Although most companies recognize the importance of risk mitigation, this work is often relegated behind other priorities, such as capital raising and new product launches. How do I know this? As a former trial lawyer representing large public pension funds suing publicly traded companies for securities fraud and corporate governance violations, my clients have often capitalized on this oversight.1 For young start-ups with limited capital, founders are typically even more focused on devoting resources to growth initiatives rather than paying lawyers to prevent missteps regarding seemingly arcane or theoretical matters. However, those issues being ignored are usually far from trivial. For example, a company’s initial foray into the capital markets can be fraught with legal exposure, which, if left unaddressed, has the potential to not only undermine the company’s ultimate success, but also prevent the founders from being properly compensated if the venture is successful.
While there is no magic formula to protect your company from all legal exposure, paying careful attention to the following issues early on can help your start-up avoid some major pitfalls down the road:
- Protect Your Cap Table: Money is everything in the beginning – so much so that many entrepreneurs forget about protecting their own equity stake. Far too often, they agree to complicated funding mechanisms that not only dilute them to the point of being unable to share meaningfully in the company’s future success, but even create unintended obstacles to the company obtaining additional financing. Planning for future investment in a manner that protects you and your team should be an integral part of every start-up’s financial modeling process from inception.
- Choose the Right Form of Business: Most entrepreneurs understand that the corporate form under which they choose to operate has significant tax and asset protection consequences. Many do not fully appreciate, however, that the choice of corporate form also has a significant impact on your ability to raise capital from the public, (whether through public offerings or private placements), without ceding undue control to outside investors.
- Think About Where You’re Incorporating. Equally important is choosing the state of incorporation or formation that best suits your needs. For example, Delaware has a highly developed body of corporate law with broad shareholder protections, but other states provide broader insulation from potential shareholder fiduciary litigation, which may be more suitable for start-ups engaging in early-stage fundraising. Franchise tax rates also vary significantly from state to state.
- Pay Attention to the Formalities: No one notices any problems in their company’s corporate formation and governance documents until something goes wrong, often resulting in expensive litigation and even restricting future fundraising options. Board minutes and resolutions should never be viewed as routine or boilerplate. As a trial lawyer, I successfully challenged numerous corporate transactions, (and put many corporate officers and directors through uncomfortable cross-examinations), based upon carelessly prepared corporate documents. Later, as a public company GC, I put this experience to work on behalf of my corporate clients to document transactions in a manner that limits exposure, based on my understanding of how these materials are ultimately used in the litigation context. I’ve learned that an ounce of prevention ends up being a lot less expensive than the pound of cure ultimately needed because of carelessly prepared minutes or resolutions.
- Approach Early Fundraising Tools with Caution: Crowdfunding, SAFE notes, and other innovations have in some ways made capital fundraising easier and more cost effective than ever before; but, they’ve also increased legal exposure for young companies. The rules for soliciting investments, which are governed by the federal securities laws and individual state “blue sky” laws, are detailed and complicated, and any misstep can have disastrous consequences. There are countless examples of early stage companies being penalized for unknowingly engaging in unlawful solicitation practices or violating other provisions of federal and state securities laws, even in a “friends and family” financing round.
- Prepare a Private Placement Memorandum (PPM): All too often, early stage companies decide that hiring an attorney to prepare a PPM is too expensive, instead opting to raise funds based on a PowerPoint presentation with some boilerplate disclaimers, or maybe a “form” PPM downloaded from a website that could apply to almost any company or industry. This is a dangerous way to save a few dollars that could cost infinitely more down the road.2 Rather, I routinely advise clients to create a PPM in preparation for a private placement, and to strictly monitor its distribution. This ensures that only qualified investors receive the offering materials, and that all have relied upon the same set of representations, disclaimers, and warnings in making their investment decision, which is invaluable protection in the event of future shareholder lawsuits. The process of creating a PPM is also a valuable organizing tool for young companies, helping to bring their business plans into focus while also serving as a precedent form as they grow and their capital needs increase. Not only is the cost usually very reasonable in relation to the amount of capital being raised, but it is likely to reduce future costs associated with additional, larger raises, as well as work associated with going public in the future, since much of the preliminary work will already have been done. Speaking of which . . .
- Avoid Going Public Until You’re Ready (and It’s Cost-Effective): Many start-ups dream of trading publicly, but the associated costs (often $1 million or more annually) are often ignored. Public companies are subject to onerous reporting requirements, expensive annual audits and quarterly reviews, and detailed disclosures regarding management, compensation, related party transactions, and other items, all of which bring additional exposure to shareholder litigation. It’s important to balance the dream of “ringing the opening bell” with careful consideration of these and other downsides before even thinking about what your trading symbol will be on NASDAQ.
- Avoid The Echo Chamber: It is human nature to be convinced of the correctness of your position in any dispute, but it is an instinct that business leaders should fight against. A good corporate attorney will explore creative solutions and act as an effective advocate, while also avoiding the allure of “drinking the Kool-Aid” or the instinct to shy away from delivering an honest, informed opinion to a hard-charging CEO who doesn’t want to hear “bad news.” The best way for you to protect your company and your investment is to encourage honest assessments from your advisors, and give them serious consideration as part of your decision-making.
While the success of any start-up ultimately depends upon the quality of its products or services, the failure to recognize and address common legal pitfalls early on can fatally undermine your venture’s prospects regardless of the strength of your core business. A company that chooses to allocate (at least some) limited resources to risk mitigation is more likely to avoid this fate and maximize its chances to prosper. If you would like to discuss your company’s risk management strategy, please contact Robert Gans at rgans@scalefirm.com.
Robert Gans is a highly experienced public company general counsel who brings a unique perspective to his clients, having spent much of his early career prosecuting securities fraud, accountants’ liability, and corporate fiduciary actions on behalf of large, sophisticated investors. Leveraging this breadth of experience, Bob advises companies of all sizes, including startups, on a wide range of legal issues and risk management strategies, including corporate governance, commercial and strategic transactions, M&A, compliance and other matters.
1 In the wake of Fox News’ blockbuster $750M settlement with Dominion Voting Systems, accounts of Fox’s internal legal staff underestimating the risks posed by the litigation provide a harsh example of this fact.
2An equally dangerous tactic – relying on artificial intelligence tools to prepare one. An attorney is currently facing sanctions in New York Supreme Court for having submitted a brief prepared by AI that, to his surprise, was filled with fictional authorities and case citations.
