This is a follow on to my June 13, 2011 post about controlling your lawyer and was inspired by a comment to that earlier post.

Cost is the overriding issue for startups when it comes to properly engaging a lawyer.  My general retort on this point is this:  expect to incur real lawyer costs and get over it.  Of course, be judicious about the engagement, but a good business lawyer can be a huge asset.

Here are 5 clues that you need a good startup lawyer (and this is just 5 out of many):

1.   You are setting up a legal entity:  unless you are the only owner of the entity to be formed, then using an online legal service is pretty tricky and inefficient as there is no one to direct basic questions to like (i) how to deal with and document founder vesting, (ii) how many shares should I authorize and issue, (iii) what type of legal entity is best for me and my business based on a set of assumptions and (iv) what state should I form the entity in.   Setting up a legal entity that will have multiple owners from inception (like 2 or more founders) requires good lawyer input.  Lawyer time required (including vesting agreements for founders):  3 to 6 hours.

2.   You need (or think you need) a stock option plan:  granting stock options (and other forms of equity compensation to employees like restricted stock) should be done under a written equity incentive plan.  And each award to a given employee requires a separate grant agreement laying out the terms of the grant.  You need a lawyer to create the plan and grant agreements (on the grant agreements, once you have the form, you can probably use it for other future grants of the same type).   Lawyer time required:   3 to 6 hours.

3.   You are hiring employees:   hiring employees comes with a host of issues such as (i) non-compete agreements, (ii) ownership of invention agreements, (iii) employee tax withholding, (iv) employee safety policies (like no harassment and privacy, etc.), and (v)  how to properly fire employees.  This is just the tip of the iceberg.  Lawyer time required:  5 to 10 hours dependent on how fast you are hiring.

4.   You are raising money:   raising funds requires documentation regardless of type of financing.  You might be doing a convertible debt round or an equity round.  The convertible debt round will take less legal time.  Despite that the documentation is pretty standard, questions for your lawyer always come up.  If you are doing a convertible debt round, expect legal fees of between $3,000 to $10,000 depending on the number of investors and length of negotiation.  If you are doing an equity round (assuming preferred stock), assume legal fees of between $10,000 to $25,000 again dependent on number of investors and negotations.  Unfortunately, the fee amount is independent of the amount being raised.   One short cut that I can tolerate is if you are truly raising funds from family members that you trust, you can use a really simple promissory note for a convertible debt round or a really simple subscription agreement for an equity round (email me if you would like forms).

5.   You want to engage an outside board member:  an outside board member (as opposed to one that is also on the management team) should sign a board member agreement and also, assuming equity compensation, get a stock option agreement or restricted stock grant based on what has been negotiated.  A good lawyer will be able to help you with all these issues and even give meaningful input on how much equity the new director should get and appropriate vesting period.  Lawyer time required:   1 to 3 hours.

Now the good news is that once you get the initial dose of good legal input, the going forward legal time for similar issues will decrease.  But then again, hopefully your business will be growing, and, if it is, then your need for even more lawyer time will go up!

As a lawyer friend of mine once told me “I love spending time with you – the fact that it is billable is just icing on the cake.”   Start eating the cake.

Hypo:  3 co-founders start a business with Joe initially owning 35%, Lisa initially owning 35% and Steve initially owning 30%.  Joe is CEO/Leader, Lisa is tech/science and Steve handles finance and marketing.  For purposes of this post, the roles are actually irrelevant.

Lisa came up with the core idea and the 3 of them form the business and create a legal entity (corporation typically).  Exciting times all around.

One of my biggest concerns in this incredibly common situation is protecting each founder from the other founders’ free riding.  I call this the “Pig on a Motorcycle” problem.  Specifically, you don’t want one founder to leave the business (for any reason) with his/her full equity slug and simply thereafter benefit (i.e., ride around on a motorcycle) from the hard work of the continuing founders.  Here is an illustration to drive the point home:

The only way to truly protect the founders from each other in this situation is by making sure that the equity owned by the founders reverse vests.  The typical vesting period would be 3 years.  Think of reverse vesting as each founder owning their shares outright, but with a risk of forfeiture of any unvested portion if they leave the company prior to the vesting period expiring.   Things to consider:

1.  How long is vesting period?  As I just stated, typical would be 3 years, but this is negotiable among the founders.  I would not recommend less than 2 years.  Longer is better, and I have seen 4 years used often.

2.  What are the vesting increments?  I recommend vesting monthly over the vesting period.   So, if the period is 36 months, and the founder leaves after month 11, he would be 11/36s vested and would forfeit 25/36s of his shares.

3.  How does the forfeiture actually work?  It is typically stated that unvested shares are subject to a right of repurchase by the company and continuing founders at a price equal to that originally paid for the stock.  And, what is that original price?  Typically ZERO.   Do not unintentionally get caught in the trap of having the repurchase price equal to fair market value on the date of repurchase.  That can be disastrous and defeats the whole point of the vesting.

4.  What happens if there is a change of control (think sale of company) prior to the expiration of the vesting period?  If written properly, a change of control has no impact on the vesting because, unlike a stock option, the founders own their shares outright.  The change of control does not cause any forfeitures and they each get their stated share of the sale proceeds.

5.  Should the forfeiture be tied to the cause of the founder leaving?  In my mind the answer is absolutely NOT.   I don’t care if the founder was fired without cause; I don’t care if the founder became disabled; I don’t care if the founder died.  Ok, obviously I care about these things from a human compassion standpoint.   I don’t care if the founder quits and goes to work at another company or decides to quit to stay home to take care of the kids.  I don’t care if the termination is voluntary (as in “I quit) or involuntary (as in “you are fired”).  The point, however, is that the vesting should be designed specifically to enable the continuing shareholders to show someone the door and always avoid the free riding problem.  Plain and simple.

6.  Is there cliff vesting?  Cliff vesting (for example, the first year of vesting does not occur until the actual passage of 12 months and thereafter vesting is monthly) is not that common for the vesting of founders stock.  I don’t recommend it.

7.  Does this post have anything to do with venture capitalists requiring requiring reverse vesting of founders’ shares?  Not much at all.  I am really focusing on protecting founders from each other right from the get go.  One benefit of putting in place the founders’ vesting right away is that sometimes VCs will just go along with the existing schedule and not impose additional vesting time periods (no guaranty of course).

Happy to answer any questions on this critical topic.  I will likely do another post on some exceptions to imposing vesting on all founders.