7. Improper Or Unwise Issuance of Shares
The formation of a legal entity creates the opportunity to compensate founders, employees, investors and others with equity in the entity. Equity that is provided to employees should vest according to some specified period, so employees are incentivized to continue working for the entity and help create value for the equity—theirs, the founders’ and the investors’. Carefully managed companies will take care to ensure that all issuances of equity are approved before issuance, are correctly documented and comply with applicable securities laws. The basic rule is that all securities sold must be registered unless exempted. Failure to comply with both state and federal registration requirements may delay future funding and can give rise to costly rescission rights and regulatory compliance costs. A company that has skipped or “short-handed” these technical requirements in connection with early capital raises has set itself up for costly compliance issues down the road—and for disputes with former employees, advisors, consultants and others arising from badly documented (or undocumented) “promises” of future equity participation.
8. Lack Of Proper Written Agreements
Entrepreneurs are busy people making lots of deals, and many of those are made, at least initially, with a handshake. In reviewing an early-stage company opportunity, be wary of relying on informal arrangements and unwritten “contracts.” Many entrepreneurs may think that they do not need written agreements because they are working with friends and do not want to impose upon those relationships. But while unwritten agreements may be testaments to friendship or informal understandings, they are unreliable and create legal uncertainty for the start-up and its investors. We advise our early-stage clients that if someone is unwilling to put an agreement in writing and sign it, they either do not have a friend or do not have an agreement. Be skeptical of “handshake” deals and unwritten commitments, and do not hesitate to ask that written documents be put in place before you invest. After all, an entrepreneur needs a reason to get documentation in place, and getting an investment is a great one.
9. Non-compliance With Employment Laws
Early-stage companies can often have serious misconceptions about employment laws and may not know that the laws applicable to employees in one state could be different in another. As a general matter, employees must be paid at least the minimum wage plus overtime, in cash, at least once a month or more often, depending on state law. Certain roles are exempt from overtime requirements, including administrative and white-collar positions, which have a multifactor test to qualify. Employees cannot work for free, for deferred compensation or for stock only. Another frequent area of misinterpretation is the difference between an “employee” and a “contractor.” Contractors are different from employees in substance, not just form, and the criteria can be difficult to satisfy. Employment-related liabilities and misclassification of employees are all too common, and can be costly, time-consuming and distracting.
10. Overpromising To Investors
Entrepreneurs are by nature optimists—creative, highly motivated, energized and willing to believe what seems impossible. Investors need to understand this orientation when approaching early-stage investment opportunities, and to recognize optimistic views, aspirations and “stretch goals” for what they are. Excessively optimistic business plans may not have been thoroughly vetted by professional advisors and can result in a loss of credibility with investors and disappointing results. Making sure that the business plan is solid and that the company’s projections are understandable and based on reasonable assumptions is the first step on the path to success.
Daniel G. Berick is partner at the Cleveland Corporate practice at Squire Patton Boggs. Tamara D. Fraizer is partner at the Palo Alto Intellectual Property & Technology practice at Squire Patton Boggs. Leah Brownlee is of counsel at the Cleveland Corporate practice at Squire Patton Boggs.