Joe Green, Thomson Reuters Practical Law, Legaltech News
Certain avoidable legal mistakes that
many startup founders make early on can lead to a startup's premature demise.
It is an exceedingly rare successful startup that gets
to where it is without having made a few potentially fatal mistakes early in
its life. Some are business-related missteps, such as rushing out to market
with a flawed product concept or targeting the wrong audience.
The startups that weather these business flubs have to
learn from them and eventually pivot their way to success—success that, in many
cases, would not have been possible without learning from those early failures.
Hence, the Silicon Valley mantra "fail early, fail often," which
celebrates these mistakes as hallmarks of the process of innovation.
Legal
mistakes, on the other hand, typically lack that sort of silver lining. On the
contrary, certain avoidable legal mistakes that many startup founders make
early on are hard to overcome and can lead to a startup's premature demise.
Mistake
No. 1: Waiting too long to seek out experienced legal advisers.
Most founders
wait until they have already made a number of preventable legal mistakes before
first consulting with a lawyer. Founders often have two traits that make them
less predisposed to reach out to a lawyer early: They are risk-seeking and
cost-averse. These traits serve them well in many respects. In order to leave
the security of a steady paycheck and take the plunge into starting a new
business venture, founders need a certain appetite for risk. Smart,
bootstrapping founders also try to start building their companies using as
little cash as possible so that they can retain more of their equity.
However,
these traits can also sabotage young companies when founders take unnecessary
legal risks because they don't want to—or don't think they need to—pay for
legal advice. The costs of cleaning up legal issues (if it's even possible)
vastly exceed the costs of obtaining legal advice at the outset. The cleanup
can also delay or potentially scuttle fundraising (the company's lifeblood) or
an acquisition.
When founders
do seek legal advice, they should find lawyers who have experience working with
early stage startup companies. Hiring any old lawyer won't do. Founders who
were previously lawyers themselves and believe they can do their own legal work
to save money (despite having no experience with startup law) often end up
making many of the same mistakes as nonlawyer founders.
Mistake
No. 2: Overcomplicating legal arrangements.
The second
biggest mistake after not getting good legal advice early enough is not taking
that advice. Savvy startup lawyers know that keeping legal costs low by
simplifying and streamlining initial legal arrangements is extremely important
for young, cash-starved companies. Despite many founders' cost-aversion, they
often have a competing desire to "optimize" their formation,
employment and financing documents by planning for every conceivable scenario.
Although that approach may make sense in a billion-dollar merger (where the
additional legal fees are justified by the dollar amounts at stake), this sort
of contractual customization is usually too costly, overcomplicated and
ultimately counterproductive for early stage startups. In addition, many of
those complicated early arrangements will likely be wasted effort in the end,
as future institutional investors often undo much of them when negotiating the
terms of their investments. Founders should listen to their lawyers and try to
keep it simple. They can use the savings to build the business (a far better
use of that cash than optimizing legal agreements).
Mistake
No. 3: Avoiding hard conversations among co-founders.
The
relationship between startup co-founders is often likened to a marriage. As
with any marriage, communication is vital. Many founders put off difficult
conversations with their co-founders about fundamental issues, such as how to
split equity, whether to subject their stock to vesting, which operational
roles each will undertake and what expectations they have of one another.
Punting on these issues for fear of rocking the boat allows tensions among
co-founders to fester until they explode in spectacular fashion in a messy
founder divorce. Founders should work through these difficult issues and
document them properly early on (which a good startup lawyer can facilitate).
Time-based vesting, in particular, can be a lifesaver by keeping founders who
exit early from keeping all of their equity at the expense of those who remain.
Mistake
No. 4: Running afoul of agreements with previous employers.
Founders
often start working on a startup concept while they are employed by other
companies. Those previous employers may present a major liability for a startup
company, depending on the founders' legal obligations owed to those companies
under employment arrangements such as noncompete agreements, nonsolicit
agreements and company policies regarding moonlighting and use of company
property. One slip-up and much of the startup's intellectual property may end
up being owned by a founder's previous employer. Early stage startups have no
cash to defend lawsuits from bigger companies, so even the threat of litigation
can make a young startup radioactive for potential investors and commercial
partners. To avoid this situation, founders should fully understand their
obligations to their existing employers before beginning work on a new startup
concept.
Mistake
No. 5: Violating employment laws.
Startup
founders often believe in many myths about employment laws that can land them
in seriously hot water with government regulators or catch the attention of
hungry plaintiffs lawyers, which in turn has a chilling effect on prospective
investors and acquirers. Many believe, for instance, that "labor laws only
apply to bigger companies, not startups." False. Or, "We don't need
to hire employees, withhold taxes, or pay overtime—we can just use
consultants." Wrong. How about, "I pay my assistant an annual salary,
so we don't need to pay him extra for working overtime." So wrong. And
finally, one of the most popular myths, "Nobody pays summer interns!"
Violating
these employment laws can quickly lead to lawsuits because plaintiffs lawyers
are often awarded attorney fees for bringing them. It's not a matter of
"if" the company will get sued for these practices but
"when," and the settlement amounts and regulatory fines can be
staggering. Startups should work with employment lawyers to avoid these
pitfalls as soon as they start hiring beyond the founding team. For a guide to
navigating the numerous federal employment laws and human resource issues
facing new and growing employers, including tax reporting and notice
requirements, immigration compliance, insurance, employment and independent
contractor relationships, and workplace policies and practices, view the Employment Law Issues
for Startups, Entrepreneurs, and Growing Businesses Checklist from Practical Law.
Joe Green writes
startup and venture capital content for Thomson
Reuters Practical Law. Before joining Practical Law, Joe was a senior
attorney at Gunderson Dettmer, where he advised startups, entrepreneurs and
premier venture capital investors on a wide range of legal and business issues.
After graduating from UVA Law, he began his career as a securities lawyer with
Simpson Thacher & Bartlett in New York.
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