Formation and Equity Basics

03.02.26

Your Legal Setup Is Your Startup’s Foundation

This educational guide is for founders building venture-scale, high-growth startups — not businesses built for profitability rather than hypergrowth. Good legal decisions early on save you time, money, and heartache down the road.

Avoid hidden risks that can derail growth

The legal structures you put in place today will either propel or paralyze your next move.

Formation & Equity Basics

Delaware C-Corp: Why it's standard

·      Investor-friendly and predictable under corporate law

·      LLCs offer pass-through taxation and flexibility, making them ideal for businesses built for profitability rather than hypergrowth or companies not seeking outside investment — but they create friction for VC due to the pass-through taxation and their flexibility

·      “You want your business to be exciting, and its structure to be “boring and standard”---this creates much less friction when you’re trying to raise a round

Founder stock: make sure it’s subject to “vesting”

·      Issue common stock to your founders when the company forms — earlier means lower fair market value and tax exposure

·      Stockholders must file their 83(b) election within 30 days of receiving restricted stock (stock that “vests” over time)

·      Vesting and 83(b): Earn It, Lock It In

Standard vesting = 4 years, 1-year cliff

Equity is earned over time – this helps to protect the company if someone leaves early

83(b) election = file with the IRS within 30 days of receipt of the stock

The stockholder tells the IRS that they want to be taxed on their common stock today (when it's nearly worthless), not later when it's more valuable. A missed 83(b) election can trigger unexpected tax on illiquid assets.

·      What if my cofounder leaves early?

If a founder leaves before fully vesting, the unvested shares typically return to the company, allowing reallocation to future hires

IP Ownership: Don't Build on Sand

Everything must be owned by the company

·      Intellectual property is the company’s valuable asset

·      Use Confidential Information and Invention Assignment Agreements (CIIA) with everyone---employees and contractors

·      Without a signed assignment, the creator often retains rights

·      Every founder, employee, contractor, or advisor must sign a CIIA. If your company doesn't own the code, brand, or product created, you have a potentially big problem that can kill deals or result in someone holding the company hostage before a large transaction.

Understanding SAFE Terms

“Simple Agreement for Future Equity” lets the company raise money quickly without doing a “priced round” (setting a valuation today that is reflected in the stock price)

·      Valuation cap = max price investor pays

·      The lower the cap, the more equity they get when it converts

·      “Most Favored Nation” (MFN) clause = matches better terms

Early investors match terms you offer later investors

·      Discount = investor bonus

Often 10-20% when converting

Always model what your cap table looks like with different scenarios to understand dilution

When to Hire a Lawyer

Don't wait for a term sheet or dispute to seek help

Legal risk compounds quietly. Fixing it later is almost always more expensive and the “clean up” will often delay closing of a transaction.

Hire counsel when:

·      Issuing equity or signing SAFEs

·      Before launching product

·      When hiring employees or contractors

Use fixed-fee or fractional models if budget is tight

Many firms, including Buell Law, offer flexible fee schedules or fractional general counsel support. Always interview more than one law firm and make sure that you’re comfortable with both the lawyer AND the fee structure; you’re building your team and the lawyer is an essential player.

The idea stage: legal considerations

April 2024: Last week I spoke at Raleigh Durham Startup Week, in the “idea track.” Here are the highlights of my talk.

First, there are three tips for the idea stage:

1. Make sure you own your side hustle

2. Beware of pre-incorporation claims and

3. Make sure everyone assigns their intellectual property (created in connection with the business) to the company.

Side Hustle: The design for the first apple computer could have been owned by Hewlett Packard. In his book, iWoz, Steve Wozniak describes how he, Steve Jobs and Ron Wayne set up a partnership with their interests at 45%, 45% and 10% respectively, in Apple Computers. Unfortunately, Woz was working as a full time employee for HP and, according to his agreements with the company, anything he designed during the term of his employment belonged to HP. Fortunately, Woz read his agreements (always a good idea!) and so he asked HP if they were interested. Fortunate for him, and for all of us, HP wasn’t interested, and the legal department said that HP claimed no right to his design (I expect they waived their rights).

Woz got lucky. What could he have done? He could have negotiated the terms of his HP contract, used good “side hustle hygiene” (worked on Apple after hours, not using HP assets or data) and carved out his work on Apple Computers.

Pre-Incorporation Claims: Sandra Lerner, co-founder of Cisco Systems, started a business with her horse trainer friend, Patricia Holmes, that became the 1990s nail polish sensation: Urban Decay. When the entity was formed as an LLC, Holmes was offered a 1% interest. In Holmes v. Lerner, the California court of appeals said that their “oral partnership agreement” was sufficiently definite to be enforceable and the judgment that Lerner pay Holmes was affirmed. In a related example, the Winklevoss twins alleged that they hired Zuckerberg to write code for their ConnectU business (which does not appear to have been formed as an entity) and he stole their idea. Like Lerner/Holmes, there was not a written agreement and the parties to that lawsuit ended up settling. What could they have done? Holmes and the Winklevoss twins could have had written agreements documenting roles, percentages, IP ownership.

Everyone Assigns their Intellectual Property: I joked with the audience that if there were a test on these three points, this last one would account for 80% of the grade. Here, I told a story about an inventor who created a product and hired an artist to create drawings for the packaging. Years later, when the company was successful, it was about to be acquired by a large company (for $$) when the artist came back and said “those drawings are mine.” Lo and behold, the company had hired her as an independent contractor and did not have a written agreement where she assigned the copyright in the drawings to the company. With a lucrative deal on the line, the company paid her for the copyright—-likely at a price that was substantially higher than what she otherwise would have been paid at the time she originally did the work. What could the company have done? It could have made sure that everyone working with or for the company assigns their rights to the intellectual property created for the company—-to the company. Indeed, this is applicable at the idea stage and beyond. Before pursuing a significant transaction, it’s prudent to get your “ducks in a row” and clean up any of these issues.