Why It’s Never Wise to Incorporate On Your Own
This Halloween, we’ve got a spooky tale from our Lawyer in Residence, Marty Finestone about a group of startup founders who made some bone-chilling mistakes along their journey.
If you ask a startup lawyer, “hey, tell me some of your horror stories” usually the big one that comes to mind is when someone incorporated by themselves — or does everything by themselves.
When these DIY founders finally have an investor or venture capital group (VC) with a term sheet in front of them and they are ready to get going, the first step is the due diligence requested by the VC's lawyer. As startup lawyers, we want to look at the company’s documents first, look for any errors, and clean it up as quickly as we can so we can so we can present the cleaned up version to the investor's counsel.
So I had this one where it was… everything was wrong.
This startup had incorporated themselves online, and then went to an “everything-type” lawyer who was an acquaintance of theirs. So this is not someone who specializes in corporate law, but we'll call it “dabbled.”
So they were taking in a $75,000 investment from an angel investor. Now, that's a lot of money to some, but not a lot of money to others. This angel investor had a lawyer who was very much by the book. The startup’s legal work ended up being a mix of their own work, because they felt that they knew what they were doing from having done some U.S. company work in the past, and a mix of some work from the “dabbler” lawyer.
I’m going to spoil the story — the deal didn't happen with the angel investor.
Here's why: when they incorporated the company, they put everyone at the table as the incorporator. The way corporate law works is first, you need to incorporate, and then organize the company. In this case, the organization of the company (which is giving life to the corporation, including issuing the initial shares, establishing the shareholders who could approve the directors and bylaws) was a mess — they had a mix of templates and something that the “dabbler” lawyer had done.
What the “dabbler” had missed is a very nuanced point that basically requires the signature of one of the incorporators. Our firm couldn't render a legal opinion without that signature because it created such a gap in the chain of logic which we couldn’t work around. Long story short, we couldn't find the guy they needed the signature from. There had been a falling out years past, and we tried different angles to reach him but couldn’t, so that created an issue for our firm to give an opinion.
We tried to mitigate that problem, but then we uncovered another issue related to an independent contractor; a small design shop they hired to do their branding work. The “dabbler” lawyer friend of theirs put together a bit of a contract to say, do this, I'll pay you this, and here's the schedule. But the “dabbler” lawyer didn't know a thing about Canadian intellectual property law, especially copyright.
In Canada, even though you pay someone to do the work, you need a written agreement to transfer, from the creator over to you, the IP rights for you to own what they create. Canada doesn’t have a work-for-hire concept like in the U.S. (which is what the founder was familiar with). Plus, in Canada, we have moral rights, and you need those to be waived by a creator. Otherwise, the creator retains certain personality or creator rights in their work even if you own it.
So, as we were going through the startup due diligence we realized they didn’t have IP rights for their branding, and it was going to take too long to get it. The company hadn't properly done what it needed to do to make sure that intellectual property was assigned and we couldn't give an opinion because of a missing signature.
It ended up spooking the angel investor, and they decided not to invest.
It may sound harsh, but this startup wasn’t serious enough to take in angel investors' money.
Sure, as a startup you have very few resources, and it might be hard to find the ROI when it comes to legal spend. But understanding where and when to spend on your legal is what's important. If you're going to spend it on someone, spend it on a lawyer who knows what they're doing and understands your industry. Don't go to an “everything” lawyer or “dabbler” because little things are going to get missed.
There are a few lessons here, the main one is to get things right ahead of time.
Prepare your due diligence and work with a lawyer before you go get that signed term sheet. The best time is once you start to get investments, get your legal stuff ready because if you're not ready, you’ll have to spend more time before you’re able to close that deal. If your lawyers look at the diligence, look at your corporate documents, and look at the fundamentals that investors' counsel is going to care about, they'll be able to catch these issues, and you can address them as soon as possible. And then you'll be presenting everything in perfect order, hopefully, to the investor's counsel.
If you are organized and prepared from day one, you look really, really good to your investors. And again, they will feel that you are serious enough for them to put their money into your startup.
Thinking about bringing on investors? Now is the time to get prepared!
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