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Common Legal Pitfalls in Angel Investing

February 21, 2018

Author: Curtis Cleaver

Angel Investors are often experienced businesspeople with a great eye for good ideas and talented founders. However, they are usually not lawyers with experience in some common legal pitfalls facing young companies. The following is a brief overview of some of the major legal issues that are encountered by angel investors in start-up companies.

1. Incorporation and Organization

Often start-up corporations will be short on cash, especially in their very early stages. We sometimes see corporations that are incorporated by the founders themselves through self-incorporation online forms. While this isn’t necessarily a fatal flaw, they will usually need to amend their Articles of Incorporation (to better define their share structure, for example) and bring their resolutions and organizing documents up to speed. If this is not done in advance of the angel investment, it can lead to tax and business problems down the road.

2. Intellectual Property Issues

Often times, founders of start-ups will work on an idea in their personal capacity before they decide to start a business and incorporate a corporation. It is of utmost importance that any intellectual property they have developed has been properly transferred into the corporation. This can be even more of an issue when there are multiple founders and/or the idea was created while the founder was working as an employee in a related field or attending post graduate studies in that area. The most valuable asset of many start-ups is their IP, and if the corporation does not actually own it, the investment is doomed from the beginning.

3. Lack of Understanding of Key Business Terms

While this may appear to be more of a business issue than a legal one, these two areas can often intersect. Angel investors will sometimes receive convertible debentures, special classes of shares, or both. It is important that they, or their legal counsel, carefully parse through these documents to ensure that they are drafted as the parties agreed and that there are no unintended consequences. Furthermore, angel investors will usually become a party to a shareholders’ agreement which will severely limit their ability to sell their shares in the future, except in very specific situations. All parties need to be on the same page and understand what they are agreeing to.

Curtis Cleaver is an associate lawyer at Miller Thomson LLP and has worked with both start-up companies and angel investors throughout the past nine years.