Tumml RAs May Samali and Jeff Carlson flag common legal errors made by entrepreneurs
First appeared in Medium on July 15, 2015
In our experience, many early-stage entrepreneurs launch their startups without consulting a lawyer. Lawyers are expensive, after all. Ironically, it almost always costs more money and takes more time to fix legal mistakes down the road.
Complying with the law is particularly important for early-stage startups courting investors. But all too often entrepreneurs scare off potential investors with messy legal documentation or impending liabilities and lawsuits. One of the worst reasons for startup failure is making avoidable mistakes. To prevent startups from falling into legal pitfalls, we’ve compiled a list of eight common legal errors made by early-stage entrepreneurs:
- Neglecting your documentation. Record every important interaction involving your company, and keep your documents in order. Legal due diligence can make or break an investment deal.
- Lacking a founders’ agreement. Think of your founders’ shareholder agreement as a “pre-nuptial agreement” for your founding team. Because nine out of 10 startups fail, it is worth thinking about how you and your co-founders might deal with failure. Your founder’s agreement should address issues of ownership, vesting rights, the roles and responsibilities of each founder, including salaries and terms of employment.
- Choosing the wrong corporate structure. In the US, there are a variety of corporate structures to choose from. You might structure your company as a sole proprietorship, general proprietorship, C corp, S corp, LLC, LLLC, Public Benefit Corporation or limited partnership, for example. Your company structure has important implications for your future fundraising, so get a legal opinion and select thoughtfully. Mistakes in forming a company are hard to undo.
- Bypassing industry regulations. Regulations exist to ensure products and services on the market are safe, fair, and accessible. For example, a commuter bus startup needs a transport permit. And a neighborhood food popup must pass health and safety standards. Ensure your startup obtains the necessary permissions and obeys industry rules. Otherwise, you might face shutdown.
- Circumventing employment law. People who work in a startup are entitled to the same employment entitlements and legal protections as those in more traditional workplaces. Do not overlook your responsibilities as an employer. And make sure you understand the difference between an intern, a casual employee, a part-time or a full-time staff member, and a contractor. Misclassifying your staff can lead to big problems.
- Ignoring intellectual property protection. Arguably, the most valuable asset of a startup is its intellectual property. For startups in the US, the three essential legal pieces of IP are trademarks, patents and copyrights. Protect your IP and brand from the get-go. Make sure you don’t inadvertently steal others’ IP. Likewise, don’t let competitors, contractors or unhappy employees steal your valuable IP. Consider getting some non-disclosure agreements drafted. Many entrepreneurs neglect identifying and protecting critical IP assets, and too many don’t figure this out until the damage has been done.
- Overlooking tax obligations. Many startups ignore important taxation issues. Consider the tax consequence of your actions — in particular, the implications of issuing stocks or options. A common blunder for startups in the US is failing to make an 83(b) election when founders’ shares are subject to vesting. If you fail to make this election, you will be taxed at ordinary income rates instead of capital gains. This is a problem because you may have substantial income tax liability when your stock vests if it increases in value, even if you do not sell it.
- Disregarding securities laws when issuing stocks. It is common for startup founders to issue stocks to angel investors, family and friends. But if you issue stocks without complying with specific disclosure and filing requirements under state and federal securities law, you risk running into serious legal issues — and your shares might not be valid.
Ultimately, we recommend getting a legal opinion on important business questions. Many law firms work with early-stage companies through fee-alignment plans or deferred payment plans. Consider these options. And make sure your chosen lawyers are well-versed in the area of law you need help with.
Disclaimer: This blog post does not constitute legal advice. If you find yourself in any of the situations listed above, you should defer to professional legal advice.