By Annal Vyas, program director, The Bit Factory and advisor to the Akron Global Business Accelerator and The University of Akron SEED Legal Clinic
Throughout my career, I have provided legal counsel to hundreds of startups and in my experience, I’ve seen startups make the same legal mistakes time and time again. Here are ten that occur often.
(Please keep in mind that the following is not legal or tax advice, but rather a general discussion of legal issues. You should consult with an attorney and/or tax professional for advice specific to your situation.)
- Not forming an entity – If you operate a business without forming an entity through the Secretary of State, you open yourself up to personal liability. For example, suppose you start a business that sells ice cream out of a truck. You accidentally sell expired ice cream to a child whose parents end up incurring $100,000 in hospital bills. The child’s parents can sue you individually for that amount – meaning that your personal assets, such as your house or your own child’s college tuition fund – could be wiped out.
But things could get even worse. Say you started that ice cream business with your best friend, and he sells the expired ice cream, not you. The parents could still sue you personally for the entire amount (not just half), even though you didn’t do anything wrong.
Forming a legal entity (usually either an LLC or a corporation) is the best way to avoid personal liability for the mess-ups of a business.
- Choosing the wrong entity - Most founders choose between a limited liability company (LLC) or corporation. If your startup plans to seek venture capital, it often makes good sense to organize as a Delaware corporation. Why a Delaware corporation? Delaware is universally recognized as the nation’s leader in corporate law and venture capital firms prefer to invest in Delaware corporations because of the flexibility and stability of Delaware law.
However, if a company is not seeking VC money, then forming an LLC in the state in which the company is located often makes more sense.
- Failing to treat your company as separate from you individually - I can’t tell you how many founders go through the process of forming an LLC or a corporation, but then continue to sign contracts personally. Moreover, many founders don’t treat the company as separate from themselves. For example, founders may fail to open a separate bank account on behalf of the business. If a court believes that you are not taking adequate steps to treat the company separate from you as an individual, the court very well could hold you personally liable for the company liabilities.
- Failing to understand IP issues - Startups often run into a whole lot of trouble by not understanding intellectual property issues. For example, a startup could pick a name for their company, only to find that it infringes on the trademark of another company. Or a startup could discover that it doesn’t actually own the copyright to software created by a third party. Or a company could fail to file a patent application in a timely fashion, thus forfeiting patent rights. The list of IP considerations is long.
- Failing to sign a founders’ agreement - Some type of agreement between the founders of the company is essential. In an LLC, this founders’ agreement is called an operating agreement. An operating agreement is similar to a prenuptial marriage agreement, but for your business. In an operating agreement, you want to deal with important issues, such as equity allocation, voting rights, vesting schedules, buy-sell agreements, and the like.
- Failing to understand key employment issues - Startups often prefer to classify workers as independent contractors and not employees, so as to avoid paying employment taxes. However, worker misclassification can lead to significant penalties.
- Failing to understand tax consequences - Startups often mess up tax issues, as tax is a complicated area with many nuances. For example, if a founder has stock that is subject to a vesting schedule, then he or she should file an 83(b) election to save money on taxes.
- Failing to adhere to securities laws - Like tax, securities law is extremely complex. For example, startups can run into problems by raising money from non-accredited investors.
- Ignoring internet legal issues - Companies often copy and paste terms and conditions and privacy policies from other websites. That’s a mistake, and can lead to significant problems down the line. For example, various states have enacted “shine the light” provisions which mandate that a website operator disclose what information is collected from users and how that information is used.
- Not seeking legal counsel from an experienced business lawyer who deals with startups - Finally, startups should seek out a business lawyer who has experience dealing with startups. You wouldn’t go to a cardiologist for a brain issue. Similarly, you shouldn’t go to your uncle who’s a divorce lawyer to handle your startup legal issues. You want to find someone who has a track record working with emerging companies.
Avoiding these common mistakes will save you time, money, and headache!