Cavitch Familo & Durkin, Co., L.P.A.
 

The Top 10 ways to mess up your startup

Michael Rasor

You have a can’t-miss idea for the next big app (or insert “service,” “blockchain,” or “product,” as applicable). It’s a billion-dollar idea, and everyone in your circle agrees.

Unfortunately, to get from Idea to Launch will take a half-million dollars that you don’t have. But, once you get it, it’s off to Shark Tank, then the moon!

Be warned; it’s at this stage where an entrepreneur is in danger of making fatal mistakes. In this article, I’m going to share the top 10 ways to mess up your startup.

  1. Lack of care with sensitive information – A great idea is exciting, and fun to share — particularly with people in the relevant industry. An entrepreneur should preface any business meeting with a NDA (non-disclosure agreement). A lawyer can prepare a form with interchangeable names, which the entrepreneur can swap for each recipient.
  2. Forming under an inappropriate model – Determining your type of entity (LLC, corporation), your tax classification (S-corp, C-corp, partnership), and your state of organization/incorporation (Delaware, or your home state) is not a one-size-fits-all decision. If you’re seeking to be a darling of venture-capital firms, you’ll want to be a Delaware-based C-corporation. If you have designs on remaining as majority/controlling shareholder, a locally formed LLC, taxed as an S-corp, is probably your choice. Don’t rely on Google or some Web site to advise you on this.
  3. Paying a finder’s fee – Wouldn’t it be great to have a Center-of-Influence running around the local country clubs and galas, pitching your company for investment? He will do it for you, in exchange for just 5% of the amount you raise from his introductions. Nothing ventured, nothing gained … so you say yes. But unless this person has a broker-dealer license, you are teeing yourself up (and he is teeing himself up) for disaster. Selling securities via an unregistered broker/finder will result in the investor having a right of rescission (they get their money back, potentially from your own pocket) and potential for fines/penalties.
  4. Common stock offering – To raise money, you’ll likely have to give up a big piece of your company, but avoid doing so with common stock/units. Instead, seek to raise money through SAFEs (Simple Agreement for Future Equity), convertible debt, and preferred stock– and keep your voting rights.
  5. Launching without governing agreement – You may think you’re being frugal by using a handshake agreements or internet form for your company’s governing agreement (i.e., code of regulations or operating agreement). But this is only deferring cost, not saving cost, because you’ll eventually have to spend the money to have a lawyer assemble a professionally tailored set of governing documents. By not doing it up front, you’re almost certainly risking litigation. Legal fees from litigation will make your operating agreement look like a fantastic bargain. Get your governing documents in line from the first inning.
  6. Making a general solicitation – If you’re selling stock of LLC interests to passive investors, you are selling securities. You will need to choose between: (1) registering with the SEC/state securities agencies, (2) qualifying for an exemption to these registration requirements, or (3) committing a serious violation of federal and state law. I put that in bold/underlined font, because many lawyers don’t appreciate the risk here. With that as background, please be aware that SEC registration is extremely expensive and time consuming, so the only real option for a startup is to find an exemption, and the best and most common securities exemption is Rule 506(B). There are many requirements to fit under Rule 506(B), but the strictest is the prohibition against general solicitation. This means no Internet pitches for selling your stock, no newspaper ads, etc. It also means that you should have a substantive pre-existing relationship with investors to whom you are introduced, before they sign up.
  7. Selling to non-accredited friends and family – Don’t shoot the messenger here, but I have some more bad news about Rule 506(B). You’re not allowed to sell to your friends and family, unless they happen to be accredited investors.* They can do this via their net worth or income. Click here for the full list of potential methods of accreditation. (*Actually, you can sell to up to 35 unaccredited investors under Rule 506(B), but your legal fees will probably be 3x what they’d otherwise be. Taking Aunt Susie’s $10,000 won’t be worth it; believe me.)
  8. Failing to file exemption paperwork – Yes, we are remaining on the topic of securities exemptions and Rule 506(B). To my surprise, many companies do not take the final step of qualifying for the exemption by filing Form D with the Securities and Exchange Commission. It’s due within 15 days after the first sale. Failing to file may jeopardize your exemption, but it also makes me wonder (as counsel for the investor) why the company isn’t following the law.
  9. State securities exemptions – More on securities law? Yes! … There are two layers of securities compliance. Fortunately, if you’re seeking to qualify under Rule 506(B), you’re selling “covered securities,” which means federal law supersedes state law, and state-law compliance is mostly perfunctory. But that doesn’t mean you can just ignore it. When you’re beginning a securities issuance, write down every U.S. state in which you’re selling, or in which an investor lives. Then go through each state’s exemptions and ensure you’ve got one that meets the criteria of your offering. In Ohio, you might have a choice between a few, and it might require you to file your Form D with the State of Ohio and pay $100. Other states are automatic; no filing necessary. Some states are more onerous, with a requirement to file offering documents and pay a higher fee.
  10. Commingling money – Your company needs a piece of equipment, but doesn’t have the cash. You think, I’ll just put it on my personal credit card and square up later. Loaning the company money is something you may have to do, but do it right. Transfer the funds to the business bank account, and document it with a promissory note. On the other hand, your company is earning money and you’d like to celebrate by buying yourself a car. Don’t just use the company’s funds; transfer the money from the business account to your account, and document the distribution/dividend by a resolution of the directors. If you ever find yourself in messy litigation, you’ll be glad you took these simple steps, to avoid the piercing of your corporate/LLC shield.

 

Attorney Michael R. Rasor advises startups, investors and issuers of private securities. Contact him at mrasor@cavitch.com or 216-621-7860.