5 Early Expensive Missteps for Startups (That Are Avoidable)

While there is a myriad of ways in which a startup can stumble out of the gates, most of the costliest are pretty predictable, and can be avoided with some early planning. There is no shortage of stories out there where early-stage companies of all sizes have cost themselves tens, if not hundreds, of thousands of dollars in cleanup work and settlement payments where the founders failed to consult with, or heed the advice of, their startup attorneys. Below are just a few examples.

1. Failing to Implement Vesting Schedules to Stock and Option Grants

One of the first conversations all new founders will center on how much each contributor will own in the new venture. However, it is important to be reminded that new companies are volatile, and that everyone's total contributions in the end are complete unknowns. It is not uncommon for one or more founders to decide against continuing on with a company quite early in the startup process, in which case their value is ultimately limited.

Even if sophisticated investors didn't require vesting schedules for everyone (and they will), the company should protect itself by putting everyone on equal footing, and applying vesting schedules to all founders and new hires. The most common choice is a 4-year schedule with a 1- year cliff date. Even if the founders have been working on some iteration of the company's solution long before incorporation, it's still a good idea to implement vesting schedules to ensure that everyone is committed to the cause for the foreseeable future.

2. Missed 83b Deadlines

When a company first forms, and a startup first kicks off, the value of the founders' shares are quite low. Typically, they are initially sold at their par value, which is often a fraction of a cent. Without getting too deep in the weeds on the financial breakdown of making the 83b election, suffice it to say that both the individual's tax impact and the company's obligations towards the founder can exponentially increase if they inadvertently miss the IRS's strict 30-day filing deadline. Indeed, the company will now have to provide constant updates to its own 409A valuation (though admittedly, it will eventually need to do that anyways), and the individual will need to report income throughout the entirety of their vesting schedule. That can be a lot of unnecessary stress and expense.

To be clear on one matter: it is and always should be the individual taxpayer's responsibility to (a) determine whether or not an 83b election is the right move for their own purposes, and (b) file the 83b election within the 30-day timeline. However, a company would be wise to make it clear to their founders and new hires that both of those responsibilities exist.

3. Forming as the Wrong Type of Entity

A common question I am asked is whether or not founders can simply form as a limited liability company at first, and then easily convert to a Delaware c-corp at a later date when fundraising becomes imminent. The answer is: of course that is a possibility, but it can be costly depending on how far down the road the company finds itself when conversion becomes a necessity. More often than not, it is better to buckle down and form as the right entity immediately to save on legal fees and the possibility of having to negotiate with vendors, lessors, and other third parties to obtain consent to contracts that have strict assignment prohibitions.

Conversely, not all companies should be a Delaware c-corporation. There are plenty of examples of operations that would be better served forming locally as a limited liability company. A short consultation with an experienced attorney can help the founders choose which entity type is the right one for their needs.

4. Forgetting to Assign IP Ownership to the Company

There are far too many DIY formation services out there, each of which could lead founders into a trap whereby they assume that once the company is formed, and their shares of stock are issued, they are done with the process. However, a key formation step is ensuring that any and all intellectual property in existence, or created in the furtherance of the company's goals in the future, are properly assigned to the company. Further to that point, there are often two agreements that must be made at the time of formation and founders' stock issuance: the agreement to assign IP a founder has already created, and the agreement to continue assigning new IP that relates to the company's business.

Nearly all companies have no value if it cannot represent that it owns all aspects of its business. There is no shortage of tales where a company had to unexpectedly redirect additional cash and equity to founders, new hires, and contractors where it had failed to include IP assignment terms under a Confidential Information and Invention Assignment Agreement (aka “Proprietary Information and Invention Assignment Agreement”) and an IP Transfer Agreement immediately upon engagement or formation. Even if some DIY services provide some version of these agreements, they should be closely reviewed by the company's counsel to ensure that there are no gaps in ownership of IP of any kind.

5. Delaying Hiring a CPA

Death and taxes, amirite? The company is going to need a CPA. There is no substitute for good tax advice, and only CPAs and qualified tax attorneys are really in a good position to give it. Heck, even numbers 2 and 3 above can be alleviated by a short consultation with a CPA. The longer a company waits to offload its bookkeeping and accounting responsibilities to its tax professionals, the more money it will have to pay in order to clean them up. In fact, a good, proactive CPA can help a company set up rules and policies to help it save money. In other words, the benefits virtually always outweigh the costs in the end. Not sure where to find a good CPA? This firm knows several.