Avoid common startup mistakes

Sacha Judd (aka @szechuan) is a partner at Buddle Findlay, based in Auckland. She works with a number of early-stage technology companies including Vend, Pocketsmith, Litmos, My Tours, GoVocab and others, helping founders with everything from setup and shareholder arrangements to capital raising. She is a not-evil lawyer who makes the scary legal stuff much less scary.

In this two-part series I’ve asked her to describe some of the common problems she deals with so you can hopefully avoid repeating those mistakes in your ventures. - Rowan Simpson.

PART I

Innovative New Zealand businesses are taking on the world, launching globally competitive products and services, raising capital from overseas investors, and getting acquired by large multi-national corporations.

Technology has made starting a business much easier. Open source development tools and cloud-based hosting services have made it much cheaper to get a new product or service built and launched. Modern accounting tools like Xero make it possible to keep your finances in order. Online banking means your bills get paid on time and you can keep on top of your cashflow. The Companies Office even has an automated and streamlined online incorporation process.

As a consequence, entrepreneurs in the start-up phase feel very self-sufficient. The DIY attitude is part of what makes New Zealand companies so amazing to work with.

But, not so fast.

There are some easily-avoided traps that I see entrepreneurs falling into over and over again. As a lawyer, it might seem like I have a vested interest in suggesting start-up founders get professional advice early. But, the alternative is that they often end up paying people like me a lot more to clean up the mess later on, assuming that’s even possible.

In this series, I’ll discuss some things you should think about to make sure you are laying the right foundation for your start-up.

There are a few important choices that young companies can make early on that have significant consequences, particularly if you intend to raise money from external investors at some point in the future. If you follow this advice it should save you time and money, both by avoiding some obvious mistakes, and by giving you a good basic understanding to work from so that when you do decide to bring advisers on board you know what you need and what to ask for.

This is my advice about when to take advice.

Wanna be starting something?
The first thing to do is form a company so that your business has a separate legal personality. This is important to separate the legal liability for the business from your own personal assets, though in practice, if you are borrowing any money or opening a facility with a bank, you are likely to be asked to give a personal guarantee as well. Make sure you understand the effect of this, and get good advice before you sign. This advice applies whether you’re a solo-founder or working with others.

If you are working with co-founders, you need to discuss candidly at the outset whether each of you will take an ownership stake in the business (shareholders), a governance role in the business (directors), or work for the business for salary or wages (as employees or independent contractors).

This can be a very tricky discussion to have at the start of a project you’re all excited about, and one that is often deferred or avoided altogether. You need to talk honestly about each person’s contribution and what value you each attribute to it.  The tendency is often to just settle for an equal split of shares, because it seems “fair”, and avoids a hard conversation.

However, that may not reflect the time and effort and expertise that each person is bringing to the table, and may lead to arguments down the road. More than that, academic research indicates that founder teams who avoid having these discussions up front, and agree to split their equity equally, tend to suffer (on average) a 10% discount to the pre-money valuation of their companies when it comes to their first financing rounds. Your company may actually be worth less if you don’t go through this process at the start.

One useful tool I’ve found helps founder teams with these discussions is Frank Demmler’s “Founders’ Pie Calculator”. This is a great starting point for working through what each of you brings to the table, how the rest of the team feel about the value of that contribution, and what your overall commitment to the business will be. It’s not a magic wand for settling the question of your equity split, but it does give you a good framework for trying to have the conversation in an objective, unemotional way.

Once you’ve settled on the percentage ownership, you can form the company. The Companies Office makes it easy to do this yourself, but in some ways this masks the compliance that sits in the background. Did you know you’re supposed to have a share register? An interests register? Opening minutes recording the issue of shares to each of the founders? You need to keep these and other records at the registered office of your company. It’s too easy to overlook this paperwork until you want to raise capital and the investor asks to see it, at which point it may be too late to put in place quickly and easily.

It’s (not just) a matter of trust
At the outset of a new venture, everybody involved is excited about the project, positive about its future prospects, and in agreement on most things. It’s hard to imagine a time when you might not feel the same way.

But things change. One of the founders gets a great job opportunity to move to another country, or wants to take time out to start a family. One of you wants to expand into Australia, but the others think it’s a terrible idea. You get approached by someone who wants to buy the business, but only some of you want to sell.

If you haven’t agreed anything in advance, you may find yourself in an incredibly stressful situation, facing disagreement without any framework to help you deal with these issues.

To avoid getting into this situation, all of the founders should, at the very least, get together and dream up all the best and worst scenarios that might play out. Talk about what you would want for an outcome in these cases, writing down everything that you agree. Ideally, you should take the next step and put a binding agreement in place to record your intentions.

A good, simple shareholders’ agreement should do a few things.

• It should reflect how decisions will be made. As a matter of company law, most decisions can be made by management. A few key decisions relating to the company require shareholder approval; sometimes 50% approval and other times 75%. Depending on your ownership structure, you might want to list out a series of key decisions that will require unanimous approval, or at the very least, a high enough threshold to give any smaller shareholders some comfort that the major founders won’t just do whatever they like. These decisions might include: entering into high-value or long-term contracts, raising capital, hiring senior employees, or major changes in business direction.
   
• It should state how you will be able to sell your shares should you wish to. Do you have to offer them to the other shareholders first (pre-emptive rights)? If a large enough number of shareholders want to sell, can they force the others to sell too (drag-along rights)? If the major shareholders want to sell, do they have to secure a deal for the minor shareholders as well (tag-along rights)? Are you free to transfer your shares to a family trust or investment company?
   
• It should deal with funding. If the company needs money, will you borrow from the bank? Do the shareholders have to guarantee this funding if that’s required? What about if you decide to issue new shares? Do the existing shareholders all have a right to maintain their existing percentages by putting in more money?
   
• It should cover what else you are allowed to do. The start-up might not be the full-time focus for all of the founders at the outset. You may have some friends and family as initial investors. The agreement should cover restraints of trade, and whether shareholders are able to work or invest in other similar businesses.
   
• It should set out what you want to have happen if things go wrong. If someone doesn’t hold up their end of the agreement, do they have to sell their shares? To the other shareholders, or to the company? At fair value or at a punitive discount?  If there are only two of you, and you have a fundamental disagreement, you may want to consider simple deadlock provisions rather than going through the time and expense of independent valuations of the business.

A good shareholders’ agreement is written in plain English, and is able to be understood by all of the founder shareholders. There will be the temptation to use a template agreement, but as you can see from the questions above, every shareholders’ agreement will be substantially different, depending on the number of investors and their respective levels of control (for example, a 50/50 company needs very different arrangements than one with a majority founder shareholder, and a number of smaller minority shareholders).

There is really no substitute for getting some good advice on this, and getting everything documented and signed.

With your company correctly incorporated and a good shareholders’ agreement in place you can get on with the business of building something great.

In the next post we’ll look at how you can make sure the company owns what you think it does and be prepared in advance for investment or acquisition.

sacha.judd@buddlefindlay.com

Read part II here.

This post first appeared on RowanSimpson.com.