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10BigLegalMistakesMadeByStartups

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10/03/2013@12:47PM 44,712views

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10BigLegalMistakesMade
ByStartups
RichardHarroch(http://blogs.forbes.com/people/rharroch/),Contributor

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ByRichardHarrochandRichardN.Frasch
Aslawyersandventurecapitalistsinvolvedwith
startups,wehaveseenplentyoflegalmistakesmade
byentrepreneursandstartupcompanies.The
followingaresomeofthemorecommonand
problematiclegalmistakeswehaveseen.

1.Notmakingthedealclearwith
cofounders
Youabsolutelyhavetoagreewithyourcofounders
earlyonwhatthedealisamongyou.Notdoingso
cancauseenormousproblemslater(see,for
example,theZuckerberg/WinklevossFacebooklitigation).Inaway,thinkof
thefounderagreementasaformofprenuptialagreement.Herearethekey
dealtermsyouneedtoaddressinsomekindofwrittenfounderagreement:
Whogetswhatpercentageofthecompany?
Isthepercentageownershipsubjecttovestingbasedoncontinuedparticipationin
thebusiness?
Whataretherolesandresponsibilitiesofthefounders?
Ifonefounderleaves,doesthecompanyortheotherfounderhavetherighttobuy
backthatfoundersshares?Atwhatprice?
Howmuchtimecommitmenttothebusinessisexpectedofeachfounder?
Whatsalaries(ifany),arethefoundersentitledto?Howcanthatbechanged?
Howarekeydecisionsanddaytodaydecisionsofthebusinesstobemade?
(majorityvote,unanimousvote,orcertaindecisionssolelyinthehandsofthe

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CEO?)
Underwhatcircumstancescanafounderberemovedasanemployeeofthe
business?(usually,thiswouldbeaBoarddecision)
Whatassetsorcashintothebusinessdoeseachfoundercontributeorinvest?
Howwillasaleofthebusinessbedecided?
Whathappensifonefounderisntlivinguptoexpectationsunderthefounder
agreement?Howisitresolved?
Whatistheoverallgoalandvisionforthebusiness?

(/)

yanlevFotolia.com

2.Notstartingthebusinessasa
corporationorLLC
Oneoftheveryfirstdecisionsthatfoundersmust
makeisinwhatlegalformtooperatethebusiness,
butfoundersoftenstartabusinesswithout
consultingalawyerand,asaresult,oftenincur
highertaxesandbecomesubjecttosignificant
liabilitiesthatcouldhavebeenavoidedifthe
businesswasstartedasacorporationorasalimited
liabilitycompany(LLC).
Thetypesofbusinessformsthatareavailabletoa
startupbusinessareasfollows:
SoleProprietorships.Generallyspeaking,asoleproprietorshiprequiresnolegal
documentation,fees,orfilingsotherthanstateandlocalbusinesspermits.Onthe
otherhand,therearedisadvantagestooperatingintheformofasole
proprietorship:(1)itonlyhasoneownerandifadditionalcapitalisrequiredfrom
anotherinvestor,theformisnotavailableandapartnershiporotherentityformis
requiredand(2)asoleproprietorshipprovidesnoprotectionforthefounder
againstcreditorsofthebusiness(inotherwords,creditorscandirectlysuethe
founder),incontrasttocorporationsandLLCswhere,generallyspeaking,the
creditorsofthebusinesscannotsuccessfullysuethefoundersandotherinvestors.
Wedontrecommendsoleproprietorships.

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GeneralPartnerships.Ifthereismorethanonefounder,ageneralpartnership
isoftenchosenasthelegalformofbusinessentity.Preferably,thefounderswill
agreeonapartnershipagreementtosettherulesamongthefoundershowever,if
thefoundersdonotagreeonapartnershipagreement,most(ifnotall)statelaws
willsupplytherulesintheabsenceofanagreement.Theincomeofapartnershipis
taxeddirectlytothepartnersgenerallyonaproratabasis.Finally,eachpartnerofa
partnershipisgenerallyliableforthedebtsofthebusinessandthusexposesthe
personalassetsofeachpartnertothebusinesscreditors.Wedontrecommend
formingageneralpartnership.
Ccorporations.Theseareformedunderstatelaw(usuallyofthestatewherethe
businesswillbefirstoperatedorinastatesuchasDelawarethatisknownforits
welldevelopedcorporatelaw).MostventurecapitalbackedcompaniesareC
corporations.
Scorporations.Theseareformedunderstatelaw
likeCcorporationsbuthavefavorabletaxtreatment
forcloselyheld(notmorethan100shareholders)
corporationsunderfederalandstatetaxlaws.
LLCs.Theseareformedunderstatelawandarea
hybridformofcorporationandlimitedpartnership
andhavecertaintaxadvantagesoverCcorporations.
Limitedpartnerships.Theseareformedunder
statelawandareoftenformedtoholdinvestmentreal
estateandalsoareoftentheinvestmentvehicleof
choiceforprivateequityfirmsandhedgefunds.

Corporations,LLCs,andlimitedpartnershipsare
formedbyfilingdocumentswithappropriatestate
authorities.Thecostsforformingandoperatingtheseentitiesareoften
greaterthanforpartnershipsandsoleproprietorshipsduetolegal,tax,and
accountingissues.However,alloftheentitiesgenerallyoffersignificant
advantagesforfounders(andsubsequentinvestors)including,significant
liabilityprotectionfrombusinesscreditors,taxsavingsthroughdeductions
andothertreatmentonlyavailabletocorporationsandLLCs,andeasein
raisingcapitalincontrasttosoleproprietorshipsandpartnerships.
SoleproprietorshipsandpartnershipscanlaterconverttoaCorS
corporation,LLC,orotherlegalentitybutkeepinmindthattheconversion
costscanbesignificant.

3.Notcomingupwithagreatstandardformcontractin
favorofyourcompany
Almosteverycompanyshouldhaveastandardformcontractwhendealing
withcustomersorclients.But,therereallyisntastandardformcontract,as
everycontractcanbetailoredtobemorefavorabletoonesideortheother.
Thekeyistostartwithyourformofcontract,andhopetheothersidedoesnt
negotiateitmuch.Herearesomekeyitemstocomeupwithyourformof
contract:
Getsamplecontractsofwhatotherpeopledointheindustry.Thereisnoneedtore
inventacontract.
Makesureyouhaveanexperiencedbusinesslawyerdoingthedrafting,onethat
alreadyhasgoodformstostartwith.
Makesureyoumakeitlooklikeastandardformpreprintedcontractwithtypeface
andfontsize.

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Dontmakeitsoridiculouslylongthattheothersidewillthrowuptheirhandswhen
theyseeit.
Makesureyouhaveclearlyspelledoutpricing,whenpaymentisdue,andwhat
penaltiesorinterestisowedifpaymentisntmade.
Tryandminimizeornegateanyrepresentationsandwarrantiesabouttheproduct
orservice.
Includelimitationsonyourliabilityiftheproductorservicedoesntmeet
expectations.
Includeaforcemajeureclauserelievingyoufrombreachifunforeseenevents
occur.
Includeaclauseonhowdisputeswillberesolved.Ourpreferenceisforconfidential
bindingarbitrationinfrontofonearbitrator.

4.Notcomplyingwithsecurities
lawswhenissuingstockto
angels/family/friends
Ifthefoundersformacorporation,limited
partnership,orLLC,thesaleofstock,limited
partnershipinterests,orLLCintereststothe
foundersandlaterinvestorswillbesubjecttofederal
andstatesecuritieslaws.Mostsecuritieslaws
requirethatthesaleofsharesmustcomplywith
certaindisclosure,filing,andformrequirements
unlesssuchsalesareexempt.Failuretocomplywith
suchrequirementscanresultinsignificantfinancial
penaltiesforthefoundersandthestartupcompanyincludingrequiringthe
startupcompanytorepurchaseallthesharesattheoriginalissuanceprice
evenifthecompanyhaslostmost,ifnotall,ofitsmoney.Consequently,in
ordertoavoidsuchfines,penalties,andrepurchaserequirements,founders
musthireknowledgeablelawyerstodocumentthesalesofsharesin
compliancewithsuchlaws.

5.Lackofemploymentdocumentation
Businessstartupsoftenencounterproblemswhentheydonotmaintain
adequateemploymentdocumentation.Consequently,startupsshouldhave
preparedacoregroupofemploymentdocumentstobesignedbymost,ifnot
all,employees.Astartinglistofemploymentdocumentsforanewcompany
wouldtypicallyincludethefollowing:
StockOptiondocuments(ifacorporationhasbeenformed),includingaStock
IncentivePlan,NoticeofStockOptionGrant,andOptionAgreement
AtWillemploymentofferletters(signedbythecompanyandtheemployee,
acknowledgingthattheemployeeoremployercouldterminateemploymentat
will)
ConfidentialInformationandInventionsAssignmentAgreement(discussedbelow)
EmployeeHandbook(settingforthcompanypoliciesonvacation,conflictsof
interest,internetusage,etc.)
USCISFormI9(todocumentverificationoftheidentityandemployment
authorizationofeachnewemployee)

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IRSFormW4(theemployeeswithholdingallowancecertificate)
Benefitforms,forbenefitsavailabletoemployeesandfamilymembers(e.g.,health
insurance,dentalinsurance,401(k),etc.)

MoreAllBusiness:
TheBiggestMistakeIMadeinMyBusinessAndWhatILearnedFromIt
(http://experts.allbusiness.com/biggestmistakeimadeinbusinessand
whatilearnedfromit/16254/)
10InvaluableToolsforRunningaSmallBusiness
(http://experts.allbusiness.com/10invaluabletoolsforrunningasmall
business/14783/)
50InspirationalQuotesforEntrepreneursandStartups
(http://experts.allbusiness.com/50inspirationalquotesforentrepreneurs
startups/13618/)
TheTop25HomeBasedBusinessIdeas(http://www.allbusiness.com/top25
homebasedbusinesses/166592921.html)

6.Notcarefullyconsidering
intellectualpropertyprotection
Ifyouhavedevelopedauniqueproduct,technology,
orservice,youneedtoconsidertheappropriate
stepstoprotecttheintellectualpropertyyouhave
developed.Boththecompanysfoundersandits
investorshaveastakeinensuringthatthecompany
protectsitsintellectualpropertyandavoids
infringingtheintellectualpropertyrightsofthird
parties.Herearesomeofthecommonprotective
measuresundertakenbystartups:
Patents.Patentsarethebestprotectionyoucanget
foranewproduct.Apatentgivesitsinventortherighttopreventothersfrom
making,using,orsellingthepatentedsubjectedmatterdescribedinwordsinthe
patentsclaims.Thekeyissuesindeterminingwhetheryoucangetapatentare:(1)
Onlytheconcreteembodimentofanidea,formula,andsoonispatentable,(2)the
inventionmustbenewornovel,(3)theinventionmustnothavebeenpatentedor
describedinaprintedpublicationpreviously,and(4)theinventionmusthavesome
usefulpurpose.YouobtainapatentfromtheU.S.PatentandTrademarkOffice,and
thisprocesscantakeseveralyearsandbecomplicated.Youtypicallyneedapatent
lawyertodrawupthepatentapplicationforyou.
Copyrights.Copyrightscoveroriginalworksofauthorship,suchasart,advertising
copy,books,articles,music,movies,software,etc.Acopyrightgivestheownerthe
exclusiverighttomakecopiesoftheworkandtopreparederivativeworks(suchas
sequelsorrevisions)basedonthework.
Trademarks.Atrademarkrightprotectsthesymbolicvalueofaword,name,
symbol,ordevicethatthetrademarkownerusedtoidentifyordistinguishitsgood
fromthoseofothers.SomewellknowntrademarksincludetheCocaCola
trademark,theAmericanExpresstrademark,andtheIBMtrademark.Youobtain
rightstoatrademarkbyactuallyusingthemarkincommerce.Youdontneedto
registerthemarktogetrightstoit,butfederalregistrationdoesoffersome
advantages.YouregisteramarkwiththeU.S.PatentandTrademarkOffice.
Servicemarks.Servicemarksresembletrademarksandareusedtoidentify
services.
TradeSecrets.Atradesecretrightallowstheowneroftherighttotakeaction
againstanyonewhobreachesanagreementor

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confidentialrelationshiporwhostealsorusesother
impropermeanstoobtainsecretinformation.Trade
secretscanrangefromcomputerprogramsto
customerliststotheformulaforCocaCola.
ConfidentialityAgreements.Thesearealso
referredtoasNonDisclosureAgreementsorNDAs.
Thepurposeoftheagreementistoallowtheholderof
confidentialinformation(suchasaproductorbusiness
idea)toshareitwithathirdparty.Butthenthethird
partyisobligatedtokeeptheinformationconfidential
andnotuseitwhatsoever,unlessallowedbytheholder
oftheinformation.Thereareusuallystandard
exceptionstotheconfidentiallyobligations(suchasif
theinformationisalreadyinthepublicdomain).
ConfidentialityandAssignmentAgreementforEmployees.Every
employeeshouldberequiredtosignsuchanagreement.Itaccomplishesseveral
purposes.First,itobligatestheemployeetokeepconfidentialtheproprietary
informationofthebusiness,bothduringemploymentandafteremployment.
Second,itensuresanyinventions,ideas,products,orservicesdevelopedbythe
employeeduringthetermofemploymentandrelatedtothebusinessbelongtothe
companyandnottheemployee.

7.Nottakingintoaccountimportanttaxissues
Whenstartingabusiness,therearesomekeytaxissuestoconsider.Hereare
someofthemostcommonissues:
Choiceoflegalentity.Theremaybevalidreasonstochooseaflowthroughtax
entity,suchasanLLCorScorporation.Flowthroughentitiesallowbusinesslosses
toflowthroughtotheshareholderstouseontheirindividualtaxreturn.Butmost
venturecapitalistsandinstitutionalinvestorspreferCcorporationsinsteadofflow
throughentities
Salestax.Thecompanyneedstocollectsalestaxonsalesofitsproducts,because
failuretodosocanhavedisastrousconsequences.Thisissueiscompoundedifthe
companyissellinginmultiplestates.
Payrolltax.Manycitiesandcountiesimposea
payrolltax.
Section83(b).Foundersandemployeesneedto
considerwhethertheycanmitigatepotentialtaxissues
byanIRCSection83(b)election.ASection83(b)
electionrelatestowhensomeonereceivesstockor
optionssubjecttovestingandcanminimizedeemed
taxableincometotherecipient.
Stockoptionissues.Companiesoftengrantstock
optionstoemployees.Ifnotdoneincompliancewith
IRSguidelines,suchgrantscanresultinadversetax
consequencestothecompanyand/ortheemployee.
QualifiedStockBusinessStock.Holdersofstock
inqualifiedsmallbusinesscorporationsmaybeentitledtoareducedrateoftaxon
gainfromthesaleofqualifiedsmallbusinessstockunderIRC1202.
TaxIncentives.Dependingonthenatureofthebusiness,varioustaxincentives
maybeavailable,suchasrenewableenergytaxcreditsandinvestmenttaxcredits.

Agoodaccountantortaxlawyerfamiliarwiththeseissuescanbeavaluable
partner.

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8.Comingupwithanameforthecompanythathas
trademarkissues,domainnameproblems,orotherissues
Whenpickingacompanyname,itsimportanttodosomeresearchtohelpyou
avoidtrademarkinfringementordomainnameproblems.Youmaybe
infringingsomeonestrademarkifyouruseofamarkislikelytocause
confusionamongcustomersastothesourceofthegoodsorservices.Hereare
someofthestepstothatcanavoidnamingissues:
DoaGooglesearchonthenametoseewhatothercompaniesmaybeusingthe
name.
DoasearchattheU.S.PatentandTrademarkOfficesite(www.uspto.gov
(http://www.uspto.gov))forfederaltrademarkregistrationsonyourproposed
name.
DoasearchofSecretaryofStatecorporateorLLCrecordsinthestateswherethe
companywilldobusinesstoseeifanyoneisusingasimilarname.
DoasearchonGoDaddy.comorothernameregistrarstoseeifthedomainname
youwantisavailable.Ifthe.comdomainnameistaken,thisisveryproblematic
andaredflag.
Makesurethenameisdistinctiveandmemorable.
Youmightwanttohaveyourintellectualpropertylawyerdoaprofessional
trademarksearch.
Dontmakethenamesolimitingthatyouwillhavetochangeitlateronasthe
businesschangesorexpands.
Comeupwithfivenamesyoulike,andtestmarketitwithprospectiveemployees,
partners,investors,andcustomers.
Thinkaboutinternationalimplicationsofthename(youdontwanttohaveaname
thatturnsouttobeembarrassingornegativeinanotherlanguage).
Avoidunusualspellingsofthename.Thisislikelytocauseproblemsorconfusion
downtheroad(thoughsomecompanieslikeGoogleorYahoohavebeensuccessful
withunusualnames,suchsuccessisoftentheexceptionratherthantherule).

Thinkaboutahiringnamingexpert,suchashiring
AlexandraWatkinsatwww.eatmywords.com
(http://www.eatmywords.com).
9.NothavingagoodTermsofUse
AgreementandPrivacyPolicyforyour
website
ATermsofUseAgreementsetsforththetermsand
conditionsforpeopleusingyourwebsite.Your
PrivacyPolicyisalegalstatementonyourwebsite
settingforthwhatyouwilldowiththepersonaldata

collectedfromusersandcustomersofthesite,andhowsuchdatamaybe
used,sold,orreleasedtothirdparties.
AgoodTermsofUseAgreementwillcoverthefollowing:

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Howthesitecanbeusedandlimitsonuses
Disclaimersonwarranties
Limitsonliabilityofthesiteowneranditsemployees,officers,affiliates,and
directors
Howdisputeswillberesolved(e.g.,throughconfidentialbindingarbitration
precludingclassactions)
Representationsandwarrantiesofthesiteuser,andindemnificationtothesite
owner
Rightstorefundsandreturnsifproductsaresoldand
Intellectualpropertyrights(e.g.,copyrights).

AgoodPrivacyPolicywillcoverthefollowing:
Whatinformationthesitecollects
Howthesiteusestheinformationcollected
Howtheinformationmaybesharedorsoldtothird
parties
Howthesitedealswithchildrenunder13
Howthesitemayallowtheusertoaccessthesite
throughthirdpartyservicessuchasFacebookand
Twitter
Adescriptionoftheuseofcookiesandother
technologiesonthesite
Thestepstakenbythesiteownertoprotect
confidentialityandsecurityoftheinformationcollectedand
Howchangestotheprivacypolicymaybeeffected.

Privacypoliciesshouldntblindlybecopiedfromothersites.Theremaybe
legitimatereasonstonarrowtheprivacygrantedandtolessenthepotential
liabilityofthesiteowner.

10.Nothavingtherightlegalcounsel
Inamisguidedefforttosaveonexpenses,startupbusinessesoftenhire
inexperiencedlegalcounsel.Ratherthanspendingthemoneynecessaryto
hirecompetentlegalcounsel,founderswilloftenhirelawyerswhoarefriends,
relativesorotherswhooffersteepfeediscounts.Indoingso,thefounders
denythemselvestheadviceofexperiencedlegalcounselwhocanhelpthe
foundersavoidmanylegalproblems.Foundersshouldconsiderinterviewing
severallawyersorlawfirmsanddetermineifthelawyersorthelawfirmshave
expertiseinsome,ifnotall,ofthefollowinglegalareas:
Corporation,commercial,andsecuritieslaw
Contractlaw
Employmentlaw
Intellectualpropertylaws
Realestatelaws

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Taxlaws
Franchiselaws

Althoughitisnotnecessarythatthelawyerorlaw
firmretainedbythefounderhaveexperienceinall
oftheforegoingareasbecausecertainproblemscan
befarmedouttodifferentlawyersorfirms,itis
oftenbestthatthefoundersretainafirmthatcan
handlesome,ifnotmany,oftheareasofexpertise
listedabovesoastoprovidecontinuitybetweenthe
foundersandtheirlawyers.
Thereareanumberofwaysforafounderorstartup
businesstolocatecompetentlegalcounsel:
Friendsandbusinessacquaintances
Statebarreferralservices
Internetlegalwebsites(e.g.,Lawyers.com(http://www.lawyers.com))

CopyrightRichardD.Harroch.AllRightsReserved.
ReadallofRichardHarrochsarticles
(http://experts.allbusiness.com/author/richardharroch/)on
AllBusiness.com.
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startups/13618/)
Forlocalbusinessinformationon15millionbusinesses,visitInBusiness.com
(http://www.inbusiness.com).
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