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The “Big O” at Startup – Why You Can’t Fake Company Ownership

You Can’t Fake Company Ownership

Oh yes, the “Big O.” (It’s not what you’re thinking.)

Among us business-minded attorneys, the “Big O” refers to the ownerhip questions that every startup founder faces:

Who owns the company (equity), and what does the company own (IP)?

All entrepreneurs face these questions, sooner or later. Some address them seriously from the start. Others are more casual, because hey, what could possibly go wrong? (A lot can, actually. Keep reading.) Or they think the problem will be easier to fix with time.

But that’s just wishful thinking.

If you’re a startup founder, you’re likely to encounter all kinds of twists and turns on the road to success. Building a company is hard; no one can predict the future. Some challenges and issues are unavoidable.

But some of the most devastating wounds are self-inflicted. They’re created early in a company’s life cycle and don’t surface until the company becomes successful. Failing to plan for contingencies, or making shortsighted (albeit well-meaning) decisions, can threaten to derail the good thing you have going. And leave you with few good options.

As business lawyers, we dream of the day a startup client goes public or receives an acquisition offer that’s simply too good to refuse. But dreams can easily turn into nightmares when these events are threatened by, say, a disgruntled partner who emerges from the woodwork and claims to own a piece of the company or its IP (or both).

“How Can I Put the Ownership Question to Bed?”

Here’s what we would advise you (and help you) to do:

Don’t give up easily.

Your company shares aren’t Monopoly money. But you could easily give away too much of your company by mistake. Promises regarding equity should always be memorialized in writing so they don’t change over time.

“Hey, I’ll give you 5% of my company.” What does that mean, exactly? What is this new “owner” going to do to earn that 5%? And do the documents make it clear that 5% means 5% today (i.e., based on today’s capitalization), rather than 5% in the future once additional shares are issued?

One of our entrepreneur clients found a contractor who agreed to manufacture her product. She was excited to get to work, so she was prone to making positive assumptions (and skipping important details) regarding the contractor’s commitments and responsibilities. She thought she’d give him 50% ownership right out of the gate, and everything would work out for the best. So we asked her a few questions:

  • Does this mean he’s going to manufacture it forever—for free?
  • How long does that go on?
  • At what volume?
  • What if he manufactures a crappy product?
  • What if he pulls the plug and stops producing?

So many important issues that she hadn’t considered.

Here’s what we advised our client: Start out owning 100% of the company, and negotiate the manufacturing deal before deciding how much equity to give the manufacturer. Instead of giving him 50% upfront for doing nothing, consider giving him 5-10% over time based on his performance.

Bottom Line:

Allocate ownership wisely. Create incentives to attract the best talent. Maintain your leverage via stock vesting, so the people you bring on board do right by the company for the long term.

In Any New Relationship, Lay Down the Law

Successful startups attract parasites. All too often, we hear of people making bogus IP claims and demanding their fair share of the ownership pie. It’s a sad and costly reality for entrepreneurs who don’t safeguard their “secret sauce” (the other half of the “Big O”).

We were recently involved with a startup that was founded by a mix of business and technical founders. One of the technical founders stopped contributing to the business and became disgruntled. The other three founders continued to work tirelessly to grow the business.

The company received a term sheet for its Series A financing from a blue-chip venture capital firm. The term sheet included a very high pre-money valuation and favorable investment terms. The company’s prospects were bright.

But this sense of optimism turned to fear and frustration when the investor learned that the disgruntled founder had refused to sign a proprietary information and inventions assignment agreement.

Not surprisingly, the investor insisted on remedying this situation as a condition of its investment. The company had no choice but to pay the disgruntled founder a $100K+ settlement payment. (Want to see how you can get your startup investor ready? Read here!)

This problem could have been avoided had it been addressed early on, when the IP in question was nothing more than an idea. This was a painful lesson for the three remaining founders, who were lucky enough to close the financing. Many companies aren’t so lucky. Countless transactions die in diligence over ownership disputes.

Bottom Line:

Don’t wait! Address the “Big O” ownership issues early and correctly to avoid bigger and more expensive problems once the company is successful.

What’s Your “Big O” Story?

How did you tackle your company’s equity and IP ownership issues? Were there any unpleasant surprises or lessons learned? What advice would you give to other entrepreneurs?

Please share your “Big O” story and insights below. You may just help a fellow startup traveler change course for the better.

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