Most Startups are so focused on hustling, launching their ideas or courting investors, that they neglect a major determining factor of their success story – the legal part! Often, the thinking is “we will cross that bridge when we get there” not realizing “there” is best sooner than later. Those legal agreements, as boring as they are, may cost you greatly if not tackled head on at an early stage.
Here are 5 common legal mistakes founders make that usually become thorns in their sides, later on:
Failing to incorporate early enough
Whilst a single founder may be able to get away with not incorporating a legal entity early enough, I dare say this is a NO-NO once there is more than one founder and for the Nigerian Startup scene, I would add once, the idea has materialized, i.e. there is some level of adoption or followership.
Reasons for incorporation include:
- All the founders being or owning part of a legal entity helps prevent a “lost founder” springing up later.
- The ability to issue shares subject to vesting, upon incorporation, prevents a co-founder who has not stayed the course from holding the same equity interest as those who stayed through.
- Ability for founders to assign Intellectual Property (IP) rights to an entity separate from them.
Choosing the wrong legal entity to begin with
From the reasons proffered above, you have probably guessed correctly that the preferred legal entity for startups is a limited liability entity. This is so that the entity’s liability is separate from the persons forming the entity. Should the entity become liable for any wrong-doing, the liability of the shareholders or partners (founders) is limited to their equity holding/participation in the company.
For profit making ventures in Nigeria, the limited liability options are few, they are: the limited liability company (LTD), the public limited company (PLC) and the limited liability partnership (LLP) (which is only available in Lagos State). The most commonly used of all three is the LTD which is preferred to the PLC because it has less reporting and disclosing obligations; it is also more convenient than the LLP where you must have a minimum of 1 General Partner who has no limited liability.
Failing to enter into a Founders’ Agreement (on time)
This is arguably the greatest mistake founders make. Most times, when founders start off, they are in utopia. However, as can be seen from the experiences of Facebook/Winklevoss Twins, Snapchat/Frank Brown and Twitter/Noah Glass, at some point, this bubble will likely burst. As such, it is best to prepare for this eventuality beforehand.
The Founders Agreement addresses issues such as contributions, IP assignment, splitting the equity pie, vesting of ownership interests, roles and responsibilities, decision making, voting especially when investors come in, exit and death. It also addresses other issues specific to each founder relationship.
No vesting provisions
Very related to the issue of not having a Founders’ Agreement is the failure of founders to vest ownership interest. It is not advisable that founders come into ownership of their entire interest at the beginning of a startup. Usually, this becomes a problem when a co-founder jumps ship early on in the relationship. Having not laboured as much as the other founders who stayed the course through, this runaway co-founder may become entitled to the same benefits as the other founders when the startup becomes successful.
However if a vesting schedule exists, (usually with a cliff year), a runaway co-founder may not have any interest or less interest as compared to the founders who continued with the startup. Because vesting is not expressly provided for under Nigerian law, many shy away from it. However, vesting is a commercial consideration that can be enforced in court like any other contract term once all the parties to the contract are agreed to it being a term of their contract.
Not hiring a lawyer or waiting until you need a (startup) lawyer before you hire one
The notion that legal issues can be solved when they arise and waiting until there is an actual need for a lawyer before hiring one is a costly mistake, literally. What happens at this time of need is that you either hire the “most” available lawyer to you who may be a friend, uncle or aunt who has little or no knowledge of startup issues or you hire a lawyer recommended by your investor who of course will dance to the tune of (s)he who recommended him.
Whilst corporate and commercial law may seem specific enough to think any corporate lawyer will suffice, startup and entrepreneurial issues are unique and you need a specialized lawyer with an understanding of startup issues to watch your back.
The above is by no means an exhaustive list of mistakes startups make, other mistakes include shoddy incorporation and allocation of shares, employee/consultant engagement related ambiguities, insufficient due diligence on prospective investors, etc. However addressing these 5 issues is a step in the right direction.