Forming a company? Don’t worry, it’s not as daunting as you may think. In fact, if the proper steps are followed, it can be a quick and straightforward process.

Unfortunately, many founders are never taught how this process works, so they make rushed decisions which can result in costly errors.

But fear not; here are the common mistakes that founders make during a new entity formation. If you follow the tips described below, you can spend less time dealing with paperwork and spend more time doing what you love – running your company!

(i) Creating a complicated entity structure.

As lawyers, one of the first questions we’re asked is “What type of entity should I form – an LLC or a corporation?” The simple answer is if you’re going to raise money from outside investors (like Venture Capital firms) soon, you should probably form a Delaware corporation.  If you’re going to self-fund, raise funds from friends and family or operate a mom-and-pop business, a LLC is probably a better option. You can always convert the LLC into a corporation if you eventually decide your company needs funding from outside investors, but there is time and cost associated with this latter approach.

What you don’t want to do is create a complicated corporate structure by forming multiple subsidiaries or entities via platforms like LegalZoom. You should also avoid issuing multiple classes of stock or LLC units. It may seem smart or creative to issue equity interests with different voting rights, liquidation preferences, etc., but it’s typically unnecessary to do so when your business is just getting off the ground.

(ii) Not papering your investments.

We understand the temptation: you meet an investor at a conference or party and BAM – they want to invest in your company. You don’t want to miss out on the opportunity, so you tell the investor to send the funds over immediately – whether it’s to a personal bank account or a cryptocurrency wallet.

Please don’t do this. First, it will make your poor accountant’s head explode. Second, it will require more paperwork than originally necessary (resulting in a higher legal bill). And third, the transactions may inadvertently raise serious legal and tax issues.

If an investor wishes to invest in your company, speak to a lawyer first so the investment is papered and the funding is delivered to the company’s bank account. While we know you’d prefer to obtain funding as soon as possible, your business will almost certainly save money and time in the long run by following the proper steps.

(iii) Mistakes regarding SAFEs.

a. Raising money via a SAFE without reviewing its terms.

SAFEs are a great way to raise money quickly from investors, but not all SAFEs are the same. Irregular provisions are sometimes thrown into the agreement which can complicate future funding rounds. Because of this, we recommend that all SAFEs be reviewed by counsel before their execution, or that you use the SAFE template available at https://www.ycombinator.com/documents and do not doctor it up. The entire point of the SAFE is that it be an industry standard document everyone can trust.

But please keep in mind that securities filings and a board consent also need to be filed in connection with the SAFE, so founders should avoid signing these agreements on their own without any outside support.

b. Raising money via a SAFE if your company is an LLC.

To be as blunt as possible, the mechanics of a SAFE don’t work with LLCs. We understand that some platforms allow founders to automatically generate SAFEs for LLCs and some law firms draft SAFEs specifically tailored to LLCs, but we caution against their use.

If your entity is an LLC, there are other ways it can obtain a similar type of funding like a convertible note.

(IV) Raising money from non-accredited investors.

The rule of thumb in the startup world is that you should only raise money from accredited investors. We agree.

While it’s technically possible to raise funds from a mix of accredited investors and as many as 35 non-accredited investors under Rule 506(b) of Regulation D, the inclusion of non-accredited investors requires additional disclosure documents similar to those typically provided in registered offerings. These additional disclosures are very detailed and prohibitively expensive, so it’s best that you only include accredited investors in your fundraising.

In order to qualify as an “accredited investor”, the investor must meet (i) an income threshold (which is $200,000 annually for an individual or $300,000 for a married couple), (ii) pass the net worth threshold (which is a net worth of more than $1 million, excluding their primary residence); or (iii) have a professional certification that is recognized by the Securities and Exchange Commission (SEC). For more information regarding who qualifies as an accredited investor, see SEC.gov | Accredited Investors.

(IV) Issuing too much equity too early.

While startups commonly issue equity to early employees and contractors, too many founders issue equity out like it’s candy. Before you promise to issue 5% of your company to that “advisor”, consider your other options. Does it make more sense to pay that advisor a standard hourly rate instead of granting them equity? And if they must receive equity, consider making their equity vest according to milestones rather than over a period of time (but please do make it vest!).

Certain valuations and consents must be executed before equity grants can be made, so be sure to contact a lawyer before issuing any such equity. Issuing equity via agreements found on Google or email exchanges typically is not sufficient. If you absolutely must offer someone equity, include the language, “Upon Board approval” in the paper so that you have an out once you do properly consult legal counsel.

If you promise to issue equity to someone, don’t speak purely in terms of percentages. This can cause confusion and infighting since it’s not clear what this percentage may refer to since companies expand all the time. Instead, if you promise to grant equity to someone, describe the number of equity interests (i.e. shares) that the individual will receive as compared to some total (the amount of authorized stock, the number of issued LLC interests, etc.) as of a particular date. By following this procedure, you will prevent confusion.

(VI) Not protecting your company’s intellectual property.

You should be thinking about your company’s IP beginning on day one of its inception. All employees, founders and advisors should execute a Proprietary Information and Inventions Assignment agreement (a “PIIA”) to ensure all IP is assigned to the company. If you hire any independent contractor, consultants, or vendors to build out the company’s technology or creative assets, such arrangements should be papered and contain IP assignment provisions and/or work made for hire language. A lawyer can help you review these agreements to ensure they contain the proper language.

Run a proper trademark clearance before you lean into a brand. Trademark lawyers are a special breed and can run clearance of registered and common law uses of a brand before you sink time and effort into it only to receive a cease and desist letter forcing you to rebrand or worse.

If the company is building proprietary technology or other inventions, seek the support of a patent specialist early and don’t fall victim to one of these agencies which say they will build your product for you! Any outside vendors should be contracted to properly assign all IP to the company.

(VII) Entering into bad commercial agreements.

So you’ve got your business idea and you’re about to onboard your first customer or hire your first vendor to build some part of the company. Exciting! But before executing the commercial agreements related to such customers or vendors, it’s imperative that you first fully form your business entity. If there’s no entity in place, you may be held personally liable for the terms of the agreement!

It’s also important that you ask a lawyer to review the terms of these agreements.  Unfortunately, we’ve seen founders execute unreviewed agreements under which they have assigned IP rights away, agreed to pay high initiation fees, agreed to pay liquidated damages or failed to obtain the IP rights to key technology. Don’t make these mistakes!

Entering into bad commercial agreements can cripple a startup quickly.

We’ve listed some of the mistakes we often see, of course there are others, but this list should help you escape the most common pitfalls. Patience, guidance, and a willingness to play by the rules go a long way in the startup world, so it’s important you contact a lawyer and the appropriate professionals at the outset.  You will almost certainly cut down costs in the long run and investors or acquirers will be more willing to play ball with you if they know you’re running a well-organized and legally compliant company.

If you have any questions or need help starting your own company, feel free to send us an email at [email protected].