Starting a new business can be both an exciting and daunting process. Many entrepreneurs love running their companies but typically do not enjoy attending to certain administrative or legal items essential to any business’s long-term success. Accordingly, it’s not uncommon for entrepreneurs to let important legal issues slide as they get caught up managing several other business issues that they view as more pressing. Unfortunately, legal mistakes can significantly set back start-ups and even kill the business altogether.
Here are five common legal mistakes that all start-ups should seek to avoid.
1. Failing to Incorporate the Start-Up as a Limited Liability Entity
This item is crucial. Every business, regardless of its type or industry, is exposed to liability. Any number of things can lead to significant liability, such as product liability or other tort claims, contract disputes between vendors or suppliers, employment law claims, problems paying back debt, etc. Every state offers a variety of limited liability entities to choose from (e.g., Corporations, LLCs, Limited Partnerships, etc.). Structuring your business in this form generally ensures that the founders’ personal assets are protected if the company gets sued, goes bankrupt, etc. Without the liability shield offered by these various entities, the founders’ personal assets (as opposed to just the company’s assets) are at risk. Naturally, it is easy to see how a failure to incorporate can devastate a business and its founders. There is no reason to unnecessarily put your home, your vehicle or your savings at risk.
2. Failing to Have a Written Agreement Between Co-Founders
It is vital to have a formal founders agreement (e.g., Buy-Sell Agreement, Operating Agreement, Partnership Agreement, etc.) in place between the key players as early as possible. Any founders agreement should cover several key business terms, such as:
- What percentage of the company each founder owns;
- Who the officers and directors of the company are;
- How the key decisions and day-to-day decisions of the business will be made;
- How salaries will be determined;
- How contributions of cash or other assets will be made; and
- What restrictions will be placed on the transfer of ownership interests in the company (i.e., what happens if a founder dies, becomes disabled, or otherwise leaves the company).
A failure to have a good founders agreement in place can lead to substantial headaches down the road. Disputes over any of these issues can ultimately lead to long and expensive litigation (the Facebook ownership dispute is often cited as a classic example).
3. Failing to Have a Good (Pro-Company) Set of Standard Terms and Conditions for Products/Services
Every company should have a well-drafted set of standard terms and conditions to govern the sale and/or purchase of goods and services. Otherwise, the business relationship in question may be governed by less favorable boilerplate terms supplied by the other party or by general legal defaults (which may or may not be favorable depending on the circumstances). A good set of standard terms and conditions should:
- Discuss what representations or warranties (if any) are being made in connection with the products or services. Generally, if you are the seller/service provider, it is a good idea to disclaim all representations and warranties (whether express or implied) except for those set forth in the relevant documents. It is obviously important to limit the start-up’s potential exposure for costly breach of warranty claims;
- Place limits on the company’s potential liability. A good set of terms of conditions will generally limit (or exclude altogether) a company’s liability for any special, consequential or indirect damages (such as lost profits). Moreover, it is not uncommon for standard terms and conditions to limit a company’s total exposure under a contract to a stated percentage of the purchase price or service fee received;
- Address payment, shipping and delivery terms;
- Protect your confidential information and intellectual property; and
- Outline how disputes will be resolved (i.e., what is the governing law, and what venue will disputes be decided in?). This item is especially important when dealing with cross-border customers or suppliers (i.e., having to litigate a matter in another country’s court system can unpredictable, time-consuming and expensive).
It is easy to see why having a clear framework governing the relationship between your customers and/or suppliers is a good idea, as it can significantly limit any potential exposure in the event of a dispute. While these terms may be subject to negotiation, they can at least provide a favorable starting point and some measure of predictability.
4. Failing to Sufficiently Protect Intellectual Property
Intellectual property (“IP”) is often the most valuable asset of a start-up. IP generally encompasses a company’s ideas, products, processes and production methods, trade secrets, name and logo, etc. The exploitation of any of these items can be severely damaging to a business. For example, it is easy to see how it could be harmful if a competitor can copy your new product or open a competing business utilizing a similar name and logo. Some common ways to protect your intellectual property are:
- Patents. A patent gives an inventor the ability to protect their invention by granting the right to prevent others from making, using, or selling the patented subject matter for a period of time.
- Copyrights. Copyrights protect various types of creative works (software, books, articles, music, movies, etc.). Copyright generally gives the owner the exclusive right to make copies or derivative works of the protected item.
- Trademarks. Trademarks protect the value of names, logos, etc. Trademarks are acquired by use; however, registering a trademark at the federal level has numerous benefits, including restricting competitors from using “confusingly similar” marks.
- Nondisclosure Agreements. Nondisclosure agreements can be used to prevent customers, suppliers and employees from disclosing a company’s confidential or proprietary information.
5. Employment Issues
Employment law is another area where start-ups frequently run into problems and experience legal mistakes:
- For instance, having employees presents tax compliance issues (i.e., certain withholdings are required from each paycheck). In addition, make sure you know the difference between independent contractors and employees, as misclassification can lead to various penalties.
- Having written employment agreements with key employees is generally a good idea. A good employment agreement should: outline the scope of the employment relationship and protect the company by containing provisions regarding the assignment of inventions, nondisclosure, and non-competition obligations.
The attorneys at Fitzpatrick Lentz and Bubba, P.C., have extensive experience advising entrepreneurs and start-ups and can help you avoid costly legal mistakes. For more information, please contact Ken Charette or any other attorney in our Corporate, Business and Banking Group.