The rise of startup culture and ecosystems has driven a proliferation of individuals holding themselves out as startup advisors. Many of these folks have at least some experience as founders themselves or as investors.
As should be expected, some startup advisors know what they are talking about and are thoughtful and insightful in advising entrepreneurs.
Others negligently provide advice that is simply wrong.
For example, how about the famous Shark Tank veteran saying unequivocally in video ads broadcasted tens of thousands of times that “an LLC is the best form of incorporation for your business.”
Really, a limited liability company is always the best form of incorporation?
Even though VC funds can’t invest in LLCs?
Even though drafting and negotiating an LLC Operating Agreement costs thousands of dollars due to legal, tax and accounting complexities?
Even though LLCs can’t issue stock options to their employees?
Even though LLC owners cannot benefit from potential capital gains tax relief available to certain early investors in corporations under IRS Section 1202?
To be clear, LLCs have their place where certain tax considerations are present. Like the need to avoid double taxation on cash distributions to owners or certain types of asset sales.
But most tech startups wishing to obtain VC funding, issue stock options, and operate in a more commonly understood governance structure actually should be corporations, not LLCs.
Bad startup advice doesn’t begin and end with entity selection. It can be about pre-entity formation concerns, governance, intellectual property protection, equity grants and allocations, fundraising, and more.
In researching for this article, it was great to find two excellent videos on the topic of bad startup advice. One is from YCombinator and the other is from Lance Cottrell:
And here's an article that also has some helpful insights from Scott Chisholm:
Consider the Source – Evaluating/Filtering Advice and Advisors
When receiving advice, founders should consider the source:
What experience does this person have to give the advice they are giving?
Is their experience relevant to your stage of development, sector, and proposed business model?
Do they have a track record of success and how were they the true driver of that success?
What motivations (including self-interest) do they have for giving the advice they are giving?
Has this person asked enough questions and received enough information to have the full context necessary to give the advice they are giving?
Regarding the Shark Tank veteran’s advice that every new business should be an LLC, this person has lots of experience, but his motivation was simply to be paid by a company that forms LLCs. He also had zero context to provide that "advice" to the entire world.
The Best and Worst Advisors
The best startup advice will almost always come from someone with experience working closely with lots of startups – some that succeeded and many that failed.
Within this group, the best advice givers are usually individuals who have launched and successfully exited their own startups.
And then, within that group, an entrepreneur will benefit most from an advisor with experience in or adjacent to the entrepreneur’s sectors.
On the other hand, bad advice is more likely from individuals with experience at only one or two startups, maybe as an angel investor or narrowly-focused individual contributor, individuals with only big-company experience recommending a lot of big-company best practices and solutions, and individuals operating physically well outside any recognized startup ecosystem, unless they have reasonably recent roots in a major startup ecosystem.
Founders should accept little to no advice from anyone with no experience in startups. Experience in large companies, family lifestyle businesses generally, or other types of enterprises is generally not relevant to startups.
One type of advisor to watch for is the person who is wealthy enough to make early investments in the $50,000 to $100,000 range, with relatively limited or mostly irrelevant experience, but who has strongly held and possibly rigid ideas. I’ve seen a few of these folks impose questionable “advice” as a condition of receiving their early-stage investment. Run….
For entrepreneurs in many small towns, finding good advisors can be a difficult quandary. Probably best to develop relationships with folks in major startup hubs, even if merely online. As the gentlemen in the YCombinator video point out, advisors in smaller ecosystems are often more adept at and focused on creating small local or regional businesses and are less interested in creating larger companies that can scale nationally or internationally.
It may also be helpful to be skeptical of the idea of relying too much on just one or two advisors, rather than networking aggressively with lots of founders and investors and absorbing, distilling and debating lots of ideas, solutions, and strategies. Don’t put all your eggs in one basket if you have any doubts.
Self-Educate to Inoculate
To thoughtfully assess advice, founders should first take the time to inform themselves across a range of business, financial, legal and regulatory fundamentals. Searching Google for “Favorite Startup Books” should help you find lots of excellent resources on strategy and execution. Power through a few widely recognized books on launching a successful business.
You can also find a wealth of reliable advice and information in the YCombinator Library, including many highly informative videos - https://www.ycombinator.com/library
The first or second page of results in any such Google search is likely to also include my book, Startup Law and Fundraising for Entrepreneurs and Startup Advisors, which can help inoculate you from bad advice in the areas of entity selection and formation, intellectual property protection, structuring key relationships, governance, and startup finance fundamentals.
Here are links to other good legal resources for startups:
Cooleygo - https://www.cooleygo.com/
Cooleygo’s Delaware Incorporation Package - https://www.cooleygo.com/documents/incorporation-package/
Perkins Coie Startup Percolator - https://www.startuppercolator.com/
Fenwick Startup Resource Center - https://www.fenwick.com/startup-resource-center
Orrick Tech Studio Resources - https://www.orrick.com/en/tech-studio/resources
And here are some of my other articles from StartupGC.us:
Startup Advisor Red Flags
In addition to weighing a specific advisor’s relevant experience and potential conflicts or blind spots, the following are some red flags to consider.
Early Advisors Seeking to Dominate. Many early investors are interested in playing an advisory role. Some of these individuals bring a lot of experience and value to their founders. Others can be more disruptive and can sometimes influence startups in misguided ways.
I recently distanced myself from a situation where an early investor in a small town was exercising influence over some young founders and guiding them toward questionable decisions. Among other things, he was driving them toward forming an LLC “… so we can dividend excess cash out to the founders and it isn’t double taxed.”
Aside from a lifestyle-type business, what tech startup ever dividended “excess cash out to the founders?” Tech startups never have excess cash. Mostly they drift in and out of insolvency while trying to figure out how to prioritize limited resources to capture market share, drive revenue, develop the product, and achieve some degree of profitability to reinvest in growth.
Needless to say, I did not want to get on that bus and butt heads with that advisor about one issue after another.
Being a founder is hard work. Advisors should not be crutches for founders that dissuade them from putting in the hard work of being their best selves as founders.
Good advisors know that helping a founder grow and develop in their role is their most important function, and they do so by asking lots of questions and causing the founder to think critically about key decisions, not dominating those key decisions.
Conflicts of Interest. Another red flag is advice coming from individuals with institutional conflicts, like those working for large companies that want to engage with startup ecosystems to advance their own corporate interests.
It is nice to have connections with entities that might ultimately provide a great exit, but realize that their advice could be antithetical to an entrepreneur’s interest, particularly if the entrepreneur is seeking to disrupt the business model of the larger company. Engage, but with caution and a proper perspective.
The Problem of Accidental Partnerships
Before one or more founders of a possible startup have actually created either a corporation or an LLC, they are vulnerable to advice that can severely impact founders’ interests and the startup’s prospects.
There is a troubling scenario that continuously repeats itself in academic innovation clinics and hubs, even in the most prestigious of institutions. Students are often instructed to form groups for the purpose of coming up with a business idea and launching it as a business.
Occasionally, one or more students already have an idea for a business that they believe they can contribute with the understanding that they will properly be a dominant owner or owners of the business.
Before contributing their idea, however, the correct thing to do would be to form and launch a company to which they have contributed their business idea and all other related intellectual property. They can then use proper documentation to have the other students become consultants or advisory board members of the new company, perhaps even receiving appropriate stock option grants.
But what almost always happens is that the program instructors first have all of the students in each group divide up and perform certain tasks, such as designing the product or service, studying the market opportunity, creating a go-to-market strategy, and developing a financial forecast and financing strategy. Months into this process they might then be instructed to form a company – frequently and sometimes mistakenly, an LLC, and often an LLC missing the critical contractual component called the Operating Agreement.
At that point, disputes sometimes arise as to roles, governance, and/or equity allocations. And sometimes the person or persons who contributed the business idea end up being told by the others that they will not be receiving the allocation they originally suggested in exchange for contributing the idea.
And this is when the law of general partnerships can muddy the waters. Most states have adopted versions of the Uniform Partnership Act that are very similar to Washington State’s, and this is what they say about what it takes to “form” a partnership:
RCW 25.05.055 - Formation of partnership.
(1) Except as otherwise provided in subsection (2) of this section, the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.
(2) An association formed under a statute other than this chapter, a predecessor statute, or a comparable statute of another jurisdiction is not a partnership under this chapter.
What this means is that, when two or more persons “carry on as co-owners” of a business, unless they have first formed another type of entity, such as a corporation or LLC, they have formed a partnership. And absent any other written agreement among such persons, they are all equal co-owners, they all can bind the partnership to contracts or other obligations, and they each have an equal claim to the profits of the business, not to mention unlimited personal liability for any debts of or claims against the partnership.
So if one of the participants is not happy with their proposed equity allocation in the new company, they may very well be able to demand equal ownership – particularly if they seek legal advice regarding the issue.
Many business lawyers also call general partnerships “accidental partnerships” because they are most often created by accident. I can think of no good reason to "form" a general partnership.
I have been asked to straighten out more than one of these accidental partnership situations and have never succeeded at undoing the damage.
MBA schools and other institutions that run these types of startup creation programs need to educate themselves and their students about these risks and stop putting student entrepreneurs at risk of losing their valuable business plans and related intellectual property.
For any innovation program manager reading this, I am always willing to send you a free copy of Startup Law and Fundraising and to give a free talk to each new cohort of students coming through your program. I would much rather prevent damage than try to fix it later.
Another solution apart from immediately forming an entity is the possibility of entering into a “Founders Agreement,” which essentially spells out what will happen among a group of prospective co-founders if they do not go forward with the business – including the idea that intellectual property will revert to those who contributed it.
The University of Pennsylvania Law School has created the best template Founders Agreement that I have seen, which can be found at this link - https://www.law.upenn.edu/clinic/entrepreneurship/startupkit/founders-agreement.pdf.
Again, I think it’s best to just properly form the entity, but a Founder’s Agreement is better than nothing.
Advisors Who Force IP Fails
A common theme among advisors from purely business, science, or academic backgrounds is to avoid spending any money on legal and governance matters, presumably based on the idea that any mistakes can be fixed later. But some legal and governance mistakes cannot be easily or inexpensively fixed.
Bad Trademarks. The lack of any trademark clearance or forethought may be the most common mistake startups make, whether or not forced or encouraged by an advisor – i.e., becoming wedded to and even somewhat stuck with a weak and highly vulnerable trademark.
The strongest trademarks are those that nobody else is using and that are either “fanciful” (e.g., “Expedia”) or “arbitrary (e.g., “Apple”).
Marks that are used by others, whether formally registered or not, are likely to cause problems, such as claims of infringement and difficulties in registering to do business in one or more states. The threshold for trademark infringement is confusing similarity – sounding the same, looking the same, and/or spelled roughly the same. Swapping a “z” for an “s” is not going to matter.
And, contrary to popular belief, being in a different industry won’t always stop an aggressive infringement claim short of going through a trial.
Marks that are “merely descriptive” are also problematic. Most startups select descriptive names – i.e., names that directly or indirectly describe the good or service offered. These marks are not only more likely to be alleged to infringe other marks and to be hard to develop effective digital advertising campaigns around, they are also more likely to be rejected for registration by the U.S. Patent and Trademark Office.
While federal registration is not a fail-safe guarantee that a common law trademark with priority doesn’t exist, smart investors will certainly see it as evidence of a reasonably investable brand.
Lost Trade Secrets. Advisors who don’t understand trade secret law are likely to encourage or participate in practices that cause startups to compromise their trade secrets through oversharing and excessive informality. Trade secrets are subject to strong civil and criminal protections under state and federal law. Under those laws, a trade secret is any idea or information that (i) is secret, (ii) has economic value because it is secret, and (iii) is subject to reasonable protections to maintain its secrecy.
All kinds of advisors and organizations create situations in which startups can be deemed to have lost trade secret protections. Any sharing of a trade secret in any context outside of a “Non-Disclosure Agreement” (“NDA”) or other binding agreement or commitment prohibiting the recipients from sharing or misusing the shared information renders the shared information NOT a trade secret.
Exceptions to this concern includes situations where the sharing occurs in a relationship of confidentiality, like an attorney-client relationship, and perhaps even in mentor relationships and other such situations where the parties verbally agree that everything shared is to be held in strict confidence.
If someone, like an investor or mentor, won’t sign and NDA, at least have them confirm orally that they will not disclose or misuse your confidential information.
Yesterday I saw a post by a sophisticated angel investor whom I respect calling for entrepreneurs to bring their ideas to a “brainstorming” session with various other angel investors and startup advisors. A previously undisclosed business plan can constitute a trade secret. Individuals who sign an NDA can be told about the business plan and it will still be a trade secret that those persons cannot steal. Sharing the business plan with a room full of other individuals who have not signed a Non-Disclosure Agreement means that any of those persons can steal the business plan with impunity.
That post was the final push I needed to write this blog post.
And to be clear, business plans are stolen all the time, even when an NDA or other contract is in place, as evidenced by recent claims that Albertsons had stolen a startup’s entire business idea - https://www.geekwire.com/2024/seattle-startup-replenium-accuses-albertsons-of-stealing-trade-secrets-under-guise-of-partnership/.
This is a tricky area for founders because they have to talk about, share, and bounce their ideas off others to make progress. Where it’s impractical to ask for an NDA, founders should simply limit their sharing to big-picture concepts and avoid sharing trade secrets.
Here’s an article I wrote about avoiding all manner of NDA/trade secret mistakes – Don’t Lose IP to NDA Mistakes!
Lost Patentability. Perhaps more concerning than losing trade secret protections is losing the ability to file an application for an otherwise patentable innovation. Again, the rigorous use of NDAs is required.
Essentially, once an innovation is publicly shared, the inventor has one year to file a patent application in the United States, but the public sharing (especially via any kind of publication or product release) of an innovation renders it unpatentable in the rest of the world. This is because an innovation must be “novel” to receive patent protection, and any pre-application disclosure by the inventor renders the innovation no longer novel.
Limited disclosure pursuant to an NDA is sufficient to maintain patentability, but the best protection is always to file before disclosing, even if pursuant to a less costly “provisional patent application.”
Angels Whose Financing Terms Taint Your Cap Table
Any angel investor requiring aggressive financing terms is likely to harm the startup, the founders, and themselves. Even if the angel is simultaneously holding themselves out as an advisor or mentor.
This is because later investors might be turned off by seeing those terms in the startup’s cap table. The most obvious types of provisions to avoid might include:
Outsized ownership interests for small investments – e.g., 20%+ for $100,000 investment.
Warrants, i.e., the right to purchase more shares in the future at the same price.
VC-level preferred stock terms in a small investment round – e.g., anything less than $1,000,000.
Weird terms, like any obligation by the company to repurchase the investor’s shares on demand.
The problems with early warts on your cap table are that they are unattractive to smart-money investors and they also tend to spread to future financings. For example, if your first investor requires warrants, all future investors will also likely require them – and warrants are dilutive.
In early financings, it is generally in everyone’s best interests to stick to tried and true, commonly used financing instruments on market terms, preferably convertible notes or SAFEs with reasonable discounts and valuation caps that won’t drive away future investors.
The False Allure of Equity Crowdfunding
Most of the hype around equity crowdfunding has fortunately died down and most of those shilling for it seem to have moved on to other endeavors.
While I am a big fan of non-equity crowdfunding on a platform like Kickstarter, equity crowdfunding should be avoided like the plague for any company that hopes to later bring in VC investments.
The simple reason for this is that no VC firm wants to invest in a company with a cap table bloated by hundreds or thousands of non-accredited investors. This is true no matter what any crowdfunding “experts” might tell you.
AngelList used to do crowdfunding-type fundraisings through syndicates that put all investors into a single-purpose investment entity (usually an LLC) that then held the startup’s crowdfunded shares as sole owner. That platform has been sold by AngelList and is now operated by a different company that I haven’t researched.
I don’t believe any current crowdfunding platform actually solves the bloated cap table problem, despite some very disingenuous assertions to the contrary that I tried unsuccessfully to verify several times with securities counsel for leading crowdfunding platforms.
No matter what a platform says, if investors from that platform do not invest through a single-purpose investment vehicle, like a newly formed LLC, then all of the investors should be listed individually on your cap table. If you are told some vague “custody agreement” solves the problem, you are being lied to. A custody agreement governs the physical custody of shares, not their beneficial ownership.
So, if you crowdfund and gain hundreds or thousands of non-accredited investors, you will have to disclose those details in any future financing. To do otherwise arguably constitutes securities fraud, as the implications of having hundreds or thousands of non-accredited investors is a material fact that must be disclosed to future investors.
VCs generally won’t touch any company that has crowdfunded, due to the high numbers of accredited and non-accredited investors, which create various substantial risks and administrative burdens for companies.
Another thing worth pointing out is that crowdfunding often does not succeed anywhere near the levels one would expect from the hype and advertising.
Misrepresentations in Advertising and Fundraising
Be cautious about taking aggressive advice regarding advertising or fundraising. These are two areas where legal and regulatory consequences can be swift and severe.
Despite what others might encourage, resist the temptation to make any factual misrepresentations in either advertising or fundraising materials. Here are some examples of factual misrepresentations that could put your company in hot water, if the actual facts/reality are something along how I have stated them.
Statement: “We’re the leading innovator in our space.”
Reality: Haven’t launched yet or taken any meaningful market share.
Statement: “Our product has been tested and validated by XYZ third party/agency.”
Reality: No such testing has occurred.
Statement: “XYZ company’s product/service is less technologically advanced than ours.”
Reality: There is no proof in the file that XYZ company’s product/service is less advanced.
Statement: “We have everything in place to rapidly scale up manufacturing.”
Reality: No basis for saying such arrangements are in place and ready to go.
It’s important to emphasize here that enthusiasm, confidence, and passion are all critical, and that even some level of actual puffery is necessary to make it as a startup.
Just don’t cross the line of lying! Especially about provable facts.
In advertising, misrepresentations will attract the wrath of competitors, regulators, and disgruntled customers and employees, and in fundraising it will hand a cudgel to disappointed investors who want their money back.
The regulators to be concerned about in these areas are the Federal Trade Commission, state attorneys general, the Securities and Exchange Commission, and state securities regulators – all no fun outside of a bar.
I have seen advisors push risky advice in these areas. They lack the expertise to assess any of these risks, and they are also not the ones who will experience any of the direct consequences for mistakes.
Inexperienced Counsel
There are lots of great attorneys and firms who advise startups. I even have a Global Startup Counsel Registry with great attorneys from all over the world – Startup Counsel Registry. You will see at the end of the Startup Counsel Registry that I am missing recommendations for a number of important cities. Please provide referrals for me to talk with about including them.
You also generally can’t go wrong with an attorney from the following firms, considered to be among the best in counseling startups and emerging growth companies:
Wilson Sonsini
Fenwick& West
Cooley
Orrick, Herrington & Sutcliffe
Perkins Coie
Sidley Austin
Some of these and other reputable firms might defer fees and/or reduce a startup’s fees in exchange for equity/stock. And that could be a good thing, depending on the terms, because the legal fees for Big Law can be large. Attorneys in Big Law are billing out between $500 and $1,200+ per hour these days.
But founders should be very careful about cost-cutting. Counseling startups is challenging. There are simply lots of areas where startup counsel should have deep expertise that is not easy to come by.
At a minimum, startup counsel should have a command of both the big picture and the nitty gritty in these areas:
Entity selection and formation
Governance
Contracts
Intellectual Property
HR law
Litigation
Regulatory compliance
Securities law
Equity compensation
Finance/Fundraising/Cap Tables
Advertising law
Founders should not retain an attorney as the primary legal advisor to their startup if that attorney cannot detail their experience and competency in most of these areas. The results could be disappointing, to say the least.
Summary
Apologies for the negative/cautionary tone. The idea of filtering and identifying bad advice is a difficult topic. Even smart people give bad advice sometimes.
It is also important to provide opportunities for competent folks to become tomorrow's awesome startup advisors, but those opportunities should be calibrated to the level of expertise they bring to the table at each stage of their development.
But just get informed and be safe out there, founders.