Starting a new company is exhilarating. Founders are often eager to turn their big ideas into reality, but this excitement can lead to overlooking critical legal formalities. For small businesses in the initial formation stage (or those that may have skipped these critical steps), a few simple, foundational documents can prevent major headaches—and costly lawsuits—down the road.
There are three aspects of the founder’s relationship with the startup that must be formally documented at the time of formation: equity ownership, transfers of intellectual property (IP) to the company, and employment status.
Essential Legal Documents for Startup Founders: Founder Equity and Vesting
Founders often fail to document their ownership stake in the new business. This is particularly important for startups with multiple founders, especially where one founder provides the majority or all of the startup funding and other founders “only” provide services. If disagreements arise later among the founders, we often see the “money” founder, the one who provided the initial startup funding, claiming the other co-founders were never business partners at all; they were merely service providers who worked for the money founder.
Or we’ll see co-founders make handshake deals to change the ownership percentages without any formal documentation. Failing to document ownership percentages (or update the documentation when ownership interests change) can lead to major disputes later, especially in the event of a nasty business divorce.
Similarly, founders need to document whether the ownership interests in the business are subject to any vesting requirements. A startup founder vesting schedule is critically important for locking in founders or other service providers who will be providing key services to the company. Without vesting requirements, these types of founders and key personnel can walk away from the company at any time. Just the potential to lose these key pieces can be a red flag with potential investors or even future acquirers if your long-term plan is to exit by selling the business.
Key Takeaway: Founders need to formally document two things in their essential legal documents:
- Equity Split: How to divide the company’s initial equity among themselves.
- Vesting Schedule: Whether the membership interests (in the case of an LLC) or stock (in the case of a corporation) is subject to vesting (a process where the stock is earned over time or based on milestones). Subjecting founder stock to vesting is a standard practice sophisticated investors will expect.
Essential Legal Documents for Startup Founders: Intellectual Property (IP) Transfers to the Company
A startup’s value lies in its innovation—its ideas, software, and other intellectual property. It is critical for founders to legally transfer this IP to the startup company at the time of its formation.
If a founder created IP (i.e., a prototype, trade secret, piece of content, branding concepts, etc.) before the company’s formation, or if there is no formal agreement in place, then the company doesn’t legally own these core assets. This leaves the company unprotected, especially if that individual founder leaves, and can severely impede future investments in the startup or even the eventual sale of the business.
Key Takeaway: Every founder should, at a minimum, sign a Proprietary Information and Inventions Assignment (PIIA), sometimes referred to as a Technology Assignment Agreement (TAA). Implementing a solid PIIA agreement ensures that all IP created by the founder(s) for the startup, both before and after formation, is legally owned by the company.
Essential Legal Documents for Startup Founders: Formalize the Founder’s Employment Status
It may seem counterintuitive for the founders to document their employment relationship when they own the company, but formal founder employment contracts are crucial for compliance with federal and state wage and hour laws, such as the Fair Labor Standards Act (FLSA).
Whether you realize it or not, the founders are the company’s first employees. As such, they should each be paid at least minimum wage and, potentially, overtime pay unless they qualify for a legal exemption under both federal and state law. Skipping this can lead to substantial liability for unpaid back wages and liquidated damages, especially when one co-founders leaves the company on bad terms. Failing to properly handle founder compensation in compliance with the FLSA can be a useful weapon in a dispute among co-founders.
There are three common ways for founders to document their employment with their new company:
Most Common Approach: Most founders remain silent on their employment status by not signing an offer letter or consulting agreement with the new company. But at the very list, each founder should sign a PIIA as discussed above. In this scenario, the founders typically don’t receive any compensation until the company raises or earns enough money to support their salaries, at which time they sign an offer letter.
Best Practice (Most Conservative Option): The founders should sign an offer letter specifying a salary that exceeds both minimum wage and the minimum salary required for federal and state overtime exemptions and actually pay themselves that salary. This is the only approach that guarantees compliance with the FLSA and state minimum wage laws.
Middle Ground: When salaries just aren’t in the startups budget, the founders can sign offer letters specifying a salary that meets or exceeds the minimum wage and salary threshold requirements. However, the founders can acknowledge that salary won’t actually be paid unless and until the company has the funding to do so. This method at least minimizes the risk of later compensation fights among the founders while still laying out duties and responsibilities to hold each other accountable.
Practical Tip for Founder Compensation (FLSA): The FLSA contains a “business owners’ exemption” for those who own at least a 20% equity interest in the business and are actively engaged in its management. Any co-founders or service providers who don’t meet this threshold must have their employment status documented and must be paid at least minimum wage or meet minimum salary requirements. There is no such thing as asking someone to work for free. State laws on this can vary significantly. Some states, like New York, do not have a comparable owner’s exemption. So if you have co-founders in other states, it is essential to consult with an attorney to ensure their compensation plan complies with both federal and state-specific minimum wage and overtime laws.
By taking the time at formation to draft and sign documents covering these three key areas—equity, IP transfer, and employment status—you establish a solid legal foundation, protect your company’s value, and show future investors that your startup is built for success.
