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Top 5 Legal Mistakes Made by Startups

| January 23, 2014 | 7 Comments

Startup Legal Advice 

Starting a new business is an exciting process.  It’s easy to get carried away with your ideas and overlook some of the boring stuff, like legal agreements.  But, making legal mistakes can set you back significantly down the road and reduce your chances of success.  For that reason, it’s important to avoid making legal mistakes at all costs.

Here are the top 5 legal mistakes made by startups, and an explanation of how to avoid them.

1.    Failing to have a proper agreement between co-founders

You need to have a formal agreement in place between all the founders of the business as early as possible.  Just look at what’s happening with Snapchat right now for a perfect example of what can go wrong if you fail to do so.

You do not want to deal with a costly lawsuit (in terms of both time and money) down the road when your company is successful.  So before you make any progress building the business, get a founder agreement in place.

Here are some of the key terms that should be covered in the agreement:

  • Who the founders are
  • What percentage of the company each founder owns
  • How ownership interests vest over time
  • What the founders’ roles and responsibilities are
  • What happens if a founder decides to leave the company or passes away
  • How major decisions will be handled, like selling the company or removing a founder
  • How contributions of cash or other assets will be made

I can’t stress this one enough.  In my first business developing iPhone apps for small businesses, my co-founder and I were inexperienced and had no formal agreements at all.  We ended up parting ways after 3 years and it was a major headache getting everything sorted out.  Save yourself the hassle, and take care of it ASAP right when you’re starting out.

2.    Not forming a limited liability entity

This one is pretty much a no-brainer, but a lot of people aren’t aware of why it’s so important.  When you are operating a business, you are inherently exposing yourself to liability.  You may not even realize it.

There are just so many possible things that could go wrong in your business: a customer could get injured while using your product, an employee could claim you discriminated against them, you could run out of money and be unable to pay back your debt, etc.

If you limit your personal liability by forming an LLC or a corporation, your personal assets are protected if your company gets sued or goes bankrupt.  This means that the only money you personally risk losing when starting your business is the money you put into the company.

It’s not worth putting your house, car, or bank account on the line.  So protect yourself by forming a limited liability entity before you get into business.

3.    Failing to protect your intellectual property

Intellectual property is one of the most valuable assets a company owns.  So it’s always in your best interest to protect it in whatever ways possible.

Everything from your ideas, to your products, to your processes, to the company name and logo, etc., can be intellectual property that you should protect.  The key forms of intellectual property protection you should consider are the following:

Patents 

A patent is used to protect an invention that is new, useful, and non-obvious.  It grants the owner exclusivity to make and use the invention for 20 years.

Patents offer an important competitive advantage, which is why companies like Apple and Samsung have ongoing patent battles in court.  If your company has invented a new product or software, you should look into applying for patent protection.

Trademarks 

A trademark is meant to identify the proper source of goods and services.  Some important things you should trademark would be your company name, logo, slogans, and specific product names.

Doing so will prevent competitors in your space from using similar names or marks to identify their own products and services, which can be confusing to customers and take away from your sales.

Copyrights

Copyrights protect creative works, such as writings and works of art.  Technically, as the creator of something you already have a copyright.  However, for added protection it can be a good idea to register your copyright with the USPTO and officially establish that your company is the owner.

NDAs (Non-Disclosure Agreements)

An NDA should be used with anyone outside the company when confidential information is likely to be shared.  This is especially important if you work with a contractor or consultant that has also worked with other companies in your industry.

An NDA can’t actually stop someone from sharing your data.  But, at least it sets forth the rules on sharing, and it can help provide a remedy if you suffer damages from your info being shared down the road.

Invention Assignments

When you hire an employee or independent contractor, you need to be certain that all work produced by that person belongs to your company.  This is done with invention assignment agreements.

Invention assignments should be used anytime you hire someone.  They can greatly reduce the likelihood of a dispute about ownership in the future.

4.    Improper employment procedures

Employment is a very common area where inexperienced startup founders make mistakes.  There are a lot of issues you should think about before hiring someone.  Here are a few of the major ones:

Know the Difference Between an Employee and a Contractor

If you make the mistake of misclassifying a worker, you can face harsh penalties.  You may think you hired an independent contractor, but legally that person could be considered an employee, regardless of what you agreed to when you hired them.

The key difference is the level of control the company has over the work being done.  If the worker has flexibility regarding how the work is done, when the work is done, where the work is done, what equipment is used, etc., it’s more likely to be an independent contractor.  The more those factors are controlled by the company, the more likely the person will be considered an employee.

Always be wary of this important distinction to avoid facing penalties from the IRS.  More info can be found on the IRS website.

Watch Out for Tax Issues

When you hire an employee (including one that you thought was an independent contractor), there are some tax issues that you need to be aware of.

First of all, you need to be sure to withhold tax deductions from each paycheck – federal income tax withholding plus social security and medicare taxes.

Also, be careful when you issue stock to your early employees because there are a number of tax concerns that come into play.  If you are issuing restricted stock or stock options, there are specific guidelines from the IRS that you need to follow.  You might consider having employees file an 83-B election to help reduce their potential tax liability in the future.

It’s a good idea to work with a CPA or tax attorney during these steps because tax mistakes early on will lead to much bigger problems as the company grows and becomes more valuable.

Get Employment Documents In Order

Finally, you should always make sure everything is properly documented when you are building your team.  The key documents you should have for each employee you hire include:

  • Employment agreement – sets forth the terms of the employment relationship
  • Invention assignment – ensures all work is owned by the company
  • Employee handbook – lays out company policies on a variety of things including benefits, vacation time, and sick leave
  • Forms I-9 and W-4 – employee authorization and withholding allowance certificates
  • Stock option or restricted stock purchase agreement – for issuances of shares in the company

5.    Not hiring a lawyer

If all this legal speak has you feeling overwhelmed, don’t worry because you’re not alone.  Dealing with all the legal issues of starting a business is overwhelming at times.

But the solution is NOT to avoid the issues and plan on dealing with them down the road.  Avoidance really is the biggest legal mistake a startup can make.

If you don’t take care of your legal matters upfront, it will only make things worse.  So the best thing you can do is find an experienced lawyer to help guide you through all the legal aspects of the startup process.

Many startup founders fear the high cost of working with a lawyer, but it will cost significantly more money to straighten things out in the future if you make a mistake.  It’s actually not always as expensive as you might think, and it will definitely cut back on the stresses that come with trying to figure everything out on your own.

So do yourself a favor.  Hire a startup lawyer and make sure all your legal issues are taken care of as early as possible.  It’s one of the most important steps you can take to get your startup on track for success and avoid costly lawsuits or penalties from the government in the future.  You can thank me later when your startup hits it big time.

Aaron George is an entrepreneur who started out in the mobile app business, and then later went to law school.  His latest startup called LawKick is a free service that makes it easy to find legal help that meet your needs and budget.

Image Credit: Shutterstock.com

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Category: Entrepreneurship, Startup Advice