Startup Legal Mistakes That Cost Founders Later: A Q&A with Cristina Chirica

Most first-time founders put legal housekeeping near the bottom of the list, right up until an investor's diligence team asks for the paperwork. Small corporate slips made in the first months of a company, such as a late stock issuance or a missed tax filing, rarely hurt on the day they happen. They tend to surface later, when a financing or an acquisition is on the table and the fix costs far more than the prevention would have.

In this Q&A, Cristina Chirica, a corporate attorney who advises early-stage technology companies and their founders, walks through the mistakes she sees most often and what they end up costing. Her examples cover incorporating too late before a priced round, delayed option grants, missed 83(b) elections, unvested founder stock that is never repurchased, skipped corporate approvals under Delaware law, and post-money SAFEs signed without a clear view of the dilution math.

Cristina also explains what founders should get right in their founder agreements, equity splits and IP assignments before raising a first round, and names the one legal task she would put at the top of any startup's list this quarter.

Disclaimer: The answers below are shared for general informational purposes only. They are not intended to serve as legal advice, and readers should consult with a lawyer about their own situation.

Q: What are the most common corporate or structuring mistakes you see early-stage tech startups make, and what do they cost founders later?

There are quite a few mistakes I see repeatedly. Most are very easy to avoid, but without proper guidance from a corporate attorney, many first time founders are simply not aware of them. Unfortunately, they can turn out to be very problematic because they either come with punitive tax consequences, or require more complex solutions down the road, or simply drive away certain investors, all of which can be a significant cost to a startup. Some examples, in no particular order:

• Waiting to incorporate until the company receives a term sheet for a preferred stock financing. If the first raise is a priced round, that means the lead investor is placing a valuation on the company. But the founders still expect to receive their founder stock for a nominal amount. While concurrent assignment of IP helps add additional value to what the founders are paying for their shares, the IRS does not look favorably at these issuances and may impute a higher value on the shares, which exposes the founders to an unwanted tax bill. Generally, it's best to have some time gap between the incorporation / original issuance of shares to the founders and raising via a priced round.
• Not issuing stock option grants on time and the fair market value goes up. The outcome is simple here: everybody is frustrated. The optionees don't appreciate the high strike price as it's not what they expected, and the founders now need to find a solution to appease the optionees, which usually involves a cash bonus or more options. It's best for start-ups to keep track of their promised options and meet regularly, such as once a quarter, to approve these options.
• Not filing 83(b) elections on time. Recipients of stock that is subject to vesting have only 30 days from the date of purchase to file their 83(b) elections with the IRS. There are no extensions to this, and failure to make the filing in a timely manner can result in a tax event each period the shares vest. This is a problem for both the stockholders and the company, which is why investors usually ask for proof of filing of 83(b) elections when conducting due diligence. There is no good, neutral solution to this, so it's important to monitor these elections.
• One of the founders leaving and the company not repurchasing that founder's unvested stock on time. Depending on how the initial stock purchase agreement was drafted, companies usually have only 90 days to repurchase the unvested shares following a founder's departure. If the company forgets to do this, the former founder keeps all the stock even though she is no longer around. In some fortunate cases, the former founder is open to a repurchase of her shares later as well, but at a much higher price. In other situations, the former founder may choose to keep all the shares, which may have a significant impact on the cap table and often drives investors away. It's best to seek legal advice as soon as possible following a founder's departure because fixing this later can be very costly.
• Not approving security issuances prior to their issuance, and generally, not following proper process for various important corporate actions (such as adopting option plans, issuing securities, amending the certificate of incorporation, electing directors to the board). Delaware General Corporation Law and related caselaw requires specific approvals for various important corporate actions. Moreover, these approvals have to be obtained in a certain order. Not following these requirements calls for more complex and expensive solutions. Worst case scenario, the deficiencies are discovered years later, in the middle of an M&A, which can cost an arm and a leg to address and simply delays the entire M&A process. It's best to engage trusted corporate counsel from the very beginning to avoid such a situation.
• Using post-money SAFEs without understanding how they actually work and in the process, agreeing to side letters without counsel review. I actually see this quite often because most startups raise via SAFEs early on. Not understanding the math behind post-money SAFEs, especially the ones with a valuation cap, can haunt the company for years. When the SAFEs finally convert, the math can take the founders by surprise if they get extremely diluted. There are some unwritten rules regarding founder ownership of a company following each priced round, and institutional investors tend to pay close attention to these numbers because they want to ensure the founders remain incentivized to grow the company. But when the founders' combined ownership drops to, let's say, 30% of the company following a Series A financing, that's obviously a problem. Solutions may require additional issuances to the founders via stock options or shares, but both usually come with a high price tag for the founders. Further, many investors ask for additional terms via side letters as a condition to their investment. Even though some terms can be very aggressive and punitive for the company, founders are often eager to sign thinking that anything can be fixed later or that a reputable investor would not ask for non-market terms. Both of which can be very wrong. It's best to consult with a corporate attorney before agreeing to terms to ensure decisions are made in an informed manner.

Q: What should founders get right in their founder agreements, equity splits and IP assignments before raising their first round?

With respect to these agreements specifically, I think that having market vesting schedules and balanced equity splits is important. Based on my experience, if they are not market, investors will subject the shares to revesting and/or reallocation that often creates unnecessary friction between the founders and the investors. Further, most investors expect cap tables to look a certain way early on, with a simple and clean cap table being the preferred approach. Finally, on the IP front, it's important to ensure that the IP was actually assigned to the company, whether as payment for the founder shares or separately, for other consideration, and that the assignment language actually works.

Q: If a startup founder could fix just one legal thing this quarter, what should it be and why?

I think it depends on what problems the startup actually has. But generally, I'd say it's always a good idea to ensure the company maintains an accurate cap table with proper supporting documentation for all the issuances, whether they are shares, stock options, or other securities. This makes the startup look professional and organized to investors and of course, it helps prevent serious issues down the road.

About the Author

Cristina Chirica is a corporate attorney who advises early-stage technology companies and their founders on corporate and structuring matters.

This Q&A is not intended to serve as legal advice. Readers should consult with a lawyer.