Good Companies Are Bought, Not Sold |  How Founders Can Get Legally Ready for an Exit With Becky Mancero of SPZ Legal

Speaker A: Today I'm joined by Becky Monsero, partner at SPZ Legal. We will be discussing common mistakes in company formation, how to use AI while staying compliant with the law, and how founders can best prepare for a successful exit.

Speaker B: Welcome to Bootstrapped the Lighter side, the podcast for B2B startup founders wanting to achieve success without giving up ownership or control. This podcast is brought to you by Lighter Capital, the leader in founder friendly financing for B2B SaaS companies. Learn more at, uh, lighter capital.com

Speaker C: we

Speaker A: are so excited to be here today with Becky Monsero, a partner from SPZ Legal. SPZ Legal is a law firm that works with technology companies from startup to exit. SPZ has worked with several Lighter Capital portfolio companies. They do a fantastic job. I think over the past decade, Becky, you've worked with over hundreds of companies, is that right?

Speaker C: Yeah, that's right. Thank you, Melissa. Um, I'm thrilled to be here today and really appreciate the opportunity.

Speaker A: So we are just going to get right into it because there are always lots of questions that Lighter Capital's portfolio companies have, um, around how to approach working with a law firm and when to get them involved and especially today in this world of AI. And we'll dig into that a little bit. Let's just start with what are some of the most common mistakes that you see founders make, especially when it comes to cap table or equity, mistakes that really become expensive to fix later.

Speaker C: I think startup equity and creating a foundation is essential for companies that are exploring kind of a scale route and plan to exit in the future. Setting it up correctly from day one not only saves, you know, a lot of money on legal cleanup in the future, but it also makes sure that as founders are preparing for that scale mode, fundraising, taking on lending or pursuing an acquisition, they don't get met with, you know, diligence issues that could create expensive tax liabilities for them in the future. So we'll, we'll talk about some of that today. But I think to answer your question directly, like the most common mistakes we see at the earlier stages around cap table and equity management are, uh, things like issuing equity amongst the founders before they actually define their role, responsibilities and longer term expectations of what their relationship is going to look like between each other and with the company. And so things that founders can do to kind of get ahead of this is, um, have those harder conversations early on, right? Understanding what each person's motivation is, what their strengths and weaknesses are, and how they plan to show up and contribute to the company, and then allocating equity ownership in A way that is equitable and fair. One thing that can kind of come out of that right, if it's not done correctly, is splitting ownership 5050 simply because both people started the company together. We've seen this happen time and time again, especially amongst like CEO and CTO roles where, you know, it's really not truly a uh, 50, 50 split in what each person is bringing to the business and how they're showing up. And so not only does that create tension with the relationship amongst the founders, but it can also create legal issues when it comes to voting and economic rights in the future. Another one to kind of look out for as early stage companies, especially in the world of AI, are getting traction and interest from investors early on is signing a term sheet or agreeing on an evaluation with an investor before the founder equity has been issued. The issue here is that you're essentially creating a valuation for the company at that point in time when you agree with that third party on what the company and idea is valued at. Which can mean that the founders don't get their equity for par value, which is like the lowest price per share, that the equity can be issued and instead we have to come up with a tax solution to fix that valuation problem.

Speaker A: So the solution is the company should be formed. An equity issued before you even sign a term sheet not only raise your first round of capital.

Speaker C: Exactly, yeah. And ideally, you know, once the founders have decided that they're going to pursue this idea together and have come up with kind of that equity split, they're talking with their lawyer at that point in time and getting the company formed and equity issued right away before they kind of go out and start having these conversations with investors.

Speaker A: Yeah, I've seen that. I think, you know, I was a vc, if I was an entrepreneur VC for a long time and then uh, I've been at lighter for the last six years. But I've seen it often where founders start a business together and then one really stays and is probably much more responsible for the growth, but has the same equity as the other co founder who may not be involved. And how would you suggest navigating that in the early stage? Because in the early stage, you know, I'm starting a business with my friend, we say we're going to split it 50 50, we're both all in. But as uh, we know things can change. But what should I do differently?

Speaker C: Yeah, I think there are a couple ways to approach it at the early stage and having those conversations to decide if not 50, 50, what's the right kind of split. Where I would start with that is outlining those roles and responsibilities of, um, what is each co founder going to do for the company in the next one to four years? So we can kind of understand, like in this earlier stage of growth, what's each person kind of committing to? And then based on the role and responsibility, does one feel kind of heavier than the other? If so, do we feel like shifting a few percentage points one way or the other is meaningful? Sometimes it just means 51, 49%, sometimes it means 70, 30, you know, and so I think it really depends on who's come up with the idea, who's bringing the business to market, who's going to be navigating investor relationships, customer relationships, building out the technology. Right. And really trying to understand what is a fair and equitable split that both founders feel comfortable with. So I think getting a sense and putting those roles and responsibilities on paper is helpful. And then putting in place vesting schedules with the equity is key as well, which I think we'll get into a little bit later. But, you know, making sure that the founders are vesting into their stock, you

Speaker A: recommend that 100% of the time, you know, we shouldn't start off with, you and I each own 50%. We say we each own 50%, but we're vesting over a period of time too.

Speaker C: Exactly. Yeah. And it solves for the problem you mentioned, right. Of like starting the business together. But maybe a couple years down the road, one person decides they're not able to take as risky of a position with a startup in their life, and they need to go corporate for family reasons or personal finance reasons or whatever it might be. Right. And they leave the company. If they continue to own a chunk of the company's equity, that can be a red flag for investors. And so making sure that they're vesting into like, the portion of the company that they've actually earned their stake in is a critical point.

Speaker A: Okay, what other advice on how founders should approach vesting schedules?

Speaker C: Yeah, so the typical vesting schedule is four years with a one year cliff. Um, and what that means is that at the onset, no equity is vested, it's all issued. So, you know, you issue the stock, you own it in a legal sense, but then you agree contractually to vest into those shares over time. And so if you leave the company, you forfeit the right to the unvested shares. And four years with a one year cliff means that nothing vests until you hit one year of service. And then at that time, 25% would vest after that point. Then you vest monthly typically until you hit four years of service with the company. So that's really like the standard vesting schedule that we see almost 100% of the time.

Speaker A: Funny how it hasn't changed. That's been it for 30 years and

Speaker C: it really has 30 or 30 plus

Speaker A: years and it just doesn't change. Must be the right, right formula. What about 83B elections?

Speaker C: Yeah, so 83B elections are really like one of the most important tax filings that a founder can make. And what it does is tell the IRS that they're going to tax you on the value of the stock at the time it was issued today when it's issued instead of as it vests over time and it becomes like a compensation. Right. That you vest into M. And so the tax filing has to be made within 30 days of when the stock is issued. And that's a strict 30 day requirement. So if you miss it, if you're going on vacation, you forget about it and you miss those 30 days. There's complicated kind of legal fixes you have to get into that uh, that are really expensive to do. And so making sure you're on top of that 30 day deadline is crucial. And the reason for this is that at the time of issuance the stock is worth very, very little. Typically, you know, it's issued at par value which is like 0.000001 cents per share or a very small value. And so that tax bill is often $0 or a very small amount of money. If the company grows significantly over time, if it signs a term sheet in that 30 day window, even filing that election can prevent the founders from having to pay taxes on the value of the company as it scales. And so if you forget to do this, it is a personal tax liability. But you can imagine that as the founder so integrated with, with the company, if they become disincentivized because they have a big tax bill that can create problems for investors and acquirers later on. And so this is a diligence item, um, that people are going to be looking out for and making sure this 83B election was complied with.

Speaker A: Yeah. And I would imagine that this is something that most people starting a company don't know about and they're not thinking about. They're trying to get their first customers and their first funding. So is this something you're often having to come in and fix and is there an easy way for companies to do this without spending a lot of money early on? Before they even have revenue or financing on legal fees.

Speaker C: Yeah, it's a really good question. Some of the formation services that are out there, like Clerky and Stripe Atlas, walk you through the 83B process if you use them for incorporation. And so oftentimes if a startup is incorporating and they have a very straightforward incorporation set up, we recommend they use one of those services, Clerky and Stripe Atlas. And those are both really well respected vetted incorporation services for startup companies. And they walk you through the 83B process, which is, you know, awesome. Of course a lawyer can do the same, but it can be more expensive from a resource allocation standpoint.

Speaker A: In this world of AI, why do I need a lawyer? Can't I just go online and ask Claude to give me all the documents I need and to get my company set up? I mean, why do I need a law firm?

Speaker C: Yeah, it's a million dollar question or a billion dollar question at this point. Uh, a lot of startups are working to solve. And so I think that the real kind of like answer here is that we should be using AI to support the legal process. But kind of consider at this stage in this point in time more of like a companion than a replacement, uh, for lawyers. I think AI is such a fantastic, like drafting assistant, so helpful for brainstorming like structure legal structures, asking complex questions and getting kind of research back. But it's not perfect and oftentimes it does hallucinate or use outdated information that can kind of have costly implications. And so I would encourage founders to use AI in the way that they might use it to kind of come up with those first ideas when they think of legal right for first drafts, for issue spotting, for initial research, for suggesting kind of redlining summaries, but not for producing like a whole agreement. Because what we typically find is that when, when you are producing an entire agreement through AI, it can have like inconsistent provisions, use kind of conflicting definitions, miss certain protections, maybe reference different areas of like different industries that are like unrelated to your business. And so it makes that, uh, agreement incomplete. Right. And so using it more as an opportunity to check things and test things versus create the full, full document.

Speaker A: Yeah, And I mean on the AI question, we see our team members and our customers using AI note takers all the time now. It's most more common than not. What are the legal privilege risks of having these tools in sensitive meetings or in meetings, period?

Speaker C: Yeah, AI note takers are again, an incredible resource, right?

Speaker A: Oh yeah.

Speaker C: It's so helpful to be able to have something in the Background that's collecting the information, synthesizing it, coming up with a summary, giving you action items. Right. And I think that, you know, with AI becoming like arguably the fastest adopted technology in business history, right. We're just integrating it into all of our processes and sometimes not thinking about these questions of like, what's actually happening behind the scenes. Um, and most people think of AI note takers as what we just talked about, right? Productivity tools, efficiency tools. As lawyers, we tend to be a little bit more skeptical about them because they can be viewed as like additional participants in the meeting. Right. It's a third party vendor essentially, who's coming in and taking notes on your behalf, listening into the conversations and then producing that output of the note summary. And so every AI note taker, to complete its role, has to create a copy of that conversation somewhere. Right? And founders often don't know what, where is that conversation being stored, how long is that information being retained for, how is that data being used to train the AI models and who can access the transcripts later. And so I think in general, right, for like internal meetings, non privileged conversations, conversations where like, confidentiality is not going to be like, as important amongst the participants in the call, like, probably fine to use that AI note taker, right? But as you think of like more sensitive discussions like board meetings, investor negotiations, employment matters, where, you know, maybe there's a potential for an employment dispute down the line, M and A discussions, and of course attorney client communications, right. We want to be really mindful about who's in the room and who's accessing that information. And the AI note taker should be considered in those questions and oftentimes kicked out of the room, in my opinion.

Speaker A: And it's. So it's not. If I'm talking to you and you're our corporate lawyer, we have a note taker. So is it no longer privileged or the note takers discoverable? Because I thought as long as the lawyer was there, then everything we talked about was privileged. Is that not the case?

Speaker C: Yeah. And it's something that we don't have a ton of like, guidance on from the ABA yet, and how they view American, uh, Bar association, how they view those note takers. And so I think the kind of guideline has been right, that if we want to ensure attorney client privilege protection over those conversations, the best practice would be to remove the note taker because it is technically deemed a third party. And once you bring in a third party to a conversation with an attorney and the client, that can break the privilege and the confidentiality amongst that conversation. Yeah, it's a tricky balance for sure.

Speaker A: Along those lines, I think it's more and more common that people are using tools that are just on your computer and recording everything you do, every conversation, everything you do. And they're incredibly helpful because capturing every follow up and it makes it very easy to recall previous conversations. How should we approach that? If I'm talking to you, I'm not using it now, by the way, but if I'm. Although we are recording this, this is a podcast, but if I'm having a conversation with you, do I need to disclose that? Do I need to get permission?

Speaker C: I think the best practice would be yes. The answer is more nuanced because recording laws are state by state. And so when you're in the U.S. for example, in California, in order to record a conversation and for that to be legal, both participants need to consent to the recording. If there's kind of shadow AI in the background recording the conversation and the other participant doesn't know that, then I think there is a question of whether that's legal recording activity. In Colorado, where I live, you only need one participant to the conversation to record the conversation. So, um, you know, it just depends kind of state by state where each person is located and what law applies. And so I think like out of, you know, respect for the other person in the conversation, it's. And to ensure like compliance with laws. Right. Probably a good idea to like let somebody know, hey, I'm using this AI platform to record our conversation and help me with taking notes to make sure we can be more efficient in our follow ups. Like are you okay with that? And kind of respect. Whatever their answer is, that makes perfect

Speaker A: sense along those lines to something that we recently put together. How should a startup, uh, or a company, any company, balance wanting their team to be efficient with AI while protecting confidential customer data or confidential company data? And what does a good corporate company AI policy look like?

Speaker C: We implemented RA policy at STZ last year as well, so I'm with you on that. And it's kind of fresh in our minds as we're figuring out our own AI strategy. But I think a good AI policy doesn't tell employees not to use AI, but how to safely and compliantly use it. A ban, as we've kind of seen with some, um, clients, with some other law firms who are skeptical of using AI is just not effective. Right. Because what oftentimes happens is that the employees want to use AI and they end up using their own personal accounts to access the platform and be able to use that for doing their job, which can create a lot of exposure for the business, especially if, uh, confidential information is entered into that personal account that's not protected by a business license. So I think like an AI policy should really be customized to the business's needs and practical implications. And for some businesses that might look like a 10 page document that breaks down all the different platforms they use and how they use it, especially if they're in a highly regulated industry. For others it might be one page that is simple and gets to the point. And I think in general just having a policy in place is more important than not having one. And so the things that should be included in that are what AI platforms that employees can use and under what licenses. So is that, you know, ChatGPT Enterprise, is that Microsoft Copilot, is that cloud enterprise, making sure that their authorized users under those licenses and that the company has vetted, you know, the platforms that the employees are accessing should also include what information can be inputted into the AI system. Right. And what information should never be inputted into it. Right. And so for some companies that might mean no customer confidential information goes into AI, Social Security numbers, personal health and protected health information, trade secrets and sensitive financial information. Like that's just a list of things that you might consider having a hard ban on putting into AI as inputs. But you know, it really just depends on the company's business, what AI platforms they're using and what those licenses say. You know, additionally in the policy, think about how you want AI and human interaction to exist in your company. Right. Do you need to require human review on certain functions like hr, like legal, like customer communications, compliance, like having a policy that says like you can't just use this AI platform to completely replace that human review, uh, may be necessary for certain companies. And then lastly, I think a good policy always includes some sort of audit procedure, right? To make sure that the policy is working, to make sure that employees are complying with the policy. And so figuring out, you know, on a regular basis whether that's quarterly, annually, how do we audit this policy and make sure it still works for our business and that our employees are following it.

Speaker A: And is there an off the shelf one that people can start with and um, tailor to their company's needs?

Speaker C: That's a good question. I'm sure you could put it in ChatGPT or Cloud and have them create it for you. I'm sure, I'm sure there are good templates out there, you know, and I Think again to our earlier point, like using it as an initial starting point and then maybe running it by your corporate attorney to just have a quick glance and give you any feedback and see if you're missing anything that should be included.

Speaker A: Okay, well, let's talk about preparing for an exit. This is something the 1200 plus rounds of financing we've done at Lighter Capital, a lot of our companies have, uh, had successful exits. And it's something they're, I'd say almost all thinking about. We have maybe a small handful that just think they want to run their company forever and never sell it. But most have some intention of selling it at some point. What I've seen is that founders are often shocked by the sheer volume of due diligence checklists. These can top 150 questions to start. Yeah, yeah, and you've probably heard this, but, you know, we've said it often good companies are bought and not sold, which means oftentimes when an exit happens, it's because a company was approached. So they weren't planning on, uh, selling necessarily at that time, but they were approached with a good offer. So what should you do when, how can a company start preparing for that process early? And what are the first things a founder should audit or clean up if they're thinking about an exit in the next, say, 12 to 18 months?

Speaker C: Yeah, this is such an important point. And I also want to say, like in an ideal scenario, a company is doing what we talk about and as the next step, it's not oftentimes the case. And so don't beat yourself up if you're not totally perfect with it. But I think starting to think through systems is crucial, um, if you're considering an M and a exit and getting ready for diligence. Because oftentimes I think startup founders are wearing so many different hats as they're building their companies. And becoming disorganized in keeping track of your company as it scales can have really negative implications on the diligence process. Can be a sign for buyers that, uh, you're not sophisticated in managing your business, which might make them dig in deeper as they go through the diligence process. It can rack up a ton of legal fees trying to get organized and figure out what agreements do you have out there, going through your DocuSign account and trying to piecemeal things together. It's just not a good use of anybody's time. And I think it can also just make the process more emotionally taxing than it truly needs to be. As founders are trying to run a business and go through an exit process. And so with that kind of context in place, right, Like, I think that having a record of your kind of key legal documents and building on that record over time is something that will help set you up for success. And what this kind of looks like in practice is just making it more of a habitual thing that you do, maybe on like a regular basis, like quarterly or semiannually, going through and updating a data room and making sure that in that data room you're adding all of your kind of crucial legal documents, which would include things like your corporate records, any filings you've made with Secretary of State's foreign corporation filings, your minute book for the board and shareholder meetings and consents, having an updated cap table, you know, if you use a cap table management system, just downloading it, putting it into that data room, having a file with all of your commercial contracts with vendors and customers, all of your fundraising documents in one place, right. You get closing sets every time you complete a funding round, whether that's with equity investors or lenders, and making sure that that's saved there as well. All of your service provider agreements with employees, consultants, advisors, whether they're active service providers or not, an acquirer is going to want to know everybody who's touched your business. And so making sure that those documents are signed, that's oftentimes an issue. They're not countersigned and saved. Things like tax filings, IP filings, and any like legal actions or regulatory actions that have been taken against the company. So just updating that regularly, right. And getting into the habit of that can really set a company up for success as they kind of grow and scale. And so once you get that term sheet or start having conversations with potential acquirers, getting that data room and diligence ready isn't going to be as challenging as it would be if you're kind of unprepared. There's so much more you can do. But that's really like, I feel like the foundation that you can set up that will make the process so much more successful.

Speaker A: One thing I've seen come up that can just really slow down and sometimes kill an M and A process. And that's clear IP ownership. So when maybe a, uh, consultant or even an ex employee has done some work and it's not clear if they might have a claim to that ip, it can steer potential acquirers away. One, that's sort of the worst case scenario. The second worst case is you could have to write a Big check to someone in order to be able to get clear ownership of that IP for the. And third is it just creates time doing an activity that should have been handled years ago.

Speaker C: Yeah. And I would add the fourth thing there would be, if you can't get a signature or you can't track down that person, you think they signed the agreement, but you're not sure. Like, the buyer's not going to take on that risk. And so they're going to make you have a special indemnity for it. Right. Or decrease the price in the company and indemnification and M and A and having special indemnity. Like, not only is it. It can be a challenging thing to negotiate because it's like admitting to this red flag in your business and having to face it, but it can also mean, like, I feel like sometimes it's an emotional tax on the more significant stockholders in the company because it's like a question mark that, you know, if this claim were to come down the line in the next three, five years, however long that special indemnity lasts for, sometimes it's even forever, depending on your leverage, until the statute of limitation expire. That can loom for founders and make them nervous about spending their money, investing their money in case they need to protect it for a potential claim that could come down the line. So, yeah, I think that's a significant point. And to the earlier question of what can you do over the next 12 to 18 months, I really think about this in like, three different categories. And it's ownership. So that includes doing, uh, what we call a cap table tie out of your equity, your cap table in the company, and making sure that all the equity was properly issued, because that's going to be one of the diligence items that, uh, an investor or an acquirer goes through and vets to make sure that the cap table is accurate and that everybody who's been promised equity has been issued equity. And then also to your earlier point, confirming IP assignments with all the service providers and that the chain of title of the IP is how you think it is. And so that's a critical point to start getting organized on and making sure you have all of the right kind of documents and assignments in place. The second bucket is around contracts. And so, you know, one of the things that will be heavily diligent are like, the company's material contracts with their customers and their vendors. And so going through and making sure you have all of those agreements and ideally creating a matrix that kind of outlines like, who the counterparty is what the date of the agreement is, what the term is, renewal terms, kind of where are you at in that contract? If you agreed to any, you know, off the shelf sort of terms for any of those customers or vendors, meaning you heavily negotiated things like indemnification, limitation of liability, sometimes dispute resolution, like understanding kind of what are the key provisions within those agreements and how they've been negotiated. And having a tracker of that can be really helpful for a diligence process. And then the last category would be compliance. Even if you're not in a highly regulated industry, like conducting a legal and compliance audit to ensure that your privacy, security, governance aspects of your business are up to snuff and if not understanding what those red flags are, because they will become questions and diligence and maybe if you have 12 to 18 months, you can start implementing more compliant practices that will heavily kind of mitigate the issues in those areas. And then of course, if you operate in heavily regulated industry, or if your customers operate in a heavily regulated industry, conducting a compliance audit. So yeah, ownership, contracts, compliance, and I think those are really three categories that are hopefully easily digestible to start kind of working away over that 12 to 18 month period as you're planning for

Speaker A: an exit on the legal and compliance audit. Is that something, One, what does that look like? Is that something with an external firm? And two, is that something that hygienically for good hygiene, you should just do that every year, every two years or I think of our company and our portfolio companies, they're busy on sales and building a business and not thinking about doing this until they absolutely have to. But is there a simple way just to make this part of if you're operating?

Speaker C: I think it is if you have an in house lawyer or in house legal team, this is something they can handle. You know, what it would look like is kind of going through each of the aspects of your business and going through and understanding like what have you been doing in those areas, where are your gaps and what do you need to do to kind of bridge those gaps? I do this with clients. Typically I offer it like in January, February to go through like a legal hygiene checklist. And we just go through the areas, have a conversation, understand what their roadmap will look like for the year and how some of the legal work can fit into it. I think having kind of that proactive approach can save on legal resources. And it can also just make sure that your legal team is, you know, really integrated in your business and understanding what's going on probably initially like a, uh, conversation to understand what those hired touch topics are and then after that diving into those, reviewing the contracts, reviewing any policies that you have in place and making sure that you're complying.

Speaker A: I would say in reality, at least in my experience, this only gets done right before an acquisition. Are, uh, you seeing companies that are really doing this just as a business as usual practice?

Speaker C: It typically is done in connection with the acquisition, like in a full, detailed scope. Ideally you're doing some sort of legal review, maybe before financings, before entering into larger partnership agreements, and to the extent you can, you know, on a regular basis with your attorney team. But you're right, it's something that understandably can get put on the back burner. And I think in an ideal scenario you are doing this regularly before the acquisition is on the table to kind of catch these issues before they can, um, have a meaningful impact on a purchase price.

Speaker A: Becky, thank you so much for joining us today. You provided so much valuable information for companies, whether they're at the stage of just getting started or exiting or thinking about how they should be using AI responsibly. How can companies get in touch with you or access some of the resources you've created?

Speaker C: Thank you, Melissa. I'm truly grateful for the opportunity to join you today and to, to talk through these legal topics which are not always the most exciting but, but are important for companies as they grow. And so again, just really appreciate the opportunity to speak with you and the lighter capital community anybody's interested in getting in touch. You can find us@, uh, spz legal.com and my email is beckypzlegal.com it's on the website so you can easily discover it and happy to share it and and be a resource for anyone who's interested in connecting further.

Speaker A: Thanks again to Becky for joining us today. And to learn more about SPZ Legal you can visit SPZLegal.com that's s p z l e g a l dot com and to learn more about Lidar Capital and what non dilutive financing can do for startups, visit lyttercapital.com the interest

Speaker B: information in this podcast is provided for informational purposes only and should not be construed or relied upon as legal advice. No attorney client relationship is intended to be created through this podcast. This podcast may be considered attorney advertising in some states. Prior results do not guarantee a similar outcome.