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Going into business with someone or choosing to invest in a startup entity is a huge step and one that could have serious repercussions if the party (or parties) turn out to be less than scrupulous. Performing personal due diligence (not to be confused with corporate due diligence) does not necessarily mean ordering a credit or criminal background check in the manner that many employers do or doing a deep dive into their corporate or financial records. Rather, by using publicly available information (as outlined below), you can check out your potential partner to determine whether he or she is an upstanding match for you.

Case in Point…

A few years ago a client called me from a Las Vegas airport. He was prepared to write a check to invest in an exciting new business opportunity: a chain of executive health care centers.  According to the business plan, the company was operational and seemingly profitable in their first location and were looking to expand nationally.  He visited one location and was highly impressed.

Him: This is an amazing opportunity.. They told me I had to have the money deposited by the end of the week or I’ll miss out on this exclusive funding round.

Me:  Cool your heels. Get me a copy the company’s Cap Table (short for Capitalization Table, a document that lists out shareholders names, contact details and their ownership percentages) so I can check them out. I’ll work quickly. Don’t write the check – I’ll get back to you in a few hours.

Him: All I have is the business plan.

Me: The law requires that they disclose their Cap Table when offering securities – if they express any resistance, tell them I’d like to speak with their attorney.

The Cap Table was forwarded and I quickly went to work.

I researched each individual on the list and what I learned was startling…not only had 3 of the directors been charged by the IRS with tax fraud but it seems that a few of them (and their wives) had previously set up a similar company and were being sued in 2 states for embezzlement. I then came across a website that named these same individuals as the “masterminds” of an alleged ponzi scheme involving executive medical facilities. To this end, my client narrowly escaped being one of their many victims.

This is a perfect example of how many people – even highly successful ones – can be too trusting and take what other’s say on face value; this is particularly true of young entrepreneurs who are wide-eyed and relatively inexperienced. Though, when you are racing to the first goal line – whether it is raising money or launching a service or product – you may take short-cuts in choosing who you work with because you are so desperately in need of another pair of hands or eyeballs. Though, wouldn’t it be beneficial to you and/or your company to limit liability and risk by conducting due diligence before entering into business relationships?

Here is some insight into my typical investigation process

1) Name and Email Address Searches: Use popular search engines to research individuals/company names and email addresses. (Best if you have both their business and personal email addresses” If the company has a list of partners or shareholders, search their names and emails too.

2) Reverse look up phone-numbers. Use www. whitepages.com or fonefinder.net and see if the registered name appears.  Then enter the phone numbers e.g “111-555-1212” . Running this search gives me a good idea if the phone number has been used anywhere online.

Sidebar Note: Sometimes I find a different name other than what they provided as the registered user, or I may find a web site where the phone number or email was used as a contact number. From there, I may even find a personal ad placed where the subject was offering employment or seeking investment. I can also find out which forums the subject hangs out at and read their comments.

3) Patent/Trademark Searches: Go to the USPTO.GOV website and see if the person is associated with any trademark or patent filings. In one case we learned that an individual making detailed inquiries into a company was in fact representing a competitor and was posing as a potential customer, trying to find out confidential information from my client.

4) Domain Name Searches: Go to www.betterwhois.com and see if this person/company owns any by searching the whois directory to see if credentials check out.

5) Business registration searches: Go to the Secretary of State’s website in the company’s place of incorporation. Do a business entity search and see whether the company is in good standing (e.g., is the company paid up on taxes and registration fees) and who the shareholders are, if listed.

6) Consumer Complaint Websites: Go to sites such as”

http://www.ripoffreport.com

http://www.complaintsboard.com

http://www.complaints.com

There you may find whether any negative reports have been filed about individuals and companies

7) Civil/Criminal Records Search.  Go to the website of the county/state to search online for civil and criminal records on the subject. You can find out which county to search based on the subject’s phone number or zip code revealed in the previously mentioned searches.

Sidebar Note: I have found numerous civil filings on subjects regarding business dealings, family law cases involving domestic violence and DWI convictions. Some of these can be explainable (hey, no one is perfect) but if someone has a record, I’d respect them more for being forthcoming (since you’d likely find out anyhow) rather than failing to disclose their history.

Based on some of the above scenarios, it doesn’t take a rocket scientist (or a lawyer) to understand the importance of conducting due diligence on a individual or company before signing agreements or entering into a business relationship.  It may, however, make sense to contact a lawyer to assist in your due diligence process — which could cost anywhere from $250 to $1000 depending on the size and scope of the investigation.

Questions? Comments? Bloggers always like to hear from their audience!

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Founders may operate on a handshake and the best of intentions but a lot can go wrong between the visionary process and when a business is actually launched. The press coverage on trending startups makes it sound as if success happens overnight but, in most cases, you will struggle for a long time before your business (or partnership) will either thrive or fold so it is important to minimize risks upfront by setting up your partnership relationships for long term success.

While it may be uncomfortable for founders of a new business to talk about issues such as compensation, day-to-day responsibilities, management roles or what happens if one partner wants out, this is one area of responsibility you don’t want to procrastinate. A friendly relationship can quickly sour when the business booms or busts – partners either get greedy or they point fingers at the other when the business doesn’t do as well as planned. For this reason, many attorneys refer to founders agreements as pre-nups for startups though, if that were the case, I would refer you to a good divorce lawyer….

The reality is that a founders agreement is simply written proof of all the things you and your partner discussed and agreed and maybe even wrote down on a napkin but haven’t properly documented and put your signatures to.

I caution startups from using free agreements from the internet. I’ve reviewed a number of these online documents and they are filled with confusing and sometimes irrelevant language that only serves to complicate the relationship.They also tend to be too broad to address the unique needs of each startup relationship and in most instances, it is also helpful to have an attorney walk you through various alternatives with respect to compensation (which is often deferred during startup phase), equity distribution or vesting periods for founders.

The costs for hiring a lawyer to draft your startup agreements range from $500 – $2500 depending on whether you are already incorporated, the complexity of the issues, number of co-founders and how much negotiation will be needed to reach an understanding; another $1000 for having a lawyer set up your corporation. If you are hiring employees, independent contractors or appointing an advisory board, standard templates tailored for your business — once drafted — can serve the needs of most of your new hires and appointees. Try to negotiate a project fee basis with your lawyer to lock down the costs.

Securing your Assets

Founders agreements are also used to ensure that all intellectual property is assigned and transferred to the company. This can include anything from protecting inventions, trademarks, logos, marketing materials to customer and supplier lists, pricing and so forth). This way, should the partnership break down, you have safeguarded your business assets from future hassles.

 It sounds simple –so, why do so many startup teams go without these essential agreements?

First, no one really wants to rock the boat – and, if you didn’t establish working terms from day one, you may be afraid to bring up critical issues for fear that it could cause the relationship to break down before the company gets off the ground.  Second, founders tend to focus on external threats and don’t make it a priority to spend the money on drafting internal agreements.  Third, you may be unsure of your commitment level and prefer to keep things loose until the business gains traction. Whatever the reason, if these agreements haven’t been put in place, consider the benefits of doing so now.

Asking the Difficult Questions: Are you and your Partner on the same page?

Does one founder see the company as his long-term employer, while another sees the company as a short-term liquidity event?

Is one partner devoting full time while the other is working another job until the business is funded? Is one partner putting in money while the other is putting in time?

Do you have the same or different vision re: the types services or products the company will provide, the company’s growth plan or the role of each founder?

As you can see, critical issues to be addressed are unique as the individuals involved. To get the dialogue rolling, here is an outline of some of the things that should be discussed:

  • The goals each of you have for the startup and for yourselves
  • Duties, job descriptions, and hour commitments
  • Who pays for what? Who gets paid first?
  • Spending authority; budgets; bank account signing authority
  • What happens if one of you wants out; what happens if one of you wants to sell the company, raise capital, or end it?
  • Whether launching other startups, i.e. is “moonlighting,” is ok?

Once you have answered these questions, documenting your understanding is the only sensible way to maintain a healthy working relationship, establish fair ownership and reduce the likelihood of disputes or litigation down the road. If you have comments or questions, please feel free to contact me.

Advisory Boards are Key

The issues an entrepreneur will deal with during the visionary process are vastly different from those they face when commercializing the business and therefore, down the line, partners can disagree on decisions such pricing or distribution strategy, choosing whether to operate the business or license it to a third party.  For this reason, most seasoned entrepreneurs put an advisory board in place. Trusted advisors that you and your partner agree would add value to your business can be called upon throughout the course of growing your business to mediate any disputes amongst founders. You can offer to compensate them in equity or options (depending on their level of involvement, these advisors receive anywhere from 1%-5%) and/or offer payment for each board meeting they attend.

In addition, once you set up your corporation, you will also need to put in place an operating agreement. An operating agreement ensures your LLC is governed by your own rules — not the default rules of your state of incorporation. An operating agreement addresses critical points such as where, when and how often board meetings are held, how many members should be on the board of directors, how profits will be distributed and other rights and responsibilities of those involved in your corporation.

The first 12 months can be make it or break it so– set yourself up for success by promoting a culture of clear communication: address, resolve, document and continue to revisit agreements as roles or commitment levels change.

If you have questions about founder or operating agreements or other startup documentation, send me an email (info@paulabrillson.com) or leave a comment.  I’m happy to answer any questions you have.

Want to read more tips on what co-founders should consider in startup phase, take a look at Deb McAlister’s Blog @ http://debmcalister.com/2012/11/25/5-legal-traps-start-up-founders-should-avoid/

Entrepreneurs face many threats that can affect the timing and the success of their businesses.  The most obvious threats are external ones – the economy, changes in regulations that directly affect your industry, the threat of competition, or worse yet, someone stealing your ideas.   For this reason, most entrepreneurs that come to me for the first time are looking to protect themselves from external threats – a standard non-disclosure agreement, a trademark or patent filing – as it is generally believed that having NDAs in place and IP pending approvals demonstrates the company has created value and is protecting it diligently.

But consider this: most investors would cite as the most compelling reason they invest in a company is the management team yet, strangely enough, these relationships are usually the least protected of all the company’s assets.

According to the National Venture Capital Association, you and your partner will have a falling out within a month of working together and it is commonly known that 9 out of 10 startups fail within the first 2 years.  (as per Forbes Invest In Startups, if You Dare, to Balance Your Portfolio, Sept. 21, 2012).

Over the years, I’ve been asked to intervene on a variety of disputes – worst of which include: one Founder emptying out bank accounts, changing office locks or another taking company equipment to use as negotiation leverage. Fortunately, there are laws to deal with these situations but no one really wants to go there when starting up a new business.

A Founders Agreement is akin to a prenuptial agreement for startups. Without them, points of contention with respect to management responsibilities, share ownership, terminating of employees (or cofounders), contract details, and personal investments can disintegrate great partnerships.

 
To bring home the point of why Founder’s Agreements are so critical to any new venture, I will share with you my experience when I was just the proverbial babe in the entrepreneurial woods.

In spite of precautions – NDAs, trademarks, privacy and disclaimer statements, the founders of my Start up didn’t have any formal agreement that addressed the issue of termination (or break-up of the Founders). We simply assumed we’d address these critical issues at the time of funding (a/k/a let the investor decide).

So clearly, a Co-Founder falling out on the eve of signing a Term Sheet with an Investor is probably the worst thing any entrepreneur could imagine.  Yet, this is exactly what happened.

After many months of investor presentations and continuing to personally bootstrap the company, my partner lost faith and patience.  So instead of shaking hands and parting ways, unbeknownst to me, he began to circumvent our business relationships for his own personal gain. He began contacting a couple of my longstanding clients to handle their business directly.  I had just gotten off a phone call with a trusted colleague advising me of this offensive behavior, when a fax came in from an investor I had previously met, setting forth terms of a very attractive offer to fund our company.

The following day I was scheduled to speak at a conference. Afterwards, a banquet was planned and there sat the traitor wearing a name badge with my company’s name. He was smiling and had no idea I knew of the wrong he had done our little company.

As I looked over at his goofy, crooked toothed-smile I felt my blood pressure rise.  I wish I could remember the exact words that set this Entrepreneur into a psycho tailspin but all I can recall is reaching down for the Crème Brulee at my place setting and without so much as a blink, dumping it directly over his head. Seeing his look of astonishment (and the startled expressions of those who witnessed this display of assault).

There was no way we were going to resolve our co-founder disputes.

So that left me with 2 choices:

  1.  Fight him in court to enforce the NDA (putting company business on hold and likely losing the investor);
  2.  Make him a buyout offer and move on.

I decided to be candid with our investor about our falling out (which, by the way is always good business practice). Turns out, not only were they willing to invest, but they also agreed to buyout his shares.

(On principle, the lawyer in me really wanted to take him to court but the CEO in me had to be commercial and do what was best for the company and the rest of the staff.  All in all, was not an easy pill to swallow).

The take away from all this:
 

The most commonly overlooked area in need of protection is the co-founder relationships.

A Founders Agreement is the single most important thing to do up front. The first year is make it or break it so– set yourself up for success by promoting a culture of clear communication. Otherwise, disputes can often lead to litigation or otherwise, as in my case, tossing Crème Brulee.  
 
It sounds so simple – so, why do so many startup teams go without internal agreements? Subscribe to my blog to receive next week’s installment on this topic.

Want to read more about Startup Agreements? Here is a blog I like from Simeon Simeonov that talks in more detail about Founders roles and agreements. I also like this book The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup (Princeton University Press, 2012).

Thanks for stopping by!

 
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