What are the worst mistakes a startup can make? 3 entrepreneurship lawyers on IP, ‘dead equity’ and more

Want to avoid making some big mistakes as you grow your startup? Heed these lawyers’ advice.

The Start Smart Legal Series — an online event series hosted by the University of Pittsburgh’s Big Idea Center, the Pitt School of Law and Carnegie Mellon University’s Project Olympus — aims to answer legal questions related to company formation, intellectual property, technology transfer and more. Past panels have focused on topics like hiring and firing, starting a business on an F-1 student visa and negotiating term sheets.

The most recent one, held Tuesday evening, convened three lawyers to share some of the worst mistakes they’ve seen startups make over the years. The three panelists included Innovation Works Legal Counsel Deborah Walker, Dentons Venture Technology and Emerging Growth Companies National Group Leader David Kalson and F.J. Lucchino, who heads his own firm, Lucchino Law.

The lawyers shared stories across a wide range of experiences they’ve had in their tech and business law careers. Below, we rounded up a few key pieces of advice that the lawyers shared at the event — but be sure to check out the full recording too.

Be careful about your company formation

Before entrepreneurs can really take off with a business idea, they need to legally form a company, whether it’s an LLC, a C corp, a nonprofit or something else. While LLCs tend to be the most popular choice for young companies due to the lower tax rates and personal asset protections, Kalson and Lucchino warned entrepreneurs of jumping the gun on that formation.

“There are times when it makes sense to be a C corporation,” Kalson said, especially if the end game of the company is to raise millions of dollars of capital and be acquired or go public through an IPO.

Lucchino agreed that one common mistake startups make is not thinking about their end game ahead of time. Another is “not getting good advice early on in the considerations of making that [business formation] decision, as opposed to going to the knee jerk route of ‘I’m going to do an LLC, because that’s what everybody does,'” he said.

There can also be serious consequences to not forming a company early enough, outside of tax and investment inconveniences. One of the dangers of not having a formal founder agreement can be a wishy-washy mindset around intellectual property. Founders split up all the time for a variety of reasons, Kalson said. So it’s important to create an official agreement from the outset that any IP created by employees at the company must be turned over as company property should they choose to leave.

“If someone owns a piece of that IP and isn’t going to turn it over, you can basically just kill the company right then and there,” he said.

Beware of ‘dead equity’

One of the biggest motivations for founders and follow-on employees to create and join a startup is the promise of investment return. In joining a company early on, employees can maximize their chance to get high-value stock options if that company becomes successful and is acquired or goes public. In a perfect world, an employee’s equity should be proportional to the amount of work he or she puts into the startup. Dead equity comes into play in cases where that proportionality is off.

Lucchino said he often sees this problem in university spinouts looking to commercialize a faculty member’s research. In those instances, “you have a faculty member, perhaps a tenured faculty member at Pitt or CMU, and they’ve been an advisor to some of the team, so they have a role [at the beginning],” he said. “And so they end up getting a larger stake of the [equity], but they’re going to be too busy to actually do much with the company.”

That can hold a company back from attracting new talent, and ward off investors who are worried about the imbalance of financial power. It also presents an awkward situation for student or alumni entrepreneurs looking to lessen that faculty member’s equity down the line, as they might have conflicting interests around needing a professional recommendation from that person and having access to other resources tied to the university.

So what can founders do? Kit Needham, the director of Project Olympus and the assistant dean for entrepreneurship initiatives at CMU, said she likes to show faculty members data on equity distribution for successful spinout companies. The hope, she said, is that once faculty members see that data, they’ll be more willing to back off, knowing that their dead equity could stand in the way of investment and growth opportunities.

Kit Needham at a Project Olympus event. (Photo taken by Foo Conner | Jekko)

Downloading forms for the internet is probably a bad idea

In an effort to save money in the early days of a startup, founders might be tempted to download templates of employment contracts, nondisclosure agreements and other business forms from the internet, rather than paying to have a lawyer draft and advise on these forms. But that can become a big mistake, Walker said.

“People know they should have confidentiality agreements, and so they’ll pull a confidentiality agreement off the internet,” she said. But often they misuse templates for mutual NDAs, while a one-way NDA is typically what’s needed instead. Furthermore, those NDA templates don’t usually cover assignment of inventions, which accounts for IP protection.

“That’s critical for technology companies, to have those bases covered,” Walker said. In her time at Innovation Works, she’s seen a lot of young companies face this challenge. One, in particular, “had a good agreement and knew what it was supposed to do, but it failed to collect the signed NDA and assignment of inventions from one of the cofounders.” The result was disastrous: “A few years later, there was a dispute and he ended up suing the company, because absent that assignment of inventions, he was a co-owner of the IP.”

The lesson? Even if your startup is strapped for cash, it’s worth consulting legal resources to ensure your bases are covered when it comes to IP protection, confidentiality and employment agreements.

At least, that’s what three startup lawyers say.