It is trite to point out that an early stage company faces a difficult balancing act in weighing the costs of “overhead” against its operational capital needs. At the very beginning, there is often very little cash on hand, and its allocation is not up to much debate, as the saying “keeping the lights on” can prove to be quite literal in the circumstances. As the company moves along its life cycle, it may gain some attention from angel investors, and spending questions will become a bit more difficult. Legal costs are often a painful experience for a start-up that needs cash to pay for basic necessities. However, while good legal advice and housekeeping will not produce cash flow, they can save a lot of money down the line. This post discusses issues that may cause headaches and create significant costs for start-ups in the context of an exit.
The integrity of its intellectual property portfolio is absolutely key to a promising start-up. As such, a start-up would be well-advised to invest in intellectual property protection measures. Unlike the other issues discussed in this post that can create significant costs down the road, material issues in the intellectual property portfolio—especially difficulties in ascertaining ownership or the patentability of technology—can be fatal to a successful exit, or substantially affect valuation. Difficulties are exacerbated here, as intellectual property is not a straightforward area of the law and can surprise unseasoned innovators with unexpected pitfalls. One such pitfall that has the potential to sink the value of a technology in a remarkable number of start-ups is premature disclosure of otherwise patentable technology, which can result in losing the ability to patent the invention in the future. Good legal counsel in the intellectual property area is an absolute must. Fortunately, most founders are aware of the importance of quality advice in this area.
Once a start-up has advanced far enough in its life cycle to attract venture capital funding, which comes with such venture capitalists’ lawyers’ scrutiny, capital raising efforts will usually be decently organized and should not prove to be a mine field in the due diligence phase of an exit. Problems usually stem from early stage capital raising from angel investors and “friends”. Securities laws are complex. These are not waters that a start-up can safely navigate without at least basic legal advice. Mistakes are often made, and non-compliance will require rectification after the fact that can prove to be much more costly than initially investing proactively on necessary advice. In the context of an exit transaction, especially a share purchase, irregularities in issued capital can create significant obstacles.
Two additional items that can often create difficulty for start-ups are employment and consulting agreements and option plans. With respect to the former, it is important to involve an intellectual property practitioner to create platform legal agreements that the start-up can use with its employees and consultants going forward. Once created, the start-up should be wary of departing from these templates without further legal advice. The latter item—an option plan—will often present a problem following its adoption. While the vast majority of start-ups obtain good legal advice for the creation of the plan, its administration is usually where issues arise. It is important to remember that organization and record keeping are crucial for the administration of an option plan, and that an option plan is not a carte blanche credit line to pay for everything a company requires. If options are granted to ineligible participants, securities laws violations will often come hand in hand, with resulting costs of fixing the issues after the fact.
Generally, a modest amount spent on the creation of a good legal groundwork for all of the above items, when combined with a significant amount of time spent on good organizational practices and record keeping, can—in the long run—result in significant savings in the context of an exit. Otherwise, a start-up can quickly face spending a very large amount on a lot of advice, or be forced to opt for “exotic” exit structures.