Most Common Early Start-up Mistakes

Posted on Aug 17, 2009 | 27 comments


michelangelo-creation-adam-This is part of my ongoing series “Startup Advice”  If you want to subscribe to my RSS feed please click here or to get my blog by email click here.

In the Beginning

This is a very important post to me because I find myself giving this advice all the time and if you don’t follow the basic advice here you can cause yourself much heartache down the line – even if your company ultimately becomes über successful.

I often talk with entrepreneurs who are kicking around their next idea.  Sometimes they’re working full time at a company or sometimes they’ve already left their employer and they’re bouncing around ideas with friends.  These periods of time can leave a founder very vulnerable in the future.

Here are some lessons to avoid common traps.  Please remember to read my disclaimer (it’s not long) - I am not a lawyer and my advice should not substitute getting formal legal advice.

1. Moonlight Responsibly - If you are still employed please be very careful not to use your company’s resources to produce your product and please do not work on your next idea during business hours.  It’s hard enough to build a successful company.  Imagine you pour 5 years of your life into your next gig and it starts to become successful.  Would you want to run the risk that your former employer could have a claim against the intellectual property you’ve created because you broke company policies and developed your ideas on company resources?  Not worth it.

To the best of my knowledge US law allows you to work on your own resources and in your own hours and let you personally own your IP.  I don’t know 100% that this is true in all 50 states (if any lawyers read this please put notes in comments section) but I’m pretty darn sure that this is statuary law in California.   In some countries outside the US (the UK for example) employers can specify in an employment contract that ANY IP you develop while you’re employed by that company is owned by them.  If you live somewhere where this is the case you’re better off discussing with your employer that you may from time-to-time work on private projects outside of work hours and you want their clearance in writing that this is OK.

2. Register a company. When I hear entrepreneurs say that they’re kicking around ideas with friends  I ask, “have you legally registered a company?” Many times the answer is ‘no.”  The problem is that you’re opening yourself up to a claim by one of these people that you somehow stole their ideas.  I know it sounds crazy because you’re talking about friends or colleagues here.  And you’re probably right.  BUT … if you do create the next MySpace, Facebook or Twitter there will be much money at stake.  Where money is at stake sometimes things get crazy.

facebook founder disputeDon’t believe me? See here for the Facebook story.  Register a company before you do anything else.  Even if you keep it dormant for 2 years while you work on your idea.  It isn’t expensive and the admin isn’t too great.  You can find a good start-up lawyer to help or if you want to do it on the cheap there are tons of websites you can find on the Internet to help.  Here is just one (I don’t endorse them – there are many).  You can probably get loads of information on Legal Zoom also.

3. Pick the founding members. This is advice that I give people all the time.   I’m reluctant to put it into writing because people get so passionate about this issue and many disagree.  But I’m so certain that this is one of the single most important areas for you to preserve your future wealth creation opportunity that I feel compelled to write it:  your founding team should never have more than 2 people total (including you).

Why?  I know that your goal in creating a company is to “change the world” or create something really cool and enduring that has a positive impact on some group of people.  Presumably you also want to make a bit of money over time.  If you start a company with 4 people you’ve just given away 75% of the value of the company.  It is hard enough to have a great financial outcome when you start with 100%.  Starting with 25% is even harder.  Assuming normal valuations at fund raising rounds you’ll be down to 6-12% after you’ve created a stock-option pool and raised capital.

I know that 6-12% is more than most senior executives who join start-ups get.  But these people seldom make retirement money from the stock options on these companies.  I know it happened in the late 90′s and there are some very wealthy minority shareholders from Google’s early days.  But many people win the lottery every week also.

The fact is that most people lack the willingness, ability or nerve to start a company from the very beginning with just an idea or a desire to start a company.  These same people will join you and your one other co-founder (maximum) 6 months later when you’ve established the company, done your Powerpoint deck, built a prototype or product and started fund raising discussions.

They’ll happily join for 5% or less and they’ll have options and not stock.  That’s the difference between a founder and a non-founder.  You’re the one who gets paid extra rewards for taking the extra risk and more importantly taking the initiative.  The world is much safer for non-founders.  There is nothing wrong with non-founders – by design they are the overwhelming majority of companies.  But the worst case scenario in my mind is more than 2 co-founders where everybody sub-optimizes.  That said, if you’re already in a company with more than 2 founders – put it behind you.  The decision is already made.  Your next business will have less ;-)

4. Research your market.  I know it’s obvious but I’m always surprised how many people just start building products without thinking enough about the market.  You need to do some analysis.  Start by evaluating areas that you have domain expertise in.  Make sure that you’ve identified a problem that you believe exists.  Calculate how much time or money this is causing the people involved.  Sketch out your solution.  Find out what solutions they’re using today.  Use all of this for the basis of a plan that defines your company strategy.

business planDon’t worry if it isn’t perfect from day 1 – just make sure it appears to be a good idea.  You will confirm that later on.  Putting your thoughts into spreadsheets, PowerPoint, HTML, etc. forces you to come to grips with whether you really have a good idea or not.  DO NOT start with product, start with the market.

5. Get customer input. This is another big mistake.  People design their products in a box assuming that they’ll show customers later and get feedback.  Get feedback before you start building anything – else you might be wasting your money.  Interview customers to better articulate their problems.  Show them multiple solutions to their problems and find out which ones resonate.  Ask if they’d be willing to pay for a solution like that if it existed.  Ask them how much they think such a solution would cost them.

6. Build prototypes and/or product. Start building out your product.  It you have a great software engineer that’s awesome.  If not, at least find someone really technical that you trust to help act as an adviser to you.  If you can’t find somebody any technical resources at all through networking please consider keeping your day job.  I’m not being flippant (OK, maybe slightly) but seriously it isn’t hard to network your way into someone technical.  If you can’t do this it is highly likely that you lack some of the basic entrepreneurial skills to be successful in your own company.

If you need a cheap way to get a prototype build consider the following options: student interns, people willing to work for stock options rather than cash or some mix, doing the work through oDesk, eLance or Rentacoder.com.

7. Make sure you own your IP.  This is a BIG mistake many early stage companies make.  They have developers or friends help code their software without having legal agreements in place.  You MUST have a legal agreement that stipulates that anybody working on the design, coding or testing of your system assigns any and all intellectual property (IP) created to your company.  Otherwise you run the risk that in the future somebody claims that the programming work that they did for you represents their IP and not yours.

Close up Women's Rowing Team8. Assemble a team. As you know my preferred route is the start the company, register it, get the basic plan in place, sketch out wireframes and/or start getting your product built AND THEN assemble your team.  You can be talking with potential employees all along the process getting them excited.  But best to bring some of your team members on as your plan starts to solidify.  If you started the company yourself consider bringing on a “partner.”  By this I mean somebody who has a large and meaninful percentage of stock options – but nowhere near 50%.  There is no specific % – it is different in each case.  But for the sake of my example – say 20%.  Treat this person like your true partner where you share all information with them and involving them in the decision-making processes.

You also need to get other people around you.  Teams create companies – not individuals.  Teams raise money – not superstar CEO’s.  Start building your team early.

9. Founder vesting. Yesterday I wrote a blog posting on founder vesting.  You should implement restricted stock with vesting at the earliest stages in your company -even before the VC’s ask.  The reason is that if you found a company with a partner (or 2) and somebody decides to leave the company do you really want them to be able to walk away with half of the value when they may have only worked with you for 9 months and all the hard work is ahead?  Founder vesting is an insurance policy for all team members involved.

This post isn’t meant to be a comprehensive guide on starting a company so I think I’ll stop here.   I just wanted to list some of the most value destroying mistakes I see many early-stage entrepreneurs make.  It’s a shame because these mistakes are often made in the first 12 months when all the work still lies head.  I’m sure there are many more early-stage mistakes – please feel free to add comments or send me a twitter message @msuster

  • http://www.jobsbyref.com Ravi K

    Absolutely. I have repeatedly seen people not following these simple things and that becomes a bone of contention going forward for certain. I have seen good products built but with no market knowledge of where the pain points are, because the founders were excited about the idea.

    Co-Founder
    JobsByRef.com

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  • marksuster

    WAY too many cool products with no market. Can you say, “Web 2.0″ ;-)

  • http://www.jobsbyref.com Ravi K

    Definitely. I see lot of social networking sites, coming out, with no revenue model, all talking about “will figure out when we have a critical mass”. How many Facebook and twitter can you have? Unless you are doing something really niche or local, that too if you are the first one and have very good traction. The presentation on Asian market, that you had posted last week here, is a good example of niche or local focussed site in China and Korea.

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  • http://b-better.com Damien Anyasi

    I don’t think it’s too late for me to apply much this to my ‘company’ so thanks a million for posting

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  • http://www.startbreakingfree.com Brian Armstrong

    Great article. One thing I wasn’t clear on, why does registering the company make it less likely for someone to claim you stole their idea? It seems having a sole proprietorship or C-corp wouldn’t affect the validity of their claim.

    I’m with you on the founders part though. I like the idea of building a team but not founders. Several startups I’ve tried with 50/50 ownership had big problems. It’s like having two presidents, the buck has to stop somewhere, and if the two founders disagree on what direction to take you’re at a standstill.

    My latest project is FeedmailPro.com – haven’t built a team yet, was able to code this one on my own.

    Thanks,
    Brian

  • http://www.dlapiper.com Dave Young

    The reference to California law actually is a bit too narrow–this is an area where entrepreneurs definitely need to be careful. What California law protects is any invention (i) that is developed by an employee entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information AND (ii) does not relate to the employer’s business or actual or anticipated research and development, or otherwise result from any work performed by the employee for the employer. So even if a founder is careful to work on their new company on their own time, if it is related to the employer’s business then the employer likely owns the invention (or has a claim that it does). Other states are even less “employee-friendly” in this area (as is usually the case as compared to California). This is an area where frankly many founders don’t pay enough attention. The issues are further increased when the potential founder is an officer of their current employer, as fiduciary duties come into play (which can point to needing to exit the prior employment relationship sooner to be able to actually start the NewCo, instead of just making preliminary plans). The key here is to be thoughtful. As an attorney who has worked with hundreds of early stage companies, I’ve had a number of situations (and a couple in particular, although I won’t name names to avoid freaking out the prior employers) where careful early exit planning by the founder was important with respect to a prior employer (and has helped launch what are now very successful companies). As with many things the key is to have thought it through and have a strategy. I had a recent financing for an LA-based VC in which these issues caused the VC to initially walk away from the deal during due diligence(although it ultimately closed a couple of months later–after a settlement agreement on acceptable terms had been executed with the prior employer). An example of where to be careful is that in another case last year a prior employer sued founders because there were conversations between the co-founders using instant messaging while using the prior employer’s network (so the co-founders were unable to claim that they developed the new concept solely without using the prior employer’s equipment and facilities). In the digital world, we all need to be careful what we put in writing.

  • Greg

    Another excellent post, Mark. Two comments/questions. First, I echo Brian’s question about how registering the company protects you from IP claims. It seems it would be one piece of evidence in your favor, but wouldn’t you also want to document your IP development pretty thoroughly?

    Second, I’m about to embark on the moonlighting stage, and I didn’t appreciate how early you want to have a good startup lawyer in your corner. I imagine these people are in demand. Any advice on finding the right one and thinking through the right level of monetary investment in legal issues early on (pre-product, pre-team)?

  • marksuster

    Again, I’m not a lawyer, but here’s how I think. It starts with having a company established. This does things like establish the business that you’re in, ensures that you own 100% of the company (either alone or with co-founders), establishes an entry price for the company before any value is created, starts the clock on long-term capital gains tax, etc. It also gives you a vehicle for entering into contracts, claiming IP ownership, establishing business bank accounts, etc. I’m sure it is legally possible to do all this without a company being established but I believe it is good housekeeping and establishes all of the precedents. It also makes it easier when you’re talking to somebody 12 months down the line about joining to discuss them joining your company rather than something you need to found together. They will join with restricted stock or stock options but if you fall out of love your “pre-nuptial” agreement is in place.

  • marksuster

    Greg, it is NEVER too early for a lawyer to be involved. I understand that there’s a trade-off between the costs and your confidence in the company. But you should network with great lawyers in the same way you network with other entrepreneurs, VCs, recruiters, etc. They want to know great people and if they believe you’ll build something very interesting some day most will dish out a bit of pro-bono advice and/or take some forms of either reduced payment or deferred compensation for when you ultimately do raise funds. Obviously if you’re getting into filing patents you’re more likely to need to shell out some dough.

    re: IP documentation – Having a company and consultancy agreements that assign IP rights are necessary but not sufficient – you need to do everything possible to document and protect your IP. That doesn’t necessarily mean filing patents. There is always a cost/benefit trade-off in IP filings and it is always case specific.

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  • http://www.walkercorporatelaw.com scott walker

    Mark – another great post. As a corporate attorney for 15+ years, I must emphasize the importance of Lesson #2 (“Register a company”), which is a mistake that many entrepreneurs make. Indeed, the venture should be incorporated and stock should be issued to the founders as soon as possible — i.e., before the company has any significant value. Clearly, as milestones are met (e.g., the creation of a prototype, the signing-up of customers, etc.), the value of the company will increase and therefore so will the purchase price of the stock (which could trigger significant taxable income to those founders receiving stock in exchange for past or future services). Moreover, if a founder intends to transfer assets (e.g., technology) to the corporation in exchange for stock, Section 351 of the Internal Revenue Code (which permits a tax-free exchange under certain conditions) may only be available at the time of incorporation and not later after more stock has been issued. Indeed, the same principle applies with respect to the issuance of stock options/equity to employees: the goal is to do it as soon as possible when the value of the company is as low as possible. Thank you.

    Scott Edward Walker
    Walker Corporate Law Group, PLLC

  • http://thesundrychronicles.wordpress.com D.M.D.

    The title and first picture are awesome together..! Bravo!

  • kevin

    nice post Mark… quite informative and useful…. I would also like to prefer this book THINK LIKE AN ENTREPRENEUR… PERFORM AS A LEADER by Steve Mellinger to those who are planning to start their own business….
    http://entrepreneur2leader.com/

  • http://www.gazetna.com gazetna

    The issues are further increased when the potential founder is an officer of their current employer .

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  • http://www.coachingfromspiritchallenge.com Sharon Wilson

    Great tips! I believe that starting your own business requires having the right tools in order to fully understand where do you want to go.

  • Michael

    Great article and loving the information on your blog. In the Registering a company section, the link to Scott Walker (lawyers) comments doesn't seem to go anywhere. Would be interested to read what he said….thanks!

  • Michael

    Great article and loving the information on your blog. In the Registering a company section, the link to Scott Walker (lawyers) comments doesn't seem to go anywhere. Would be interested to read what he said….thanks!

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  • Les

    Good advice – we registered our company and nearly 18 months on we are only now really thinking about beginning trading, but it's important to protect your own identity and get yourself legal as soon as possible.

    Leave it to slip and someone else will take advantage of that opening.

  • Les

    Good advice – we registered our company and nearly 18 months on we are only now really thinking about beginning trading, but it's important to protect your own identity and get yourself legal as soon as possible.

    Leave it to slip and someone else will take advantage of that opening.

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  • Joe Beck

    Most software developers get really pi*ssed off when people/friends ask them to write code for little or no money, even in return for stock options (which, 99% of the time, turn out to be worthless). If you were developing property, you would have to PAY the architect from Day One, even for just drawing a few rough pictures. Why does everyone assume programmers will be happy to work for magic beans?

    Writing the code is the bulk of the work in developing a web business, and takes the bulk of the professional knowledge and experience. Unless you're going to make them an equal partner in your business, don't expect good programmers to work for peanuts (or fresh air).

  • Joe Beck

    Most software developers get really pi*ssed off when people/friends ask them to write code for little or no money, even in return for stock options (which, 99% of the time, turn out to be worthless). If you were developing property, you would have to PAY the architect from Day One, even for just drawing a few rough pictures. Why does everyone assume programmers will be happy to work for magic beans?

    Writing the code is the bulk of the work in developing a web business, and takes the bulk of the professional knowledge and experience. Unless you're going to make them an equal partner in your business, don't expect good programmers to work for peanuts (or fresh air).

  • Joe Beck

    Most software developers get really pi*ssed off when people/friends ask them to write code for little or no money, even in return for stock options (which, 99% of the time, turn out to be worthless). If you were developing property, you would have to PAY the architect from Day One, even for just drawing a few rough pictures. Why does everyone assume programmers will be happy to work for magic beans?

    Writing the code is the bulk of the work in developing a web business, and takes the bulk of the professional knowledge and experience. Unless you're going to make them an equal partner in your business, don't expect good programmers to work for peanuts (or fresh air).

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  • http://www.onlinewill.co.uk Wills Online

    When starting out nowadays i think it's worth contacting organisations like SeedCamp who specialise in supporting entrepreneurs. They can give you invaluable tips on getting off the ground and ensuring that your new business does not stagnate.

  • http://www.tothemoonknitwear.com Handmade Knitwear

    I think there is a lot to be said about preparation. We have recently set up a new company in the fashion industry and have spent the last 12 months preparing for the launch. This included the premises, materials, a website, and of course everything financially behind the scenes. We have a whole host of trade shows to visit in our attempt to market our company, and all of this was penned in a long time before the company launched. Admittedly we are a very small company so the planning may not be anything like that of a larger set up however the same rules apply. There's some great advice here.

  • Coniferousone

    9. Founder Vesting: I strongly disagree with this idea, at least without significant mitigating discussion. For example, how is one to handle a situation where founders initially split the initial investment, and equity is based on this split. Several may be working, others may just front the money. It strikes me as highly unethical, as someone who has experienced this situation as an investor/employee to retroactively determine that someone's previous investor-only (an investing non-employee) investment is somehow 'less valuable' as time goes on. A drop in relative percentages may certainly be appropriate, but it should be accompanied at the very least by a tangible, provable increase in the overall stock valuation. My percentage stake may go from %30 to %20, but the value of it as an asset should not drop from $300 to $200. This sort of approach may be something one could expect from Uriah Heep, but it is behavior of a sort that I do not believe ought to be tolerated.

  • http://www.karateinternetvideos.com/shotokan-kata Rharrison12

    Loved reading this article, very good advice. Thanks very much

  • http://pulse.yahoo.com/_LW3WAGLE4YR4MMOJM7DQ2Y2X7E MeXaHuK

    I have a question. You are talking about a tech start-up here where building a prototype is relatively inexpensive. How about other industries? I have a real-estate start-up and building a prototype without raising a capital first is impossible. I did a market research and financial model and I am ready to talk to investors to raise capital to open a first location. Should I build it out in full scale and call it prototype for the next round of financing, or should I build a scale down version to really test the market first?

  • http://www.mortonsmailing.com Mailing Fulfilment Services

    There are some excellent tips here thank you Mark.