5 Common Legal Mistakes Startups Make (And How to Avoid Them)

The following is guest post from Nick Brown. Nick is a blogger and marketing expert, currently engaged on projects for Media Gurus, an Australian business and marketing resource. He is an aspiring street artist and does Audio/Video editing as a hobby.

The world is full of ideas. Especially the business world, where rapidly growing competition has made innovation mandatory at any cost.

Your idea can be a real game-changer, but that doesn’t mean anything if you don’t know how to set it in motion in the right way. If you own a startup, you probably can’t wait to see it launch, and that’s completely natural.

But just remember all those space movies with close-ups of faces behind monitors drenched up in sweat – if you’re off by just a 10th of the degree, the deviation is multiplied by a hundred and you can say goodbye to your precious rocket.

In other words, launching a startup requires great precision.

And the biggest part of that precision depends on how well-informed you are. The rhythm of life has become incredibly fast so people tend to skip the research part, which can lead to many misconceptions regarding startups. It is okay to be a dreamer who dreams big, but if you’re unaware of the reality around you your biggest dreams could turn into nightmares.

And the biggest nightmares, as always, are the legal ones.

Today, entrepreneurship and the legal industry are completely interwoven. You can’t escape the far-reaching hand of the law, but you can choose your perspective on it. People usually decide to look at it as a burden or as a cost they must pay for doing business, but it can also be interpreted as a useful tool on the road to success.

All you need to do is learn to recognize its traps and evade them, ultimately turning them to advantages. We’ve prepared some detailed guidelines that will put a name to these unknown legal dangers lurking throughout your dream quest and enable you to place your rocket on the map of the stars.

1. Not knowing an LLC from a C-corp

Before you can interpret and pursue your dream you need to give it a concrete form. That’s why your first business decision as a founder must be to choose the right legal structure in which you’ll operate your business. Unfortunately, many young entrepreneurs march right in without consulting a lawyer and later suffer higher taxes or fall under significant liabilities which they could have avoided if they only started a business as a limited liability company (LLC) or a corporation. Of course, that doesn’t mean that every startup owner should choose between these two – the choice must be made based on the business requirements.

If you choose a sole proprietorship you won’t be required to provide any filling, fees, or legal documentation other than local business and state permits. But there are some disadvantages to this form of operating of which the most notable one is that there is only one owner, meaning that if you need more capital from another investor there is no available form and a partnership form is required.

Furthermore, you will not be provided with the protection against the creditors of the business (which means they can directly sue you) while with LLCs and corporations the creditors cannot sue successfully founders nor other investors. In short, we do not recommend this option.

If you go for a general partnership there can be more than one founder and they can set the rules together through a partnership agreement. However, if there is disagreement among the founders the state laws will be the ones who will supply the rules. If we also consider the fact that each partner is liable for the business debts and therefore exposes his personal assets to the creditors, we also wouldn’t recommend this one.

C Corp vs S Corp
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C corporations are formed under state law and these structures are mostly used by venture capital-backed companies. With S corporations it’s a similar story but there is favorable tax treatment for corporations that have no more than 100 shareholders under state and federal tax laws.

LLCs are also formed under state law and are the most popular choice due to their hybrid form between the corporation and limited partnership which offers some tax advantages over C corporations.

A limited partnership is an option also formed under state law often used for hedge funds and private equity firms or to hold investment real estate.

benefits of starting an llc startup legal
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The choice might be obvious, but we need to mention that limited partnership, corporations, and LLCs have higher costs of forming and operating than sole proprietorships and partnerships because of the accounting, legal, and tax issues. On the other hand, there are significant advantages such as liability protection from creditors, greater ease in raising capital, and tax savings (only for LLCs and corporations). Also, keep in mind that you can later convert partnerships and sole proprietorships to LLC, S, or C corporation (or any other legal entity) but that conversions can have significant costs.

2. Not making crystal clear agreements with your co-founders

Nobody is able to start a business on their own. In order to make a dream come true, you need to assemble other people who share it. Even though you’ve all come together around one dream, that doesn’t mean that each person has the same picture in their head.

If you’re not on the same page at the beginning, this could lead to confusion and conflict, especially if it’s a 50/50 partnership. Everybody is in it together, but that doesn’t mean the roles don’t need to be clearly defined.

The questions such as who controls what, who owns what, and who does what will have to rise eventually so it’s better to pose them right at the beginning. This is important not only because it will prevent the possibility of future dispute (just remember the (in)famous Facebook litigation) but also because knowing the answer to these questions will also define every co-founder’s responsibilities.

We know that dreams can be pretty hazy at the beginning (especially the big ones), but that doesn’t mean you have to wait for a more stable picture to deal with formal things. If you’re going to wait to form the company to issue equity formally to the founders you’ll be dealing with phantom income.

The reason is simple – equity is taxable. And taxes, as we all know, can rise pretty fast. Especially if the recipient of the equity pays less than fair market value for it. As you work on the business that value will probably go up, leading to the increase of the tax burden.

The best solution is to let everyone have their fair share as soon as possible when the value has not started going up. Just keep in mind that there are circumstances when the tax laws have special rules for determining the fair market value so it’s mandatory to check things with your legal counsel or tax adviser.

3. Leaving rules unwritten (and non-existent)

All dreamers are enthusiasts. They often go on their business quest without a lot of initial capital and find partners or co-founders in their friends or family. There is nothing wrong with this approach as long as it doesn’t become sloppy considering the required documentation.

You can define the titles, responsibilities, and duties of all your co-founders, but if you do not document each of them you’ll never come to a well-structured and thorough agreement. If your agreements with every last one of them are not in writing that will leave a lot of space for subjective interpretation which can lead you all the way to the court.

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Creating a business usually requires trying out different roads and options before choosing the right one. This also means discussing things with different people who maybe won’t be the part of the final team. It is not uncommon to have an uninvolved party appear, claiming that your company has promised them a certain share and that they have emails or other means of correspondence to prove it.

Yes, you might have sent those emails. But if you have a written agreement with the co-founders you’ve chosen, that won’t be the problem. The simple mistake of not putting it on paper can cost you a lot, including a derail of potential investments.

Lawsuits and other unpleasant complications don’t need to come your way only from the co-founders. It is very important to use the same meticulous approach when it comes to contract templates for your employees, too. This might seem like some unnecessary extra work, but that’s far from the truth. The most frequent startup problems are caused by an absence of adequate employment documentation.

Tools like People – which integrates with Process Street – can be used to ensure legal compliance with employment regulations

And the last, but not the least – there are clients and customers. If we are to be completely honest, the success of every business transaction is measured by your ability to ‛cheat’ better. You want to negotiate on your own terms. While contract templates have many advantages, their greatest value lies in the possibility to make them in favor of your company.

Although referred to as ‛standard form contracts’ there is nothing really standard about them because they can be tailored to be more favorable to the particular side. If you have your own form of contract ready, that side will be your company. However, that doesn’t mean you can put in everything you want. It is mandatory to have an experienced business lawyer to do the drafting due to liability claims and possible disputes.

Of course, all this written documentation is for nothing if your company doesn’t have an adequate filing system. You need to have a clear record of all your startup’s activities from the beginning.

4. Choosing a ‘single-purpose’ lawyer

While your family and friends can be your co-founders (as long as all the documentation is in order!), they can’t be a part of your legal counsel. You can say: ‛Well, it just so happens that my brother-in-law is a lawyer!’, but that will do close to nothing for your business.

It is okay to try to save on expenses, but your effort in doing that can easily be misguided. Can you imagine your brother-in-law handling out all the things mentioned above? We’re not trying to say that the lawyers among your family members are inexperienced in their field, but simply that one field is far from enough. What you need is a variety.

In order to acquire an experienced legal advice in every field, you need to combine several law firms or lawyers with different areas of expertise. Legal matters cover far more ground than tax and contracts, including:

  • Employment
  • Franchise
  • Intellectual property
  • Real estate
  • Security, etc.

Of course, you can ‛farm out’ certain problem to different firms and lawyers, but you should always try to make sure that the ones you have retained have experience in as many mentioned areas as they can in order to maintain the continuity in communication with your legal counsel. And don’t think that you won’t need a certain expertise just because you don’t need it at the moment.

For example, many young businesses decide to go international and without an experienced and trusted immigration agent, your road trip adventure might be over before you meet even a single investor or business partner.

We are aware that most people go into this business-building adventure with not much in their pockets, and we’re not saying that you can cover all the legal areas at once. It is okay to cover the essential ones first (meaning essential for your line of business) but the important thing is to be aware of the need for future investment.

5. Getting your idea stolen before it materializes

As soon as you tell your dream to other people it becomes open to different interpretations. It is not uncommon that your listener will make sense of it quicker than you who actually dreamt it. Same goes for business ideas that need time to develop and blossom.

So, before you develop a very concrete shape of the idea and obtain a patent it is crucial that you keep your invention as a trade secret. As soon as you offer any open information it becomes a fair game for public use. Of course, the information can also leak from the inside so you need to make sure that all your co-founders and employees are under a non-disclosure agreement.

Keeping your ideas protected is not only in the interest of the company founders but also your investors have a stake in ensuring that they don’t end up in hands of a third party. No matter if you have developed a service, technology, or a product, it is extremely important to carefully follow the steps to protect your intellectual property.

The safest way to make sure that your new product is protected is to develop a patent. That way you will have the right as an inventor to prevent others from selling, using, or making the product which is described in words in the patent’s claims. However, getting a patent is far from easy and there are certain requirements:

  • Your idea or formula must be in the form of a concrete embodiment. Just a concept won’t do
  • Your invention needs to be original and new. Obviously, if someone has done it before it can’t be a patent
  • Your invention must not have been patented before, but not even described in any printed publication previously
  • The invention you have created must have a certain useful purpose

Even if you meet all these requirements the process of obtaining a patent from the U.S. Patent and Trademark Office can be very complicated and can take up to several years. That’s why it’s important to have an experienced patent lawyer who’ll draw up your patent application.

If you’re an author of books, music, articles, movies, software, advertising copy, etc., it would be enough to get the copyrights. They will give you as an owner exclusive right to make the copies of your work and to produce derivative works such as revisions or sequels.

Whatever the type of your product is, a trademark is a must. This is the right that protects the thing you use to distinguish your goods from those of others – a symbolic value of symbol, name, or word. Think American Express or Coca-Cola. Contrary to a patent, the trademark is much easier to get – all you need to do is to start using the mark in commerce. There is no need to register it to get the rights on it, although federal registration with the U.S. Patent and Trademark Office offers some advantages.

The legal side of the business is a thick, dark forest right in the center of your dreamland. Keep your path structured, keep things straight between your fellow travelers, don’t talk about your discoveries until they’re confirmed, and bring some experienced advisers along.

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Benjamin Brandall

Benjamin Brandall is a content marketer at Process Street, and runs Secret Cave on the side. Find him on Twitter here.


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