9 Common Legal Mistakes Made By Startups

The reality of startups is fierce. Facing challenges approximately 90% of them are trapped in the valley of death. «Valley of death» is a term referred to the terrain, which lies between the proof of concept and going public with significant sales. But why do hundreds of startups find themselves stuck on their way to public recognition and serious revenues? It seems that lawyers and venture capitalists have an answer. According to them, startup mortality can occur due to legal mistakes made by entrepreneurs.

Let`s have a look at eleven common legal mistakes, which can prevent the successful launch of your venture.

#1 Failing to make the deal clear with co-founders

Like any other type of relationship between human beings, there can be many positive feelings in the beginning. When two friends decide to become business partners and start earning money together, least of all they would focus on discussing a kind of prenuptial agreement or potential legal disputes between them. However, it`s crucial to make the deal clear with co-founders as early as possible, otherwise, you will face enormous problems later, just as Cameron and Tyler Winklevoss whose partnership with Harvard classmate Mark Zuckerberg resulted in fallout and legal battle over ownership of Facebook.

Bear this in mind and think of concluding a written founder agreement with the following key deal terms addressed:

  • Who are the founders?
  • What is their ownership percentage?
  • Is the ownership interests subject to vesting over time?
  • What are the roles and responsibilities of the founders?
  • Does a founder have the right to buy back shares of another founder, who leaves the company or passes away?
  • How to make day-to-day decisions (unanimous or majority vote, or certain decisions only in the hands of the CEO)?
  • How to handle major decisions (like removing a founder or selling the company)?
  • What salaries will the founders get?
  • How to make contributions in cash and other assets?
  • Can a founder be removed from the business? Under what circumstances?

#2 Not Forming an LLC or Corporation

It`s probably a no-brainer, but many potential entrepreneurs don`t know why one of the first decisions they should make is what legal form to operate the business. Launching a venture without consulting a lawyer can result in incurring higher taxes and significant liabilities. You can avoid this by forming a corporation or LLC. Forming corporation or LLC means protecting your personal assets in case something goes wrong in your business. If your business is goes bankrupt, you risk losing only money you put into the company. Your personal assets, including your bank account, car, and house, will remain inviolable.

There are several forms of business organization available to a startup business:

Sole Proprietorships

A sole proprietorship is the most popular type of business forms. It is simple and inexpensive to organize, as it requires no legal paperwork, fees or filings except for state and local business permits. To put it simply, a startup businessman will spend more time on pursuing customers instead of doing paper work. In the meantime, a sole proprietorship is not an optimal form of a startup business organization as it has several disadvantages. If there is a need for additional capital from another investor, you should form a partnership or other legal, as sole proprietorship allows only one owner. Moreover, it does not protect the founder from creditors, which can directly sue him (in contrast to LLCs and corporations).

General partnership

If a business venture has more than one founder, a general partnership is formed. This legal form of entity has several advantages including the tax benefit. Companies structured as partnerships are do not pay income tax. All profits and losses are passed through to the partners on a pro rata basis. In the meantime, the general partnership means that each partner is liable for the debts and obligations of the business, so if the company goes bankrupt, personal assets will be at risk.

LLCs

This legal entity is very easy and cheap to set up. Founders define how much each of them owns a percentage. LLC is not taxed as an entity, and it is one of its advantages. The members pay taxes in ratio to their ownership percentage. The major benefit of LLC is to protect personal assets from the liability of the business.

#3 Not protecting intellectual property

Intellectual property is one of the most valuable company`s assets, so founders and investors should protect it in whatever ways possible. Company`s products, services, technology as well as its name and logo is an intellectual property. Below are the key protective measures start-ups should undertake to protect their intellectual property.

Patents

When a new product or innovative technology is invented, its authors should apply for a patent, which will grant him exclusivity to make and use it for 20 years. The patent also guarantees that others have no legal rights to make, use or sell the patented product or technology. Before applying to the U.S. Patent and Trademark Office, make sure that your invention is new or novel and has some useful purpose.

Trademarks

A trademark is a sign, that distinguishes the services or goods of one company from those of other companies. Entrepreneurs should trademark company name, slogans, logo, and product names to protect them by intellectual property right and prevent competitors from using them to identify their own products.

Copyrights

Copyright protects original works of authorship, such as works of art, articles, books, software, etc. from unauthorized reproduction.

Non-Disclosure Agreement (NDA)

NDA also referred to as Confidentiality Agreement, is a contract signed by the parties to ensure that a confidential information (could be manufacturing process, a sales plan or a formula for a new drink) will stay secret or have legal recourse if it is disclosed or misused.

Trade Secret

Trade secrets range from computer programs to formulas, which are not ascertainable by others. A trade secret rights make it legal for the owner to take legal actions against those who breach confidential relationship, steals secret information or use any improper means to make it public.

Confidentiality and Invention Assignment Agreements

Every employee or independent contractor should sign such agreements. Confidentiality Agreement entitles the employee or independent contractor to keep confidential the proprietary information of the business (including know-hows, trade secrets, customer lists, etc.) both during and after employment. Invention Assignment Agreement ensures any work produced by that person (inventions, products, or services) during the employment belongs to the company.

#4 Ignoring securities laws when seeking investments

A startup has to comply with securities laws regulating the offering and sale of securities. According to the Securities Act of 1993, a company should register stock with the Securities and Exchange Commission (SEC) before issuing it, unless there is a corresponding exemption. Failing to comply with these requirements can entail significant financial penalties and criminal liability. In some cases, a startup company may have rights to buy back all the stocks at the original issuance price even if the company has lost its money. When planning sales of shares it`s crucial to hire a knowledgeable lawyer who can guide through the process.

#5 Not having a favorable contract form

Startup company should consider having a standard contract form when dealing with clients or customers. In spite of being “standard” a contract can be briefer to be more favorable for a startup. It`s essential to start with your own form of contract and hope that the other side does not want to make changes. Consider the following key items when writing your contract form.

  • Obtain standard contracts of other companies in your industry. There is no need to reinvent the wheel.
  • Hire a knowledgeable business lawyer to do the drafting
  • There is no need to frustrate your potential clients and customers, keep a contract form as short as possible
  • Clearly spell out pricing, date of payment as well as penalties or interest owed if the payment is not made
  • Limitations on liability should be included in the contract form to be protected in case the product or service fails to meet expectations.
  • A “force majeure” clause will protect from breach in if something unforeseen happens
  • Don`t forget about a clause related to how to settle disputes.

# 6 Lack of proper employment procedures

Employment is an area where unskilled startup founders can make legal mistakes. By following these tips, they will be able to avoid major pitfalls.

An Independent Contractor vs. Employee

Startup companies can face harsh penalties for misclassifying a worker. For instance, an independent contractor can legally be considered an employee no matter what they negotiated before.

The key difference between an independent contractor and an employee is the level of control the company has over the working process. Independent contractor has flexibility regarding where, when and how to do the work. The person is considered an employee if the company controls those factors. Beware this distinction not to face penalties from the IRS.

Employment Documents

When building a team startup founders should have everything properly documented to avoid problems. An adequate employment documentation should include:

  • Employment agreement -specifies the terms of the employment relationship
  • Invention agreement – ensures that company owns all work
  • Employee Handbook – sets forth company policies on a variety of things including vacation, sick leave, conflicts of interest, etc.
  • Stock option documents or restricted stock purchase agreement
  • USCIS Form I-9 and IRS Form W-4 – employee authorization and withholding allowance certificates
  • «At-Will» employment offer letters – specifies that either company or employee can terminate employment «at will».

#7 Infringing Trademarks

Prior to picking up a brand name or domain name, it`s important to do due diligence to avoid trademark infringement issues. If the name of the brand, product or service resembles someone else`s mark and is likely to confuse customers, you may be an infringing trademark. Below are some basic steps to avoid naming issues:

  • Go to the U.S. Patent and Trademark Office trademark database at www.uspto.gov to find out whether your proposed name has a federal trademark registration. Search also for similar sounding names, variant spellings, synonyms, etc.
  • Search for proposed domain name on Google and online domain registrants such as GoDaddy.com
  • Make sure the name is distinctly pronounced and easily memorized.

#8 Not Creating an Adequate Privacy Policy and Terms of Use Agreement

Not having a proper Privacy Policy and Terms of Use agreement may discourage potential customers from trusting the company. The privacy issue is very sensitive for visitors to the websites. Privacy Policy is a legal statement, which explains to them how their personal data will be used, whether it will be released or sold to third parties.

Never copy a privacy policy from other websites. An adequate Privacy Policy should cover the following issues:

  • How the company uses personal data collected and how it may be disclosed to third parties
  • How the website uses cookies and similar technologies
  • What information the website collects
  • How the website owner protects confidentiality and security of the personal data collected
  • How users can modify or delete their personal data

What the website Terms of Use Agreement should include depending on the nature of the business. However, make sure to include the following basic issues:

  • Website access and limits on uses;
  • Intellectual property rights
  • Disclaiming accuracy of information

#9 Not Hiring a Lawyer

The magic world of entrepreneurship allures people, but only a handful of them can survive. The starting period when the valley of death tests young entrepreneurs` determination, commitment, and problem-solving ability is very essential, as it separates the true businessmen from the wannabes. Early-stage companies win not only because they have better ideas, smarter personnel or better understanding of market tendencies. Having legal matters settled upfront is one of the key components of success so don’t hesitate to hire an experienced lawyer to guide you through the legal aspects of the startup process.

Armen Margarian

Armen Margarian is an attorney with The Margarian Law Firm.

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