As an early-stage founder, you are likely focused on things like finding your product-market fit or growing your user base. However, as you approach your first major fundraising round—be it a seed round or Series A—institutional or strategic investors will invariably seek to understand the state of the company’s intellectual property (IP) and equity ownership before deploying funds. Ensuring proper ownership and protection of the company’s IP, and creating a bullet proof capitalization table are two major steps to take to give your first investors what they will be looking for.
1. Owning and protecting your IP
Investors, as part of the diligence process, will ask their lawyers to confirm IP ownership and the company’s overall IP protection strategy.
The startup should be incorporated as a regular corporation and it is the company itself, as opposed to the founders or employees, who should own the IP. There are, however, a few common ways that a company’s ownership of its IP can be compromised.
First, it is common for founders to start working on a business before having formally and legally incorporated the company. When a company is formed, it is essential that all pre-incorporation IP gets assigned into the company (this is usually transferred as consideration for the founders’ shares).
Second, many founders launch their startup while working for another employer. In this case, investors will want to know that your former employer has no claims against the company’s IP. You will want to pay particular attention to any limitations in your contract with your former employer which would restrict your ability to assign your startup-related IP into the company.
Lastly, all employees, contractors and advisers should sign an invention assignment and confidentiality agreement on day one of their relationship with the company. The document will differ slightly depending on the category that an employee falls into; however, what will stay materially consistent is that this document will clearly establish that the IP is owned by the company itself and not by the person or employee. This is a “check-the-box” diligence item for every investor. Some investors may ask to see the form of agreement and have confirmation that each relevant person signed the same form, whereas others may go further and review each executed agreement.
Once the company owns all the IP, you should clearly map out your IP protection strategy as investors will want to know that you have been thoughtful about what IP you need to protect and how to do so. It is important to determine where the value in your business is, and to work with good counsel to select the various tools to best protect that value. IP protection includes patents, trademarks, copyright, and trade secrets. These are the “IP tools” that are at your disposal to protect your company’s product and brand—and ultimately, its value. The selection and use of these tools will be different for every company depending on what it is building. For example, the IP strategy and tools for a software or SaaS business differs significantly from what a consumer hardware or consumer eCommerce business would use.
2. Capitalization table
Investors will also want to have a crystal-clear understanding of who owns what, and whether the founders are properly incentivized by their equity packages.
One of the first diligence items for any sophisticated investor will be to ensure that the company’s capitalization table includes everyone who thinks they have an ownership claim in the company. It is vital that you have extremely clear documentation of any equity issuances—this should be done in writing and expressed as absolute share numbers.
Founders, especially in the early days, tend to promise equity to people who are helping the company. However, it is imperative that you quickly document and track those promises. This allows for clarity and ensures that there will be no misunderstanding as to what number of shares have been promised to who.
Second, equity should always be expressed as absolute share numbers, not percentages. Percentages can be confusing as it can be difficult to identify the actual amount being measured. Instead, use clear language and numbers. The same approach should be taken with options.
Ultimately, investors want to know that they are putting in X dollars for Y percentage of the company and, if the capitalization table either does not reflect everybody or some are promised an indeterminate amount, then potential investors will not have confidence that their money will get them the ownership stake they bargained for.
At the same time, investors will want to ensure that there is proper vesting in place for founders and other key individuals at the company. If any employees receiving shares are U.S. tax payers, they will need to file an 83(b) election to avoid adverse tax consequence. It is entirely standard for anybody who gets equity in a startup (whether they be an employee, contractor or advisor) to have that equity be subject to vesting, whether it is in the form of shares or options. This incentivizes you, your co-founders and your employees to stay and contribute to the company’s success. It is important that vesting schedules are clearly documented, and that people understand what the requirements are.
Investors will absolutely expect the founders’ shares to be subject to reverse vesting, and if they are not, they will require vesting to be retroactively put in place. As a result, it is in your interest to impose reverse vesting as soon as you receive the shares to start the clock as early as possible on the vesting schedule. The standard vesting schedule for founders and employees is a four-year vest with a one-year cliff (meaning no shares or options vest for the first full year) and monthly or quarterly vesting thereafter until all shares or options have vested on the fourth anniversary of the vesting start date. For advisors and contractors, there are sometimes less onerous vesting schedules (for example a two or three-year monthly vest).
It is easy to lose sight of the fundamentals when you are caught up in the early, and often exciting, stages of building up a company. Addressing the fundamental things potential investors will be looking for will keep you on a strong trajectory towards success.
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This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
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