Legal Insights for Startups: Equity Structure and Patent Filing
Thank you Anil Advani - Founder and Managing Partner at Inventus Law and Richard Peters - Partner and Patent Attorney at Inventus Law for this wonderful session on Legal Insights for our startups, as a part of Excelerate's Startup Growth Series initiative.
Startup founders spend the majority of their time on product development, business growth, and fundraising. However, it is of paramount importance to familiarize yourself with the equity structure and patent filing process. This will help you to avoid legal pitfalls that may come in the way of seeking capital or patent procedure.
Here goes:
Legal Documentation at Early Stage
It is advisable to have good counsel and structure everything right from the formation stage from both legal and business perspectives. The logic of the phrase ‘good fences in your backyard make good neighbors’ (setting clear boundaries to avoid property disputes and keep amicable relationships) applies to startups too. You should document all terms and conditions upfront with co-founders, investors, and customers to rule out ambiguity in the future or else it could result in the death of your startup.
Initial Equity Structure
The initial equity structure varies from one country or jurisdiction to another. For example, Indian startups can start with 10,000 shares but Singaporean startups usually do much lower. However, Facebook and Google started with 10 million shares which went on to become a gold standard. You can start with even one million or 100 million shares.?
However, 100 million shares could be just overkill because you will need more shareholders, investors, employees, customer bank loans, etc as you grow. Let’s say, you want to hire a key employee who has already received an amount of 100, 000 or 250,000 in options from another startup. Would your startup have that structure to match or surpass this amount and get that employee excited to join your company?
Stock Issuance to Founders
Ideally, founders should issue stocks to themselves as soon as possible, a taxation rule that most jurisdictions follow. Whatever you earn from the company in the form of stock becomes taxable. For example, if the company is issuing ‘x’ numbers of shares, it is taxable unless you pay in full value. When you start the company on day one and buy 100% shares by paying USD100, the value of those shares is USD100, and there is no tax payable until you sell the shares.
Unfortunately, most founders either fail to do this or don’t do it right. They realize the mistake at the time of fundraising. Let’s say, you get a term sheet from an investor who is willing to invest USD5 billion at USD10 billion evaluation. Let’s also assume that the company already issued 50% shares to you at the formation stage. So, these shares are subject to external valuation. You are reserving 50% of the shares for the investors. Now, you either have to pay USD5 million to buy 50% of the company or pay tax on the stock you are getting as equity income from the company.?
You could have easily saved the taxes if you had issued 100% to yourself when you started the company. You might have to restructure the company which is an additional cost.
Founder Vesting?
Vesting is the company’s ability to buy back the shares based on a timeline, typically four years in a scenario when the founder quits, is underperforming, or is fired by the company. This is based on the premise that a company will need this equity to issue to a new co-founder of the same caliber.
You should discuss vesting terms with your co-founders, whether they are your sibling, spouse, colleagues, or school/college batch mates. Even if you know each other very well, the relationship dynamics in a startup are different.
Everything that you are building with your hard work, sacrifices, and investment is eventually locked up in a piece of paper called shares and the cap table. Hence, fair division of equity is necessary. Vesting enables you to distribute the equity and percentage ownership and safeguard your company against the time when one of the co-founders exits.
One common mistake that a company with three co-founders make is distributing one-third of equity among each other. However, fair doesn’t mean equal. You should have a proper, clear, and transparent conversation about the value each of the co-founders brings to the table. Equity should reflect that value, including roles and responsibilities. For example, it is not a good idea to have two core CEOs because it may result in conflict at a later stage and investors also don’t prefer such a structure.
Written Agreement with Employees
You should have a written employment and IP agreement with all employees or consultants for their services to your company. If you overlook this, then there is a risk that these employees may claim your product as their own and either steal/copy it or demand more money from you.?
Patent Filing Model
Patent laws are fairly uniform across the world, primarily due to several international patent treaties between nations.
One of the biggest risks for startups is a delay in patent filing. If you invented something today but didn’t file the patent for a few months, you could lose it to another company which invented the same thing after you but filed for the patent immediately and got it issued too!
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The question that arises now is what constitutes the definition of inventions and which inventions you should prioritize for filing patents. The ideas that you have are most likely inventions and differentiators from other companies. As subject matter experts, you are in the best position to determine whether your idea is an invention or not based on your knowledge of competitors or scientific literature study.
It is also pertinent to note that inventions evolve continuously, especially in software models. So, an invention can also be something you chase in time as compared to mechanical inventions which are pretty much static after development.
Types of Patent Applications
There are two types of patent applications you can consider:
Provisional: You can file your invention within one year of developing it. However, it is temporary and not the final document for patent issuance.?
Utility: It is the actual document that a patent examiner in the jurisdiction reviews to issue a patent. It is assigned to your startup once it’s filed.
However, it is advisable to file a provisional application because it helps you to establish an early filing date for your patent at a low cost. The patent office uses a provisional application date regardless of subsequent filing dates to consider the utility application. A provisional application is a snapshot of everything you are doing currently and aspires to do in the future.
This model allows you to get the worth of your money in provisional filing and then develop it as you go through Series A, Series B, and so on.?
Freedom to Operate Analysis (FTO) and Patent Search
FTO allows you to find out the list of patents that are issued or applied for issuance so that you don’t infringe on some other company’s claims. While it is expensive, it can safeguard you against lawsuits.?
Usually, an FTO search doesn’t happen at the early startup stage. This is because a patent owner wouldn’t act against you until there is an acquisition or a similar event. FTO searches are likely to happen before Series A or Series B.
If you anticipate competition, then you can look up the patent portfolio in Google’s AI patent search for pending claims, issued claims, and potentially-issued claims.
Evidence Requirements for Provisional Patent Applications
The provisional patent application must include the description of the invention in a way that it can be used without undo experimentation. As long as inventions are anchored in a sufficient technical description, it usually works for provisional filing. The patent lawyer can then fill in the gaps with more generic material. This description might not be sufficient to get a patent but it can be a reason for rejection for your competitors when they apply for a similar patent.
Early Stage Startup Equity Issuance and Valuation
The general dilemma with early-stage startup founders is to determine the right time to issue ESOPs and the correct method to evaluate them when the company valuation has not been derived yet.
It is important to keep in mind that investors typically expect a percentage of the unallocated option pool in your startup. When you have launched your company, you should keep aside around 10% for Series A and Series B. The founders should always keep at least 80-90% of the allocation with them.
After raising the capital, the company’s board should determine the valuation. The exercise price should match the fair market value of the company’s common stock at that price. If you don't do it, then it will have to be the fair market value in the future whenever you seek professional legal expertise for the paperwork and that may be higher and the employees will just have to pay a higher price. The bottom line is that whoever is around the table at that time, issues them early enough. As employees join, issue them the options, have board approval, do the paperwork, and set the price which should be the fair market value at the time you're approving this.
Conclusion
Startups should take legal compliances, formalities, documentation, terms and conditions, equity structure, and patent filing seriously right from day one of starting. This will help you avoid legal pitfalls, especially at the time of fundraising and patent applications. It is advisable to hire legal professionals who have experience and expertise in working with startups to help you do things quickly and efficiently.