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Startups: Legal Key Questions between Founders

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Last Saturday, I was triggered by a tweet from @osma (Osma Ahvenlampi) to discuss the most relevant key legal questions for startups. As it in turn triggered several comments, all of which added to the picture, I started to think about collecting the tweets here.

So this discusses the most important legal and relationship questions each startup entrepreneur and founder will need to concentrate on. Preferably sooner than later, in order to move focus forward (instead of the present or the past).

@osma triggered this:

Thanks for all the congrats! This is where the work starts.. cc @metrify @pyryis @KristoOvaska @triekki (@osma, Sat 12 May 13:40)

Based on this and some earlier tweets I assumed the Metrify founders (Kristo Ovaska – @KristoOvaska, Osma Ahvenlampi – @osma, Tuomo Riekki – @triekki, Pyry Åvist – @pyryis) had signed a shareholders agreement (often referred to as a SHA), possibly transferred existing assets to their company, perhaps also formally founded the company. So:

Good to get incentives formalised, clear. Drives work! RT @osma Thanks for all the congrats! Work starts… cc @metrify @pyryis @KristoOvaska (@mvonwillebrand, Sat 12 May 16:21)

@mvonwillebrand yes indeed! Get the home base in shape before the real attack! cc @osma @metrify @pyryis @triekki (@KristoOvaska, Sat May 17:15)

Exactly! RT @KristoOvaska @mvonwillebrand yes indeed! Get the home base in shape before the real attack! cc @osma @metrify @pyryis @triekki (@mvonwillebrand, Sat 12 May 17:33)

“Get the home base in shape before the real attack!” – That’s the whole point. But it begs the question what is the right moment to do so. So:

Startups: One trap for beginning entrepreneurs is to fail in agreeing early, clearly what the incentives, ownership %s are. Slows down… (@mvonwillebrand, Sat 12 May 16:26)

Startups: early incentives for founders are mostly based on ownership %s of a company, so founding formally helps. (@mvonwillebrand, Sat 12 May 16:26 – 16:29)

Startups: then again, its some paperwork. When balancing when to formally found, remember the point on incentive clarity. (@mvonwillebrand, Sat 12 May 16:30)

So the key point here is: founders should agree early on who owns and how much. I have seen many times a startup or development project linger on and on without clear focus. Perhaps a portion of the Finnish nature makes it difficult to speak about money and ownership. But leaving the question on ownership open will slow down your team. Team members’ focus will be distracted by “is this actually my project or his/hers?”.

So with my first point made in a couple of tweets, I was warming up:

Startups: also, all important assets need to be placed in the company, for clarity. And two more important things… #aaltoes (@mvonwillebrand, Sat 12 May 16:32)

Startups: when founding, agree on amounts of work each of the founders are committed to, during the, say, next 6-12 months. #aaltoes (@mvonwillebrand, Sat 12 May 16:33)

Assets? Many times startups have started exploring or operating already prior to formal founding. This means there are rights to the name, domain names, presentations, videos, code, business model proposal documents, client contacts etc. All of these should be transferred to the company. If there are inventions, normally these should also be transferred to the jointly owned company, rather than having some assets remain in the personal name of one founder. The startup could also have some money, or, if not, it is probably in need of money. Founding will require someone to put money into the company too.

The other aspect is work commitments. While bootstrapping with a group of founders it is important to balance the expectations between all founders: will all of us work 100% on this startup, or less, or will someone work full time whereas someone’s role is more like an advisor?

This is clearly legal already, but I have more serious stuff coming:

Startups: And final very important thing: agree what will happen, if one of the founders leaves (share redemption, vesting) #aaltoes (@mvonwillebrand, Sat 12 May 16:35)

Yes, my gut experience says that this will happen to most startups, not just 1 in 5. During the very first years, one of the founders will probably leave. It isn’t odd, there’s nothing wrong in it and it’s just life. But if you aren’t prepared, you have a crisis in the foundation:

Startups: It’s quite usual that founders will change in the first 6-24 months. Need to prepare, otherwise crisis may loom. (@mvonwillebrand, Sat 12 May 16:36)

Startups: It’s difficult, almost impossible to bootstrap, if, say, 1/3 of shares are held by ex-founder,who nowdays works elsewhere #aaltoes (@mvonwillebrand, Sat 12 May 16:38)

@mvonwillebrand Maybe the startup vesting mistakes cannot be taught? Everyone hits the same issues. (@aukia, Sat 12 May 17:01)

My RT follows: Hear, hear: important issue RT @aukia @mvonwillebrand Maybe the startup vesting mistakes cannot be taught? Everyone hits the same issues. (@mvonwillebrand, Sat 12 May 17:04)

@aukia valid point, not easy to learn, but can be learned. I’ve got examples both ways. It’s not the standard pitching lesson though… (@mvonwillebrand, Sat 12 May 17:13)

But I’m optimistic, can be learned! RT @aukia @mvonwillebrand Maybe the startup vesting mistakes cannot be taught…(@mvonwillebrand, Sat 12 May 17:05)

@aukia, Sat 12 May 17:05: @mvonwillebrand And no-one makes the vesting mistake a second time. (@aukia, Sat 12 May 17:05)

@aukia (Petri Aukia) shares his experience that vesting, leavers and work-amounts (as we’ll learn in a little while) are crucial. I must say, I agree. You need to agree in advance how much shares, how much work, how vesting works and what will happen if one leaves. These are all intertwined and the picture is made complete by juggling all these to a common understanding.

But I think this can be learned. I have collected a couple of examples of what went wrong and some examples in which the team was well prepared. Added with the following conceptual way of solving this, I believe teams are better off.

Example on Work Commitments and Vesting

Let’s say a startup has three major founders, each with 30% equity share. And two advisors with 5 % shares each. So the straight forward situation is that all of the major founders work equally for the company, whereas the advisors have more of – ahem – an advising role.The bootstrapping agreement could include that each of the 30 % holders agree to put at least 75 % of their time to the company, whereas the advisors could agree to put one day per month.

And, now, if the work amounts are established, we can look at the vesting schemes more intelligently than just bluntly throwing a sheet with four steps at it. Ok, work is difficult to measure and the value of input is difficult to appraise. But let’s not give something up because it’s difficult. Fortunately, the teams normally choose their members due to some reason and some trust in the abilities of the members. So we can look at the work time, and as long as no better measurement is available, that should also be used. So the 30 % founders could agree: vesting in three years, 75 % work commitment during the first year and board to decide on second and third year targets for work amounts. The vesting would occur only in the proportion that the founder has – in the average – achieved the work commitment. If a founder questions the work amounts of another founder, then a simple working time follow-up can be made.

But if the major founders don’t have equal expectations, and nothing clear is agreed as to work commitments, then there is a clear potential for differing expectations for commitment. Vesting alone does not solve this: it must be solved through boot-strapping work commitments combined with vesting.

E.g. in our probono startup program, we discuss good/bad leavers&vesting up with examples, confirmed by a participant (3rd startup for him) (@mvonwillebrand, Sat 12 May 17:08)

Re startup leavers/vesting problem: real life examples, confirmations help startups to learn: one crisis less, better off @aukia But I’m optimistic, can be learned! RT @aukia @mvonwillebrand Maybe the startup vesting mistakes cannot be taught… (@mvonwillebrand, Sat 12 May 17:10)

@mvonwillebrand Vesting issues teach negotiation in real life to the tech team. Not everyone is honest, and words are cheap. (@aukia, Sat 12 May 17:30)

@mvonwillebrand Sounds excellent. Although good/bad leavers create a whole bag of issues. (@aukia, Sat 12 May 17:31)

Our law firm, HH Partners, run a pro bono startup program this winter with 5 startups, helping them to be better prepared (these startups): founding the company and drafting a shareholders agreement. It was a good program in many respects: one was that we had several teams in same meetings and we discussed these challenges. While I was giving my examples, Paavo Perttula from Cute Attack – a participant for whom this was not the first startup – told his experinces. I believe the point was well received.

Also, to support what @aukia mentions regarding teaching negotiation skills: I think it is valuable to go through a shareholder agreement with an expert at the same time you are actually planning to make one. It is good preparation regarding concepts, terminology and – to quote @aukia – real life with a tech team: because agreeing about work commitments and vesting is not just words on a document, it’s about what others expect from you and what you can expect from others.

But this was not the end: the twitterverse brought up another point of view:

@mvonwillebrand @aukia I work with a lot of startups, most seem aware of vesting issues. No doubt thanks to startup communities sharing exp (@oniiranen, Sat 12 May 17:31)

@oniiranen @mvonwillebrand Everyone aware, yet I see similar mistakes over and over again… (@aukia, Sat 12 May 17:36)

@oniiranen @aukia I think there is awareness, but focus tends to distribute between too many issues. 3-4 really important ones. (@mvonwillebrand, Sat 12 May 17:58)

@oniiranen (Ossi Niiranen) brings up the fact that vesting is actually a well known concept. And he is correct. At the same time, I think the vesting concept – that people are aware of – tends to blend into a number of other questions: non-competition, secrecy, contractual penalties, share transfer restrictions, redemption of shares, sale rights, drag-along/tag-along, board positions, veto rights etc. These are all legal concepts, used in a startup and venture capital setting. While none of these is irrelevant (actually many are important), the concepts discussed in the tweets here are the crucial ones, for the beginning and the early team dynamics.

@oniiranen @mvonwillebrand No vesting for founders, excess equity to idea-man, equity to guys working on the side… (@aukia, Sat 12 May 17:38)

Incentives fail: RT @aukia @oniiranen @mvonwillebrand No vesting for founders, excess equity to idea-man,equity to guys working on the side… (@mvonwillebrand, Sat 12 May 21:40)

Re last RT of @aukia: while all situations are unique, the choices in the RT were clearly of the risk increasing type, in central Q:s. (@mvonwillebrand, Sat 12 May 21:44)

That was an interesting observation from @aukia. One risk increasing factor is to have a founder with clearly higher portion. In a startup setting, someone having 50% or more is slightly risky: there could be valid reasons, but it also means that the startup will die or thrive with that person, which in turn means that others are less willing to invest their time and money into such startup. But there are many companies that work well with one majority shareholder. Equity division should also be always proportional to the contributions (in work, money, other assets), otherwise there’s a potential source for demotivation. Small shares to advisors – as long as they are in proportion to contributions – seem to work.

Back to the central questions:

Startups, recap, central Q:s: equity-division; work and asset contributions; leavers and vesting. Clarify early->focus forward #aaltoes (@mvonwillebrand, Sat 12 May 21:49)

The standard shareholder agreement covers, not only these most important questions, but a horde of others:  non-competition, secrecy, contractual penalties, share transfer restrictions, redemption of shares, sale rights, drag-along/tag-along, board positions, veto rights etc. I wonder if the shareholder agreement step is a tad too big, resulting in people pushing it for too long and simultaneously failing in agreeing on the most central questions. Thus, this begs the question:

  • Should there be a simpler initial agreement to just cover equity-division (how much everyone owns of the company); work and asset contributions and commitments; leavers and vesting?

Notes on this Blog

As a practical note, I have added some spacing to the tweets and corrected some typos.

I’m a Finnish tech lawyer with wide recommendations. I head the tecnology team at HH Partners. At HH Partners, we work a lot with startups and have acknowledged that startups are not a business for us when they start, but they can be a business if they succeed. So we want to help startups, build the ecosystem and our contacts.

This is my personal blog – see about page.

Written by Martin von Willebrand

May 15, 2012 at 2:29 pm

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