We’re back with part two of our discussion of formation considerations for startups and founders. Items one through four were covered here.
5. Transfer Restrictions on Shares.
Founders should consider whether to impose transfer restrictions on shares issued at formation. Transfer restrictions put guardrails on how and when shares can be transferred to others, whether via sale, gift or otherwise.
Transfer restrictions are often included in a standalone agreement between the shareholders (typically a shareholders/stockholders agreement), which agreements often include other provisions relevant to share ownership and transfer. Transfer restrictions can also be incorporated into the corporation’s bylaws, though care must be taken to ensure that the transfer provisions are legally binding on each shareholder as intended.
I typically recommend that founders impose transfer restrictions at formation, whether via shareholders agreement or in the corporation’s bylaws. While it does put limits on a shareholder’s ability to transfer shares, it also provides a level of comfort that another shareholder won’t transfer shares to a third party who the other shareholders may not have a history with. Further, transfer restrictions may be amended or waived on a case-by-case basis. Imposing transfer restrictions at formation gives the corporation and the non-transferring shareholders the opportunity to review a proposed transfer before it is made.
6. Corporate Governance; Directors and Officers.
The initial founder team must also decide how the corporation will be managed and governed. The founders (as the corporation’s shareholders) are, by law, given the power to approve certain major actions of the corporation, including electing a board of directors to manage the corporation’s affairs. The board of directors then appoints officers to manage the corporation’s day-to-day affairs.
While it may be tempting to avoid tough conversations by giving each founder a board seat, I typically recommend that initial boards not exceed three individuals. Early on, it is important for the startup to act decisively and quickly, and a board with too many contributors often slows down decision making.
7. Intellectual Property Ownership.
It is crucial that any startup—especially a technology-focused startup—own all intellectual property (IP) necessary to conduct its business. At formation, this is accomplished by having each founder assign to the corporation all intellectual property rights pertinent to the business. This typically takes the form of a proprietary information and invention assignment agreement (PIIAA) which, in addition to assigning IP, imposes confidentiality obligations on each founder to ensure that important information relevant to the startup is protected from disclosure. While PIIAA’s tend to be standard form agreements, founders should take care to ensure that all IP relevant to the business, including past IP created by a founder and future IP created by the founder in the course of their employment with the startup, is owned by the startup.
For a tech-focused startup, IP ownership will be heavily diligenced by investor counsel or as part of an acquisition of the business. Failure to own the IP necessary to conduct business is an expensive issue to fix after the fact (assuming it can be fixed at all).
8. Clean Recordkeeping.
Good corporate hygiene is vastly underrated by startups who are understandably more focused on product development and the excitement of getting the business off the ground. A startup looking to raise capital or exit will be required to turn over a wide variety of corporate and other company-specific documents as part of the due diligence process.
Putting processes in place at formation to maintain corporate records, operating contracts and other documents pertinent to the company’s operations will make the founders’ lives much easier down the road. In extreme cases, good recordkeeping can lead to higher valuations as it gives investors or buyers greater comfort that the business is cleanly operated. Poor recordkeeping can have the opposite impact and in certain cases can cause an investor or buyer to walk away from the deal entirely.