among other things, that your company owns its intellectual property, the equity ownership of your company is clear, terms of indebtedness are clear, board and stockholder approvals have been documented and tax filings have been made.

All of these items should be carefully documented as time progresses and transactions occur; you shouldn’t wait to document them until just before a financing round. To maintain relevant documents, it is best to keep a corporate minute book with complete documentation in it. All documents should be fully signed and correctly dated; all board and stockholder consents should have the correct exhibits attached; and documentation should be organized. Your lawyer should take a look through your minute book, if he or she doesn’t keep it in the office, and straighten out any sloppy and missing documents well in advance of a financing round. Otherwise, your financing round will be delayed, your prospective investors will question your professionalism and expensive mistakes can occur.

Given the expense, headache and other problems that can arise from engaging in the risky practices described above, you’ll want to work with counsel all along as your startup progresses. Working with counsel does not have to be expensive, particularly when weighed against the costs of cleaning up the effects of the items described above. You can work with counsel to determine a specific budget for various projects and for specific periods of work.

Even with flawless legal documentation, founding a company is difficult enough; why create extra headaches and costly problems for yourself by engaging in the practices described above?  Law firms that regularly represent startups will understand your financial constraints and can work with you to determine a scope of legal coverage that suits your budget.

More by | Christopher Edwards Christopher Edwards , Law.com Subscriber
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