By Idan Bar-Dov and Omer Goldberg
Be it software, hardware, or firmware, entrepreneurs focus on their company’s core product. While this focus is key, too much can lead to tunnel vision. What is usually sidelined is the legal work.
Too often entrepreneurs delay legal until absolutely required, and create a mass of unnecessary risk, for themselves and the company alike. Though perceived as complicated, legal it must be engaged with as early as possible.
The purpose of this piece is to familiarize you with the essentials, to demystify complex legal terms and clarify key issues usually encountered when starting your own company.
Though we intuitively understand what a company is, its legal definition is quite different from what we know.
There are different kinds of companies. However, in the context of the startup world, when someone says “I just started my own company”, it usually means that they have incorporated a private for-profit organization. In other words, it’s a privately-operated legal entity intended for financial gain.
Legally speaking, a company is independent. It can enter into agreements, assume obligations, and be held accountable for its actions. Incorporators may share a great deal of interest with their company, but legally they are notthe company. The employees, founders, board members, and even the CEO are all a part of the company, but combined do not equate the company itself.
Nevertheless, companies are run by people. Like a ship, steered by the captain and crew, companies are led by their Board of Directors and operated by the people who control the “Company Organs”. These include shareholders, directors, officers etc., who affect the decision-making processes at their different capacities.
Company Incorporation and the Corporate Veil
Founders are usually the individuals who “give birth” to the company. They fill out the paperwork, pay the incorporation fee and sign the relevant documents.
In this context remember the following rule of thumb: No Registration = No Incorporation!
Namely, that company registration must be approved by the state.
The main benefit of incorporating is gaining a distinction between individual and company — a.k.a. a “corporate veil”. As separate legal entities, companies are accountable for their debts and obligations, as opposed to the individuals who operate them. In other words, each individual’s contribution marks the limit of their potential financial risk. Hence the term “limited liability company”.
However, the veil’s protection is not absolute. In certain cases Individuals may be held personally accountable for their actions. For example, when using a company for fraud, illegal actions, or to circumvent existing obligations.
Equity, or Company “Currency”
Crash course definition: equity = holdings, owning a chunk of the company.
When founders say equity they usually refer to shares. This is the company’s “currency”, which entitles its holders to certain privileges, such as financials, control, and information rights.
There is no gold standard in dividing equity between co-founders, it’s subject to discretion. Founders may be equal equity partners, divide the equity based on their skill and contribution to the company, etc.
Preparing for Founder Departure
Once equity has been issued, a founder’s reason of departure won’t matter much. They are already an equity owner — it’s theirs, no turning back.
Such a departure may generate “dead equity”. Shares which are held by a founder who is no longer involved with the company. This creates an involvement-equity mismatch, which has negative impact, especially on the company’s fundraising front.
The solution is defining the founders’ relationship upfront, by entering into a Founders Agreement. A departure case must be addressed before it occurs, preferably even before incorporating. Think of a Founders Agreement like a prenup, which obviously should be signed before getting married.
Equity-wise, it is customary to include a “vesting schedule”, which determines the founders equity eligibility. The purpose of a vesting arrangement is to incentivize founders to remain engaged with the company and diminish any involvement-equity mismatch.
A standard time-based vesting schedule will specify that if a founder leaves before date X, then he will give-up Y equity. For example, in a linear 3-year period vesting schedule, if a founder leaves after 1 year, then he gets to keep ⅓ of his shares, and has transfer the other ⅔ to the remaining founders. It’s a quid pro quo arrangement: work = equity.
Top Takeaways for Entrepreneurs
1. Don’t procrastinate — Even it seems dull, take care of your legal foundations from the get go and don’t wait until it’s too late.
2. Expectation Management — Defining the Founders’ relationship early on helps all founders see eye to eye.
3. Attracting Investors — Even if your product or tech is extremely impressive, a neat legal duck is always a plus. It conveys awareness and shows investors you’re sincere, organized and devoted.
4. Prevention is the best medicine — Building a company is an intense endeavor, and it can bring out a drastically emotional side of you. So set up defense mechanisms before taking-off with your team, when everyone is as clear-headed and calm as possible.
Idan Bar-Dov is an Associate at Pearl Cohen’s Hi-Tech Group. Idan’s practice focuses on the representation of investors, tech entrepreneurs and emerging growth companies.
Omer Goldberg is a Software Developer and Entrepreneur. Omer works as a software engineer and recently graduated from Y Combinator’s Startup School with his current venture Mindflow.ai.
Disclaimer: The content herein is intended for informational purposes only and does not constitute legal advice, nor does it create any attorney-client relationship.