Investing in a startup involves legal considerations such as risk assessment, due diligence on the company and founders, understanding regulations, and tax implications.
A startup may also incentivize its employees by granting stock options (in a corporation) or profits interest (in an LLC). These grants must comply with securities laws and IRS rules.
Legal Issues for Founders
Private equity law encompasses various matters such as forming investment funds, financing, venture capital investments, and mergers and acquisitions. As such, it is critical for those involved to have a solid understanding of the various agreements, negotiations, and components associated with these types of deals.
Many startup founders need to pay more attention to the legal facets of their business in favor of getting their product or service on the market. However, such ignorance can quickly escalate into serious legal problems. For example, suppose a startup founder structures their business as a general partnership rather than a corporation or limited liability company (LLC). In that case, they will likely pay higher taxes and could be held personally liable for the business's debts.
Additionally, if a startup founder sells shares to friends or family, they must document the issuance of such stock to comply with applicable securities laws. Failure to do so can result in substantial financial penalties.
Likewise, startups must be mindful of intellectual property issues and obtain the necessary business permits. Failure to do so could lead to expensive litigation and significant fines. For example, some startups may need help to register their trademarks, leading to losing rights and potentially costly disputes with third parties. Lastly, startups must ensure they have proper insurance policies to protect their assets and mitigate the risks of unforeseen litigation.
Legal Issues for Investors
Private equity involves investing significant sums of money in startups in the hope that they can be sold or taken public, often using a large amount of leverage. It is a high-risk investment as startups sometimes fail, but it can bring very high returns on investments. Private equity investors typically form funds for their ventures, generally structured as limited partnerships or trusts. These are regulated under state and federal securities laws, including the Securities Act of 1933 and state blue sky law. These laws regulate what a fund must disclose and ensure all investors have transparency and honesty in investing.
A private equity investor's legal counsel must consider issues like negotiating and drafting transaction documents. They will also need to advise on tax matters, particularly if the startup is a C corporation or has shareholders from non-FATF-compliant countries. This is because the FATF regulations require startups to make certain disclosures and undertake due diligence on their foreign investors.
Legal Issues for Startups
Investing in startups is often high risk for investors and requires them to conduct extensive due diligence. They should also understand the regulatory environment for this type of investment. For example, laws may govern how a startup can offer equity to investors, as well as disclosure requirements that need to be met. In addition, there may be restrictions on how and when a startup can sell its equity.
When forming a business, founders should consider whether their percentage ownership in the company is subject to forfeiture over time (commonly referred to as vesting). They should also decide what legal structure they want to use, such as a corporation, limited liability partnership, or sole proprietorship. Each of these entities has different advantages and disadvantages. For example, an LLC can provide liability protection for the owners against claims by other members and provides tax savings through deductions and other treatment not available to partnerships and sole proprietorships.
Legal Issues for Venture Capitalists
Venture capital firms invest in early-stage businesses with extraordinary growth potential. This financing helps these startups grow to full maturity and potentially create jobs. However, this investment comes with unique compliance risks, such as insider trading, and investors must understand these issues.
Investors often seek control provisions to protect their investments in VC deals, such as transfer restrictions and affirmative vote rights. They may also request veto rights and require disclosure of all material facts about the company, including financial statements and business operations. They also require that the company register all securities offerings with the Securities and Exchange Commission to comply with federal investment laws. These laws include the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities Exchange Act of 1934, and state blue sky laws.
The risk of losing control is a concern for founders seeking VC funding, especially in the early stages of a startup. Founders must have a clear plan regarding how much control they will give up. They must carefully negotiate key control terms like drag-along rights, which empower a majority shareholder to force the sale of minority shares. Founders should also push for limitations on warranties, covenants, and representations during sales processes. For example, they should ask for several liabilities instead of joint liability and ensure there are knowledge qualifiers to limit the scope of such representations.