By Richard Harroch and Richard N. Frasch
As lawyers and venture capitalists involved with startups, we have seen
plenty of legal mistakes made by entrepreneurs and start-up companies. The
following are some of the more common and problematic legal mistakes we have
seen.
1. Not making the deal clear with
co-founders
You absolutely have to agree with your co-founders early on what the
deal is among you. Not doing so can cause enormous problems later (see, for
example, the Zuckerberg/Winklevoss Facebook litigation). In a way, think of the
founder agreement as a form of “pre-nuptial agreement.” Here are the key
deal terms you need to address in some kind of written founder agreement:
Who gets what percentage of the company?
Is the percentage ownership subject to vesting based on continued
participation in the business?
What are the roles and responsibilities of the founders?
If one founder leaves, does the company or the other founder have the
right to buy back that founder’s shares? At what price?
How much time commitment to the business is expected of each founder?
What salaries (if any), are the founders entitled to? How can that be
changed?
How are key decisions and day-to-day decisions of the business to be
made? (majority vote, unanimous vote, or certain decisions solely in the hands
of the CEO?)
Under what circumstances can a founder be removed as an employee of the
business? (usually,
this would be a Board decision)
What assets or cash into the business does each founder contribute or
invest?
How will a sale of the business be decided?
What happens if one founder isn’t living up to expectations under the
founder agreement? How
is it resolved?
What is the overall goal and vision for the business?
2. Not starting the business as a
corporation or LLC
One of the very first decisions that founders must make is in what legal
form to operate the business, but founders often start a business without
consulting a lawyer and, as a result, often incur higher taxes and become
subject to significant liabilities that could have been avoided if the business
was started as a corporation or as a limited liability company (“LLC”).
The types of business forms that are available to a startup business are
as follows:
Sole Proprietorships. Generally speaking, a sole proprietorship requires no legal
documentation, fees, or filings other than state and local business permits. On
the other hand, there are disadvantages to operating in the form of a sole
proprietorship: (1) it only has one owner and if additional capital is required
from another investor, the form is not available and a partnership or other
entity form is required and (2) a sole proprietorship provides no protection
for the founder against creditors of the business (in other words, creditors
can directly sue the founder), in contrast to corporations and LLCs where,
generally speaking, the creditors of the business cannot successfully sue the
founders and other investors. We don’t recommend sole proprietorships.
General Partnerships. If there is more than one founder, a general partnership is often chosen
as the legal form of business entity. Preferably, the founders will agree on a
partnership agreement to “set the rules” among the founders; however, if the
founders do not agree on a partnership agreement, most (if not all) state laws
will supply the rules in the absence of an agreement. The income of a
partnership is taxed directly to the partners generally on a pro rata basis.
Finally, each partner of a partnership is generally liable for the debts of the
business and thus exposes the personal assets of each partner to the business’
creditors. We
don’t recommend forming a general partnership.
C corporations. These are formed under state law (usually of the state where the
business will be first operated or in a state such as Delaware that is known
for its well developed corporate law). Most venture capital backed companies are C
corporations.
S corporations. These are formed under state law like C corporations but have favorable
tax treatment for closely held (not more than 100 shareholders) corporations
under federal and state tax laws.
LLCs. These are formed under state law and are a hybrid form of corporation
and limited partnership and have certain tax advantages over C corporations.
Limited partnerships. These are formed under state law and are often formed to hold investment
real estate and also are often the “investment vehicle of choice” for private
equity firms and hedge funds.
Corporations, LLCs, and limited partnerships are formed by filing
documents with appropriate state authorities. The costs for forming and
operating these entities are often greater than for partnerships and sole
proprietorships due to legal, tax, and accounting issues. However, all of the
entities generally offer significant advantages for founders (and subsequent
investors) including, significant liability protection from business creditors,
tax savings through deductions and other treatment only available to
corporations and LLCs, and ease in raising capital in contrast to sole
proprietorships and partnerships.
Sole proprietorships and partnerships can later convert to a C or S
corporation, LLC, or other legal entity but keep in mind that the conversion
costs can be significant.
3. Not coming up with a great
standard form contract in favor of your company
Almost every company should have a standard form contract when dealing
with customers or clients. But, there really isn’t a “standard form contract,”
as every contract can be tailored to be more favorable to one side or the
other. The key is to start with your form of contract, and hope the other side
doesn’t negotiate it much. Here are some key items to come up with your form of
contract:
Get sample contracts of what other people do in the industry. There is
no need to re-invent a contract.
Make sure you have an experienced business lawyer doing the
drafting, one that already has good forms to start with.
Make sure you make it look like a standard form pre-printed contract
with typeface and font size.
Don’t make it so ridiculously long that the other side will throw up
their hands when they see it.
Make sure you have clearly spelled out pricing, when payment is due, and
what penalties or interest is owed if payment isn’t made.
Try and minimize or negate any representations and warranties about the
product or service.
Include limitations on your liability if the product or service doesn’t
meet expectations.
Include a “force majeure” clause relieving you from breach if unforeseen
events occur.
Include a clause on how disputes will be resolved. Our preference is for
confidential binding arbitration in front of one arbitrator.
4. Not complying with
securities laws when issuing stock to angels/family/friends
If the founders form a corporation, limited partnership, or LLC, the
sale of stock, limited partnership interests, or LLC interests to the founders
and later investors will be subject to federal and state securities laws. Most
securities laws require that the sale of shares must comply with certain
disclosure, filing, and form requirements unless such sales are exempt. Failure
to comply with such requirements can result in significant financial penalties
for the founders and the startup company including requiring the startup
company to repurchase all the shares at the original issuance price even if the
company has lost most, if not all, of its money. Consequently, in order to
avoid such fines, penalties, and repurchase requirements, founders must hire knowledgeable
lawyers to document the sales of shares in compliance with such laws.
5. Lack of employment
documentation
Business startups often encounter problems when they do not maintain
adequate employment documentation. Consequently, startups should have prepared
a core group of employment documents to be signed by most, if not all,
employees. A starting list of employment documents for a new company would
typically include the following:
Stock Option documents (if a corporation has been formed), including a
Stock Incentive Plan, Notice of Stock Option Grant, and Option Agreement
“At-Will” employment offer letters (signed by the company and the
employee, acknowledging that the employee or employer could terminate
employment “at-will”)
Confidential Information and Inventions Assignment Agreement (discussed
below)
Employee Handbook (setting forth company policies on vacation, conflicts
of interest, internet usage, etc.)
USCIS Form I-9 (to document verification of the identity and employment
authorization of each new employee)
IRS Form W-4 (the employee’s withholding allowance certificate)
Benefit forms, for benefits available to employees and family members
(e.g., health insurance, dental insurance, 401(k), etc.)
6. Not carefully considering
intellectual property protection
If you have developed a unique product, technology, or service, you need
to consider the appropriate steps to protect the intellectual property you have
developed. Both the company’s founders and its investors have a stake in
ensuring that the company protects its intellectual property and avoids
infringing the intellectual property rights of third parties. Here are some of
the common protective measures undertaken by start-ups:
Patents. Patents are the best protection you can get for a new product. A patent
gives its inventor the right to prevent others from making, using, or selling
the patented subjected matter described in words in the patent’s claims. The
key issues in determining whether you can get a patent are: (1) Only the
concrete embodiment of an idea, formula, and so on is patentable, (2) the
invention must be new or novel, (3) the invention must not have been patented
or described in a printed publication previously, and (4) the invention must
have some useful purpose. You obtain a patent from the U.S. Patent and
Trademark Office, and this process can take several years and be complicated.
You typically need a patent lawyer to draw up the patent application for you.
Copyrights. Copyrights cover original works of authorship, such as art, advertising
copy, books, articles, music, movies, software, etc. A copyright gives the
owner the exclusive right to make copies of the work and to prepare derivative
works (such as sequels or revisions) based on the work.
Trademarks. A trademark right protects the symbolic value of a word, name, symbol,
or device that the trademark owner used to identify or distinguish its good
from those of others. Some well-known trademarks include the Coca-Cola
trademark, the American Express trademark, and the IBM trademark. You obtain
rights to a trademark by actually using the mark in commerce. You don’t need to
register the mark to get rights to it, but federal registration does offer some
advantages. You register a mark with the U.S. Patent and Trademark Office.
Service marks. Service marks resemble trademarks and are used to identify services.
Trade Secrets. A trade secret right allows the owner of the right to take action
against anyone who breaches an agreement or confidential relationship or who
steals or uses other improper means to obtain secret information. Trade secrets
can range from computer programs to customer lists to the formula for
Coca-Cola.
Confidentiality Agreements. These are also referred to as Non-Disclosure Agreements or NDAs. The
purpose of the agreement is to allow the holder of confidential information
(such as a product or business idea) to share it with a third party. But then
the third party is obligated to keep the information confidential and not use
it whatsoever, unless allowed by the holder of the information. There are
usually standard exceptions to the confidentially obligations (such as if the
information is already in the public domain).
Confidentiality and Assignment Agreement for
Employees. Every employee
should be required to sign such an agreement. It accomplishes several purposes.
First, it obligates the employee to keep confidential the proprietary
information of the business, both during employment and after employment.
Second, it ensures any inventions, ideas, products, or services developed by
the employee during the term of employment and related to the business belong
to the company and not the employee.
7. Not taking into account
important tax issues
When starting a business, there are some key tax issues to consider. Here are some of the
most common issues:
Choice of legal entity. There may be valid reasons to choose a flow through tax entity, such as
an LLC or S corporation. Flow-through entities allow business losses to flow
through to the shareholders to use on their individual tax return. But most
venture capitalists and institutional investors prefer C corporations instead
of flow-through entities
Sales tax. The company needs to collect sales tax on sales of its products, because
failure to do so can have disastrous consequences. This issue is compounded if
the company is selling in multiple states.
Payroll tax. Many cities and counties impose a payroll tax.
Section 83(b). Founders and employees need to consider whether they can mitigate
potential tax issues by an IRC Section 83(b) election. A Section 83(b) election
relates to when someone receives stock or options subject to vesting and can
minimize deemed taxable income to the recipient.
Stock option issues. Companies often grant stock options to employees. If not done in
compliance with IRS guidelines, such grants can result in adverse tax
consequences to the company and/or the employee.
Qualified Stock Business Stock. Holders of stock in qualified small business corporations may be
entitled to a reduced rate of tax on gain from the sale of “qualified small
business stock” under IRC § 1202.
Tax Incentives. Depending on the nature of the business, various tax incentives may be
available, such as renewable energy tax credits and investment tax credits.
A good accountant or tax lawyer familiar with these issues can be a
valuable partner.
8. Coming up with a name for the
company that has trademark issues, domain name problems, or other issues
When picking a company name, it’s important to do some research to help
you avoid trademark infringement or domain name problems. You may be infringing
someone’s trademark if your use of a mark is likely to cause confusion among
customers as to the source of the goods or services. Here are some of the steps
to that can avoid naming issues:
Do a Google search on the name to see what other companies may be using
the name.
Do a search at the U.S. Patent and Trademark Office site (www.uspto.gov) for federal trademark registrations on your proposed name.
Do a search of Secretary of State corporate or LLC records in the states
where the company will do business to see if anyone is using a similar name.
Do a search on GoDaddy.com or other name registrars to see if the domain
name you want is available. If the “.com” domain name is taken, this is very
problematic and a red flag.
Make sure the name is distinctive and memorable.
You might want to have your intellectual property lawyer do a
professional trademark search.
Don’t make the name so limiting that you will have to change it later on
as the business changes or expands.
Come up with five names you like, and test market it with prospective
employees, partners, investors, and customers.
Think about international implications of the name (you don’t want to
have a name that turns out to be embarrassing or negative in another language).
Avoid unusual spellings of the name. This is likely to cause problems or
confusion down the road (though some companies like Google or Yahoo have been
successful with unusual names, such success is often the exception rather than
the rule).
9. Not having a good Terms of Use Agreement and
Privacy Policy for your website
A Terms of Use Agreement sets forth the terms and conditions for people
using your website. Your Privacy Policy is a legal statement on your website
setting forth what you will do with the personal data collected from users and
customers of the site, and how such data may be used, sold, or released to
third parties.
A good Terms of Use Agreement will cover the following:
How the site can be used and limits on uses;
Disclaimers on warranties;
Limits on liability of the site owner and its employees, officers,
affiliates, and directors
How disputes will be resolved (e.g., through confidential binding arbitration
precluding class actions);
Representations and warranties of the site user, and indemnification to
the site owner;
Rights to refunds and returns if products are sold; and
Intellectual property rights (e.g., copyrights).
A good Privacy Policy will cover the following:
What information the site collects;
How the site uses the information collected;
How the information may be shared or sold to third parties;
How the site deals with children under 13;
How the site may allow the user to access the site through third party
services such as Facebook and Twitter;
A description of the use of cookies and other technologies on the site;
The steps taken by the site owner to protect confidentiality and
security of the information collected; and
How changes to the privacy policy may be effected.
Privacy policies shouldn’t blindly be copied from other sites. There may
be legitimate reasons to narrow the privacy granted and to lessen the potential
liability of the site owner.
10. Not having the right legal
counsel
In a misguided effort to save on expenses, start-up businesses often
hire inexperienced legal counsel. Rather than spending the money necessary to
hire competent legal counsel, founders will often hire lawyers who are friends,
relatives or others who offer steep fee discounts. In doing so, the founders
deny themselves the advice of experienced legal counsel who can help the
founders avoid many legal problems. Founders should consider interviewing
several lawyers or law firms and determine if the lawyers or the law firms have
expertise in some, if not all, of the following legal areas:
Corporation, commercial, and securities law
Contract law
Employment law
Intellectual property laws
Real estate laws
Tax laws
Franchise laws
Although it is not necessary that the lawyer or law firm retained by the
founder have experience in all of the foregoing areas because certain problems
can be “farmed out” to different lawyers or firms, it is often best that the
founders retain a firm that can handle some, if not many, of the areas of
expertise listed above so as to provide continuity between the founders and
their lawyers.
There are a number of ways for a founder or start up business to locate
competent legal counsel:
Friends and business acquaintances
State bar referral services
Copyright Richard D. Harroch. All Rights Reserved.
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