As lawyers and venture capitalists involved with startups, we have seen plenty of legal mistakes made by entrepreneurs and start-up companies. The following are some of the more common and problematic legal mistakes we have seen.
1. Not making the deal clear with co-founders.
You absolutely have to agree with your co-founders early on what the deal is among you. Not doing so can cause enormous problems later (see, for example, the Zuckerberg/Winklevoss Facebook litigation). In a way, think of the founder agreement as a form of “pre-nuptial agreement.”
2. Not starting the business as a corporation or LLC.
One of the very first decisions that founders must make is in what legal form to operate the business, but founders often start a business without consulting a lawyer and, as a result, often incur higher taxes and become subject to significant liabilities that could have been avoided if the business was started as a corporation or as a limited liability company (“LLC”).
Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax, and accounting issues. However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital in contrast to sole proprietorships and partnerships.
Sole proprietorships and partnerships can later convert to a C or S corporation, LLC, or other legal entity but keep in mind that the conversion costs can be significant.
3. Not coming up with a great standard form contract in favor of your company.
Almost every company should have a standard form contract when dealing with customers or clients. But, there really isn’t a “standard form contract,” as every contract can be tailored to be more favorable to one side or the other. The key is to start with your form of contract, and hope the other side doesn’t negotiate it much.
4. Not complying with securities laws when issuing stock to angels/family/friends.
If the founders form a corporation, limited partnership, or LLC, the sale of stock, limited partnership interests, or LLC interests to the founders and later investors will be subject to federal and state securities laws. Most securities laws require that the sale of shares must comply with certain disclosure, filing, and form requirements unless such sales are exempt. Failure to comply with such requirements can result in significant financial penalties for the founders and the startup company including requiring the startup company to repurchase all the shares at the original issuance price even if the company has lost most, if not all, of its money. Consequently, in order to avoid such fines, penalties, and repurchase requirements, founders must hire knowledgeable lawyers to document the sales of shares in compliance with such laws.
5. Lack of employment documentation.
Business startups often encounter problems when they do not maintain adequate employment documentation. Consequently, startups should have prepared a core group of employment documents to be signed by most, if not all, employees.
6. Not carefully considering intellectual property protection.
If you have developed a unique product, technology, or service, you need to consider the appropriate steps to protect the intellectual property you have developed. Both the company’s founders and its investors have a stake in ensuring that the company protects its intellectual property and avoids infringing the intellectual property rights of third parties. Here are some of the common protective measures undertaken by start-ups: