Startup founders often make these legal mistakes

Early-stage founders face many challenges. Some of the trickiest and most foreign are legal because the legal world is unfamiliar and ever changing. What are some of the impactful legal mistakes founders make, what are the implications, and how can they avoid them or mitigate risk?

As a partner at Grellas Shah, I have done sophisticated legal work in transactional and litigation matters. As a startup and venture lawyer with extensive experience in handling a broad range of corporate, transactional, and intellectual property matters, including work on multi-million-dollar financings and acquisitions, I have deep expertise in handling complex corporate and intellectual property transactions, as well as in counseling startups and investors on avoiding and navigating litigation.

Ill-defined relationships

In imprecise language, founders discuss issues around equity, other compensation, and roles and they make promises to each other and early employees before relationships are documented.

Often, the intent is not nefarious. Instead, imprecision results from founders not being lawyers and not thinking about how an oral statement or casual email might be interpreted.

For example, a founder might promise early employees equity in percentages without clarifying what vesting terms apply or what type of stock will be issued. Employees receiving paperwork months later when a lawyer is hired may say no to signing. Where does that leave the company? That earlier vague promise could potentially be considered a binding contract with unsettled terms, leaving a cloud on the company’s capitalization that can be hard to clear without litigation.

These aren’t theoretical problems. Founders or early employees frequently claim that promises were made orally or by email. Fixing these problems dwarfs the cost of avoiding them in the first place. Sometimes, though, these problems don’t quite get fixed. Instead, the early employees might wait to see if the company grows and then file a lawsuit.

The recent lawsuit brought by early employees of Consensys against its founder/former CEO, Joseph Lubin, and the company demonstrates the real-world danger of ill-documented relationships and their impact as the company grows.

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As the early employee plaintiffs describe it, Consensys, like many early-stage companies, couldn’t offer much of a cash salary. So, to attract talent, Lubin made specific equity-related promises to employees that were allegedly made in a mixture of oral statements, internal memoranda, and other nonlegal documents.

The first such promise dealt with Consensys’ structure. The company was to be built on a hub-and-spoke model, per the plaintiffs. The hub would own and develop specific IP, with that IP being spun out into spokes that would be their own companies. The “hub” company would own equity in all spokes, though they would not be wholly owned subsidiaries.

Lubin’s alleged promise was that early-stage employees would receive equity in the “hub” company, including owning portions of all the “spoke” companies, and hub owners would benefit from everything done in the various spokes.

One reason these promises weren’t made in legal documents? The “hub” didn’t exist.

Eventually, Consensys AG (CSAG), purportedly the “hub,” was formed, and employees received equity. But what did that mean?

Eventually, plaintiffs allege, Lubin and Consensys transferred CSAG’s assets into a new entity in which the plaintiffs owned no equity.

If the asset sale was done improperly, fiduciary duty issues are implicated, and plaintiffs did claim breach of fiduciary duty. However, in the Consensys case, there was a different set of claims: The plaintiffs allege that the asset sale breached the contract between them and Consensys. While they received equity in what was originally the “hub” company, in a sense, Consensys fulfilled its promise, but the original promise was purportedly broader and less well-defined.

The promise was not that plaintiffs would get equity in CSAG; it was that plaintiffs would own equity in the “hub.” So, if a new company became the “hub,” does that mean plaintiffs were required to get equity in it? It’s unclear, which is why the parties are now litigating.

A second ill-defined promise was also allegedly made. Lubin purportedly promised that early shareholders would not be diluted by additional issuances of stock from the “hub” and that if there were to be any such dilution, it would have to be approved by a majority of the “hub” members.

Unsurprisingly, plaintiffs allege that they were diluted. In particular, they were diluted when a new investor came in.

Did Lubin mean that new investors would never dilute legacy shareholders, or did he mean that only new service provider shareholders wouldn’t dilute legacy shareholders? It’s unclear. It’s impractical for a company to grow if shareholders cannot be diluted at all, even by new investors. But the promise allegedly made was vague enough to be interpreted as potentially meaning there could be no dilution without “hub” member approval. And, who are these “hub” members in the first place? That is also unclear.

How could Consensys and Lubin have avoided these problems at the outset? By making promises about equity compensation (amount, terms, or otherwise) when it could be properly documented with advisers who could counsel on the implications of those promises.

Creating an entity and issuing equity is simple and cheap. Instead of offering equity in a “hub,” offer equity in a defined entity and present a legal agreement that describes the offer’s terms.

A lawyer can explain the implications and draft more bespoke terms in a way that doesn’t lead to unintended consequences.

Not understanding fiduciary duties

Many early founders face legal problems because they don’t quite understand what it means to be a fiduciary to a company and its shareholders. In a world where founders have to negotiate hard (e.g., with VCs) and might see huge dollar signs, the line between self-advocacy and breach of fiduciary duty is often blurred.

The role of “founder” is not a legal status. Most founders act as directors and officers of the companies they establish. In both roles, founders owe duties of loyalty and care to the company and its shareholders.

Founders often need more oversight. They own most of the company; they control the board and know what’s going on at the company — and what information to share and not to share.

To that end, founders sometimes issue themselves shares after their initial grants, diluting other shareholders and not knowing that those shareholders can challenge this. Or they unilaterally use company money to pay personal expenses — justifying it since they are not being paid anyway.

Or, sometimes founders — perhaps due to a pivot or the desire to get purportedly unproductive shareholders off the cap table — engineer transactions to buy out shareholders without thinking about how they do it.

A recent case is instructive. A startup, Community.com, and one of its founders (Matthew Peltier) was sued by two co-founders and an early investor who were all bought out of the company.

The company was co-founded in 2013 by Peltier, but his co-founders left in 2017. However, they retained an equity stake in Community. The co-founders allege that Peltier attempted to get them to sell back their stock in the company for a relatively small amount of money, claiming Community was near bankruptcy. The co-founders eventually agreed.

But, according to the co-founders’ legal complaint, Peltier didn’t disclose that the company was on the precipice of rapid growth, with potential investment and major partnership deals in the works.

The case eventually settled on undisclosed terms, and we cannot know definitively what Peltier did or did not share with his co-founders. Assuming the plaintiffs’ allegations were true, it would not be the first time a founder saw dollar signs and found a way to convince co-founders to relinquish their shares without being upfront about the state of the company.

Other than pure greed, why does this happen? For too many founders, once co-founders are gone or exiting, the remaining founders don’t offer value.

But that’s not how the law works. A director or officer (roles most founders take) has a fiduciary duty to all stockholders, even those who no longer contribute to the company.

Therefore, full disclosure is the best protection whenever a founder is acting in their own interests and to the potential detriment of other stockholders. This is the case with buyouts, just as with any self-interested deal a founder wants to engage in.

If full disclosure isn’t possible, founders are taking a risk. It can be mitigated with well-drafted documents (to an extent, Community/Peltier did so), but that’s often not a panacea.

Misusing form documents

It’s not hard to access a legal document template. Ask an entrepreneur friend for a form they use or for terms of service or privacy policies you can copy from other websites. This may seem like a clever tactic to minimize legal fees, but there’s a risk.

For example, take your company’s privacy policy. Violating your own privacy policy can be deemed a deceptive practice in violation of the Federal Trade Commission Act. The FTC can — and has — brought action against companies for privacy policy violations. In 2022, Twitter was fined $150 million in penalties; Facebook was assessed a $5 billion fine.

How does this relate to copying other privacy policies? Copying someone else’s privacy policies means you must comply with what you’ve copied. Does that work for your business? Do you understand what you’ve been agreeing to? If either answer is no, then you will run into legal trouble.

Further, it’s not just the FTC — you could also face class actions brought by users if you violate your own privacy policy.

But it’s not just privacy policies. What if you copy employment agreements, for example? Employment law frequently changes and varies from state to state. Let’s say you copy an employment agreement template with a noncompete clause. You may think, “Maybe it’s not enforceable in some states.” True, but that’s not the only problem. In certain states, including California, you can get sued or fined for giving an employee an employment agreement with a noncompete. A violative noncompete can also result in liability in Colorado, Nevada, and Illinois. New York is poised to become next on that list.

It’s tough to avoid this problem without hiring lawyers. Look for lawyers who specialize in working with early-stage founders. They likely have templates to leverage, making the process much less expensive.

Treating everyone as a contractor

Another common mistake founders make is hiring early service providers as “contractors” and paying them little or no cash compensation. This is understandable — money is tight in the early days.

But there is no state in the United States where putting “consultant” or “contractor” on an agreement means the service provider isn’t an employee. Whether a service provider is an independent contractor or an employee depends on the state and federal laws that apply. States and the federal government use various tests to determine whether someone is an employee or a consultant. However, none of these tests rely on the label used by the company and service provider.

What does this mean? Unquestioningly, treating all early service providers as contractors and not paying them correctly can mean liability for the company.

It can also mean liability for the founders. State and federal law sometimes imposes personalliability for nonpayment of wages. California law imposes it on managing personnel who violate California labor law (California Labor Code Sec. 558.1). New York law also imposes it on a private company’s top 10 largest shareholders (New York Business Corporations Law Sec. 630). Under certain circumstances, the federal Fair Labor Standards Act similarly imposes liability on officers and directors.

What is there to do? At the outset, know what you are getting into. If you know hiring people as contractors might result in personal liability, be prudent in hiring and how long you go without paying people. That may mean prioritizing paying service providers — even those happy to work for “sweat equity.”

In addition, think carefully about getting releases from contractors when they depart the company. You don’t want them coming back later and claiming unpaid wages.