Entrepreneurs are known for thinking big, from product conception to launch. With plenty of thought given to innovation, legal considerations can easily be overlooked by founders because they're often viewed as overwhelming and challenging. At some point in every entrepreneur's journey, they will need to face these legal challenges head-on, especially once they pursue fundraising from investors.
Konata Lake sat down with Venturepark Labs to explore what kind of questions entrepreneurs should be asking themselves when they are ready to approach investors, and how legal consulting can help prevent issues from arising in your business.
Venturepark Labs: From a legal standpoint, what should every entrepreneur have in the early stages of their business?
Konata Lake: Our goal when we work with clients during the early stages of fundraising is to ensure the process is as smooth as possible. We make sure things are in order from an entrepreneur's minute books to corporate documents.
You want the legal piece to be easy for the investor to look at. You will need to provide documentation around the formation of your company, issuance of shares, meetings of directors, and it needs to be presented in a way that investors can quickly review. Additionally, if you are at a stage where you have commitments with a supplier and are generating revenue, it should be written down. Early-stage entrepreneurs may think that verbal commitments are sufficient, but it needs to be documented.
If you are an entrepreneur that is still at the concept or idea stage, this may be viewed as less important. But with that said, you want to make sure your company is still incorporated and that you have documents on hand because an investor will most likely ask for them.
VPL: What are the common legal challenges you've seen entrepreneurs faced with?
KL: The biggest challenge we see is entrepreneurs giving up ownership interest in their company and it's not been properly documented. I've seen entrepreneurs who've launched their company and they have conversations with many different people, promising 1% of their company. Usually this is in exchange for resources or opportunities that may help push their business forward. For example, "I'll give you 2% of my company, if you give me an hour of your time for 6 weeks", and it goes on and on. Sometimes it will be an oral agreement, or even an equity agreement written on the back of a napkin. An investor wants to know who the founder of the company is, what they are investing into, and how much of the company they will own if they make the investment. If an entrepreneur has side agreements and arrangements that were made off the table with others, it's hard to give that investor a clear confirmation on who owns what.
The best-case scenario: don't make any side arrangements and if you do, make sure you are being counselled on how to properly document it. I understand the need to shy away from paying legal fees up front, but oftentimes experienced firms will have different packages that work well for founders. A $5,000 start-up package that puts you on your way is much better than a $15,000 bill later on due to the effort it took to clean up improper processes, such as not granting equity properly.
VPL: Do you have any tips for entrepreneurs who are selling direct-to-consumer online rather than in retailers, but are ready to fundraise?
KL: When launching online, one of the benefits entrepreneurs have over a brick-and-mortar company, is the cost related to physical space. You are also more likely to have cost synergy, which appeals to investors. One of the things we've seen online-focused businesses do well is minimizing the amount of labour and employees they take on. They do this by subcontracting everything, from the shipment of their product to using a software company to manage their accounting. Having an employee base is important because you are contributing to the labour market, but you can contribute in a similar way with subcontracting without the challenge of managing a workforce. You can have someone who specializes in logistics, who will manage a workforce for you, meanwhile you will have the time to focus on your core competency, which is building your brand and the message you want to convey with your product. That is the reason you started your business, not to manage 100 people.
VPL: Let's discuss intellectual property rights. An entrepreneur has a unique, one-of-a-kind product offering - how do they protect it while they scale?
KL: It's an unfortunate reality that knock-offs are inevitable when you build a product. If someone buys your product at a store and re-engineers it, you can battle it out in the world of established intellectual property rights. It's a lot harder to do this if it's done by your co-packer.
We see entrepreneurs create this secret sauce and to produce it, you may have to hand it out, which can be daunting and/or concerning. I've seen entrepreneurs divide up their product with different co-packers and have a third-party responsible for putting it together. That way no individual co-packer has the full components of the recipe.
Outside of dividing up production, do your due diligence to determine if the co-packer is trustworthy. Talk to other founders who've used the co-packer. This step is critical and is an opportunity where you can learn from them. In the agreement itself, make sure to get advice around your intellectual property provisions. Having an expert look at the provision and offer support early in the process will help you long-term to keep costs down.
The deal you make when you are first starting up is probably not going to be the same deal three years down the road when you are doing well. When the agreement ends, you can renegotiate it. Rather than going for the cheapest co-packer or opportunity that may be a bit sketchy in terms of honoring intellectual property obligations, go for someone that costs a bit more, but is established. Once your business grows, you will have more volume to negotiate and leverage switches, while sticking with reputable parties up front. Even if it costs more initially, you will drive down costs in the long run as you scale.
VPL: On the topic of investor due diligence, what questions should every entrepreneur be asking themselves?
KL: When you are looking at investors, it is important to ask: – what do they bring to the table? How do they interact with portfolio companies and what companies are they invested in currently? Are they looking to exit in two years or three years? If they have a fund, what is the stage of the fund? Once you have this information, ask if you can speak to the founders they've invested in so you can hear more about what their experience has been like working with that investor.
Understanding who the investor is and having a well-rounded perspective on how they operate, what they think, and their motivations, is extremely critical. If you come across red flags, don't ignore them. I've seen founders receive a big check from an investor, but it was clear that there was not a personality fit between the two. The way the investor approached negotiations was clearly suggestive that the values were not aligned with the founder, but the entrepreneur felt the check was too big to pass up. Now that the entrepreneur took the check, the investor has to join the board of directors and there is consistent tension with the founder due to a misalignment of values. It can be very challenging when you see your vision and know you can get there because the money you received is great, but the investor doesn't want the same things.
It's better to be delayed in your growth than take that investment with someone you are not aligned with. Having a "rocky marriage" with an investor for the next few years will suck the life out of you and your journey. Most founders are excited about the things they are creating and to have an investor relationship pollute that is not a good place to be.
VPL: What is one legal term that you think every entrepreneur should know?
KL: In convertible note instruments or safe notes, which are two measurements used for early-stage investments for entrepreneurs – there is a concept of a valuation cap. Valuation cap is the future value of the company into which an investor would be comfortable converting. It is not the valuation of the business today. It's important to know this distinction so that founders and investors can negotiate the right concept.
Read the blog originally published with Venturepark Labs.
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