One of the first steps you’ll take as a founder is to hire an attorney to incorporate your company - an exciting milestone for all founders - and coincidentally, the first step in potentially eroding control of your business.
Let’s break down the standard start-up modus operandi: You come up with a world changing idea and decide to pull the trigger and pursue your dream – you first step is to make it official and incorporate your business. While you could do some of this work yourself, you’re better served by using an attorney for the essentials, specifically:
- Articles of Incorporation – will you want to be an LLC, B-Corp, C-Corp, etc.? Do want to incorporate in your home state, or in Delaware for legal, liability and, tax benefits?
- Your employment agreement and restricted stock purchase agreement – these are critical, as they will include your ongoing rights as an employee (once you formally incorporate your company, you are employee from day one - it doesn’t matter that you started it), your equity vesting and more. These become even more important if you have partners/co-founders. Upfront, you want to set clear expectations on what will happen if one of you leaves the company or has a breach of duty/service.
- Employment and contractor template agreements – these will allow you to hire new team members as employees or contractors – the obvious first and critical elements needed to start developing your new product or service.
If you’re well networked, one of your friends or a prospective investor may recommend a start-up attorney – the primary players in this space are Cooley, DLA Piper, Fenwick, Latham and Watkins, Perkins Coie, Pillsbury Winthorp, and Wilson Sonsini.
Here within lies the problem: in addition to representing founder’s companies, each one of these law firms represents investors, as well (each of the links above redirects to the mentioned firms respective investor practice). These firms’ representation of both Founder and investors represents a massive conflict of interest that can hurt Founders for the entirely of their tenure, and potentially shorten it significantly, as well.
Between the two companies I have founded and the dozen I advise, we all have used at least one of the mention attorneys referenced above – And time after time I have witnessed the squandering of Founder’s opportunities to incorporate controls into their businesses upfront that give them significant benefits and leverage through their tenures and beyond by these firms – most of which are impossible to implement later. Let’s deconstruct this:
Incorporation
When typical start-up attorneys are assisting Founders with incorporate their companies, they generally are only allocating a single board seat to the founder (as the common stock representative).
This approach kneecaps Founders from day one. Founders with a single board seat can be outvoted by their board as soon as a single investor and independent board member join their board. This means they can be fired and removed from the company that they started – something that happens all too often. This is the reason that nearly half of all Founder’s being fired after their Series A financing according to the Founder of Sequoia. Brutal and preventable.
Stock Issuance
During incorporation, attorneys will also work with founders to setup their company’s capitalization structure – the number of shares initially outstanding, the number of shares in the employee pool, and share allocation and vesting to the founders.
In nearly all cases, these attorneys are allocating Founders with common stock. The issuance of common stock only prevents a Founder from seeing any liquidity in a downside scenario. For example, if a Founder raise $100M over the course of the company’s tenure and later sells for less than the total amount the company has raised (for example, let’s say $80M), the Founder will receive nothing – even if they have worked on the business a decade of their life. That’s because the investors have preferred stock, which allows them to get their money back first in this scenario.
To mitigate these issues, there are numerous controls that Founders have the opportunity to include during the incorporating process. Prime examples are:
- Making Founder board seats irrevocable
- Adding additional (placeholder) common seats to the board to balance out future investor seats
- Issuing class FF shares to Founders for more flexible liquidity (selling of the founder’s shares)
When I speak to Founders for the first time, I always ask them about these questions – in nearly every case their attorneys have never mentioned these options to the Founders They just gave them the boiler plate incorporation documents and sent them on their way.
Founder Employment Agreements
As with the incorporation documents, Founders are generally significantly under protected in their employment agreements, and many cases they do not even have one.
Think about the situation where you are hiring a seasoned executive – they would want a severance package, performance bonuses, and other protections. As the Founder, you are an executive at your company and you are entitled to similar, robust mechanisms and protections to cover your interests - after all, you started the company.
Pragmatic protections for Founders in their employment agreements include:
- A severance package including cash and vesting acceleration in the case you are terminated
- Periodic raises based on performance and the revenue/fundraising stage of the company
- Bonuses at successful completion of each financing round
- A cure clause in the case that the board wants to terminate you
- Clear definitions for ‘firing for cause’
- The ability to transfer your equity to a family member or in the case of death
- Extended exercising on your option vesting
Critical in implementing your employment agreement is recognizing that the attorney you hire to incorporate the company is the company’s attorney and not your personal attorney. They represent your company and are not your advocate. The negotiation of your employment agreement should be between you and your board, not you and the company attorney. The company’s attorney should never be drafting, redlining, or approving your employment agreement.
You should retain your own employment attorney and have them walk you through the controls that will best protect your interests. I have a robust agreement that I have designed with my attorney that protected my interests at my last company – it was a prudent investment.
Term sheets
Receiving a term sheet is an extraordinary milestone for every Founder. When you receive the termsheet, you will review it with your company attorney. You will work with your attorney and your potential new investor to negotiate a few key terms – valuation, employee pool, and board structure.
From there, most Founders let their attorneys take the lead to negotiate the fine points with the investor’s attorneys. The process can be black box and the output are the investment documents – these are generally 50-70 pages for series a financing, for example.
The problem is that embedded in these documents are a number critical items that can impact you and the company, such as a co-sale rights and blocking rights – these can be incredibly gnarly terms that can hinder your ability to get liquidity (sell your personal stock with autonomy), raise more money, and even make a decision to sell the company.
Founders need to run their companies and are never in a position to review these documents personally – but after all, that’s they are paying your attorney $1,000+ an hour – to protect your interests.
There’s a deep reason that the large firms do not represent Founder’s in a stronger way --
Because it will alienate investors, who may no longer chose to use them – And at the end of the day, investors drive more in billables through deals they do across their portfolio than your start-up. One of the reasons these mediocre terms are “market” is because you don’t have the fortitude to negotiate assertively for. There’s a major opening in the start-up space right now for a law firm that’s truly Founder centric with no ties or conflicts to investors – I hope someone fills this void soon.
A final note – if you do not feel that your corporate attorney is representing your best interests the solution is simple – get new counsel. When I was running my first company, I felt like we were embedded with my attorney – I'm not sure what drove this narrative – But simply wasn’t the truth.
If you’re seeing flags with your attorney where they are not negotiating aggressively in your favor and willing to fight for terms that protect you or they seem too aligned with your investors, the solution is simple, let them go. If you’re the CEO, you can do this unilaterally without board permission. Know that the services that most of the mentioned firms provide are truly commoditized and you can move to a new one overnight without skipping a beat.
