And what are the top ten? 

10.       Failing to incorporate early enough.

9.         Issuing founder shares without vesting (restrictions).

8.         Hiring a lawyer not experienced in dealing with entrepreneurs and venture capitalists.

7.         [Refers to an IRS election relating to the valuation of shares with vesting]

6.         Negotiating venture capital financing based solely on valuation.

5.         Waiting to consider international intellectual property protection.

4.         Disclosing inventions without a nondisclosure agreement, or before the patent application is filed.

3.         Starting a business while employed by a potential competitor, or hiring employees without first checking their agreements with the current employer and their   knowledge of trade secrets.

2.         Promising more in the business plan than can be delivered and failing to comply with state and federal securities laws.

1.         Thinking any legal problems can be solved later. 

The full article can be viewed at http://hbswk.hbs.edu/item/3348.html.

The first is Guy Kawasaki’s “The Art of the Start: The Time-Tested, Battle-Hardened Guide for Anyone Starting Anything”, published in September, 2004.  This is a practical, informative book, intended to be the definitive guide for anyone starting anything. It builds upon Kawasaki’s experience as an entrepreneur, and later as a venture capitalist who found, fixed, and funded startups. In Kawasaki’s words  “it cuts through the theoretical crap, theories and gets down to the real-world tactics of pitching, positioning, branding, recruiting, bootstrapping, and rainmaking.” 

The second is Eric Reis’ “The Lean Startup: How Today’s Entrepreneurs Use Continuous Innovation to Create Radically Successful Businesses”, published in September 2011. Reis first coined the term “lean startup” in a blog post in September, 2008. His inspiration was the Japanese lean manufacturing process, which he applied to the entrepreneurial process. Says Reis, “Startup success can be engineered by following the process, which means it can be learned, which means it can be taught.” 

The basic lean startup idea is to move quickly, and reduce waste. How that plays out in entrepreneurship  is to launch as quickly as possible with a “minimum viable product” (MVP), a bare-bones product with just enough features to allow feedback from early adopters. The company can then refine its product with incrementally improved versions based on early adopter feedback. This mitigates against wasting time on features nobody wants. Lean startups don’t invest in scaling up the company until they have achieved a product/market fit (PMF), when they finally have a solution that matches the problem. In the course of achieving a PMF, the company may find, based on customer feedback, that it has to make a significant change in approach; in effect a quick fail or “pivot”.  The change could be in the product, or in the underlying business model. In framing the process in this way, the inherent tension between the founder’s vision and the market reaction is illuminated, and thus can be more readily managed.

Securities law also requires that persons “engaged in the business of trading in securities” must be registered. Generally speaking, a company that sells its own securities on an infrequent basis and does not hold itself out as being “engaged in the business of trading in securities” will not be considered to be in the business of trading and will not have to register as a dealer.

The most common types of exemptions from the prospectus filing requirements are (i) the private issuer exemption, (ii) the friends, family and business associates exemption, (iii) the accredited investor exemption, and (v) the minimum investor amount exemption.

The following is a summary of each of the above exemptions. Please note that this is a summary only. In many cases there are extended definitions and special rules that apply, which are not listed here. You should consult your legal advisor before you embark on an issue of securities.  

Private Issuer Exemption.  The private issuer exemption allows a company whose securities are subject to the so-called “private company restrictions”, to raise capital by selling its securities to a fairly narrow group of individuals. A company is subject to the private company restrictions when its Articles restrict the number of shareholders to not more than 50 people (not including employees), its securities are subject to resale restrictions either in its Articles or by agreement, and its securities have been issued to a limited class of persons.

The private issuer exemption permits the sale of securities without the need for a prospectus to such people as the directors, officers, employees, founders or control persons of the issuer (called “inside persons”), spouses, parents, grandparents, brothers, sisters or children of the inside persons, close personal friends of the inside persons, close business associates of inside persons, and various other permutations of these relationships; but all have the common element that they are so intimately connected to the principals of the company that they will be protected by virtue of the nature of the relationship itself.

The other class of permitted investors for a private issuer exemption is an “accredited investor”, which is a defined term in securities law (discussed below). Unlike the closely connected individuals, these persons have no connection at all to the principals of the company but they are presumed, by virtue of their worth, experience or resources, to be able to assess the merits of the investment on their own.

Friends, Family & Business Associates Exemption.  The friends, family & business associates exemption permits trades to a slightly narrower group of inside persons than is the case with the private issuer exemption, and also is subject to the proviso that no commission or finder’s fee may be paid to any director, officer, founder or control person in connection with the distribution.

Accredited Investor Exemption.  Under the accredited investor exemption, a company can distribute securities to persons who meet one of the criteria set out in the definition of “accredited investor”.  The more frequently used accredited investor exemptions are those based upon the investor having a high net worth. The qualifying tests generally are:

(a)        individuals who beneficially own (alone or with a spouse) financial assets (excluding the value of real property assets) with an aggregate realizable value (before taxes but net of related liabilities) in excess of $1 million dollars;

(b)        individuals with a net income before taxes in the past two years in excess of $200,000 in each year (or combined with a spouse, $300,000) and who in either case reasonably expects to exceed that level in the current year;

(c)        individuals who (alone or with a spouse) have net assets of at least $5 million;

(d)       a non-individual other than an investment fund that has net assets in excess of $5 million as shown on such entity’s most recently prepared financial statements of net assets.

The financial thresholds are bright line tests (they must be strictly complied with) that have to be satisfied at the time of the trade. Financial assets consist of cash, securities or a contract of insurance or a deposit that is not a security.

Minimum Amount Exemption.  The minimum amount exemption is limited to those persons who can invest more than $150,000, again operating on the premise that such a person is sophisticated enough to know what information to obtain from the company and has the leverage to access it.

This exemption is available where a person purchases the securities as principal and the security has an acquisition cost to the purchaser of not less than $150,000 paid in cash at the time of the trade. The trade must be in the security of a single issuer and the purchaser must not have been created or used solely to purchase securities in reliance on the exemption.

General.  The issuing of securities in Manitoba is governed by The Securities Act (Manitoba). The regime for exempt distributions generally is set out in National Instrument 45-106 – Prospectus and Registration Exemptions, with some exceptions.  The rules must be strictly followed, so it is recommended that you obtain legal advice before engaging in an exempt market distribution. The company (not the purchaser) is responsible for ensuring that the particular exemption the company is seeking to rely upon is available to it, so you must obtain evidence that your purchaser complies with the requirements of the particular exemption.

A Manitoba company selling its securities to a purchaser resident other than in Manitoba must comply with the securities law requirements in each jurisdiction in which the trade is deemed to occur. If that other jurisdiction is a Canadian province, then the issuer must comply with NI 45-106, as well as with the local rules in Manitoba and in that other jurisdiction.

The capital the company is seeking can consist of debt, equity or a hybrid of the two (convertible debt). What’s right, or available, for your company will depend on the company’s stage of development and its stage of financing, illustrated below, and the cost of the capital.

The relative cost of the various types of capital is determined on a risk/return basis, as illustrated below. Equity capital is expensive, and dilutive, but often is the only type of available capital if the company is early-stage, has no hard assets, is facing rapid growth or is engaged in new product development.

The common sources of capital for tech start-ups are the founders, friends, family and close business associates of the founders (“inside persons”), government assistance programs, employees, angel investors, suppliers or other strategic investors, and venture capital and private equity investors. Occasionally, at some stages of development, traditional financial institutions will be a source of capital.

Pre-seed and seed debt and equity capital will depend on founders and inside persons, although financial assistance for this stage often can be sourced from government programs (see the TDS Guide to Financial Assistance Programs for Manitoba Businesses for assistance in this area www.tdslaw.com/financialguide ).

Beyond founders and inside persons, it would be unusual to find investors interested in debt financing in any of the early stages.

Angel investors may invest at the seed stage, but more typically want to be involved at the early stage, which often is pre-revenue. Series A and, if required, Series B round early stage financing often comes from angel investors. Venture capital investors may invest at the early stage, but typically only if the company has good management, with early adopter customers and its business plan demonstrates very fast, very high growth.

Some strategic investors may be willing to invest at the early stage if the investment is consistent with the investor’s overall business strategy. Start-ups should take the time early on to identify potential strategic investors.

It has to be recognized that raising capital is difficult. Data from the U.S. demonstrates that less than 1 in 10 start-ups obtain angel funding, less than 1 in 10 angel deals see VC money, less than 1 in 100 start-ups are venture financed,  and less than 1 in 10,000 new companies go public.

Consulting Agreements. Again, it is important for the company to ensure its arrangements with consultants are set out in writing. Obviously, any consulting agreement should be clear about terms such as scope of services, territory, payment terms, treatment of expenses, term and termination, supervision, exclusivity, and the like.

Two of the more important provisions from a legal perspective, however, relate to the nature of the relationship between the consultant and the company, and confidentiality, non-disclosure and  invention assignment.

If a consultant is determined after the fact to have been an employee rather than a consultant, then the company will be liable for withholding taxes, employment-related premiums (such as WCB), wage-related payments (such as overtime or vacation pay), notice on termination, and possible fines and penalties. On a dispute, the courts will look beyond the agreement itself, and will examine how the parties behaved in relation to each other to determine the true nature of their relationship. There are a number of factors the courts will consider when making this determination, and the company would be well advised to take these factors into consideration when structuring its consulting relationships.

The second point is that, generally speaking, intellectual property generated by a consultant will belong to the consultant unless the agreement otherwise provides. Thus, it goes without saying that any consulting agreement should have explicit provisions relating to confidentiality, non-disclosure and  invention assignment. This can get complicated. What if the consultant has employees? You will want to know that the consultant has agreements with its employees ensuring that any IP they generate does not belong to them, and that there is a legal chain facilitating transfer of any IP back to the company.

Confidential Information and Invention Assignment Agreements. Hopefully, the sheer number of posts in this Tech Start-Ups series related to circumstances when explicit provisions related to confidentiality, non-disclosure and  invention assignment are required will have driven home the point that the company needs to pay attention to its IP protection. Generally, these agreements are important for anyone who works on, or with, the company’s IP. The form of these agreements will vary depending on whether you are dealing with employees or consultants,  and must be drafted carefully to ensure they cover employees and contractors of consultants.

Mutual Non-Disclosure Agreements. These agreements are critically important in circumstances where you have to your share proprietary information with another party in order to conclude a business arrangement. Without it, you could lose your IP protection. Unless specifically adapted, however, this type of agreement generally is not by itself adequate where the other party is going to be generating IP for you. In that circumstance you will want to ensure that any IP generated by that party (or their employees) must be assigned to you.