Common Legal Mistakes Startups Make

 

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My name’s Scott Bleier, and I’m a corporate lawyer at the law firm Morse Pendleton in Boston, Massachusetts where I focused my practice of representing entrepreneurs, start-up companies, and venture capital investors.

Today we’re to talk a little bit about some of the common mistakes that I see otherwise promising start up companies make in the nascent stages of their life cycles with the hope that if you watch this video you might do to avoid those mistakes yourselves. You know it’s been said that starting a company is a lot like launching a rocket. You can be just a 10th of the degree off at the launch but as result of that deviation be hundreds of miles off downrange, and so again this video today we hope to uncover those little bit and hopefully be able to avoid those down the future for you.

Conflicts in Founding

The first misstep that I often see with start up companies deals with issues between members of the founding team. Often times, these people have a pre-existing relationship or they’re very comfortable with one another the trust one another and they fail to put the specifics with respect to the business and the interrelationship of the founders in writing in a clear and concise way.

So  what will typically happen the founders will start a business and a plow full steam ahead without really having difficult conversations about roles and responsibilities of the different founders allocation of equity amongst the different founders, who is going to have a what sort of title what sort of role with the business, and oftentimes I find if you don’t have those conversations early on can be too late there ought to be some misplaced expectations a month amongst the founding team. I think it’s very important that founders also consider subjecting their equity in their company’s divesting.

What I mean by that a vesting schedule for founders equity essentially means that a founder needs to on his or her equity over time as opposed to owning it out right on day one of the of the business transaction. I call this flaky founder insurance there sometimes the founders will start businesses with the best of intentions expecting to be in any business for the long haul. It’s a tough situation of the founder owns all of their shares free and clear and after possibly a matter of weeks can leave owning all of their shares in the business. Make sure that you get your got your business deal with your cofounders down in writing, have a difficult conversation now as opposed to later, consider seriously subjecting all of the founders equity divesting to avoid situations where a founder leaves after short period of time with all their equity free and clear.

Business Structure

Another issue that I see with a start up companies is a situation where a business has not been structured properly.  It’s important that you go through a couple of checkpoints to understand exactly what the right business structure is for you because choosing the right business structure can have adverse tax consequences and other consequences for you that are necessarily intended, and you don’t want to trip out of the gates with the wrong sort of business structure. When I’m counseling clients, and they’re asking me what type of business structure to form I usually ask five questions of the founders to determine what type of business structure is appropriate for them.

The first one is how many founders you have? Is it just a solo founder or do you have multiple founders on your team? The next component that’s important to ask founders when they’re considering what type of business structure to use is how quickly the company will be making money. I know that often involves having to look in the crystal ball a little bit but the company thinks it’s going to be profitable and earning money more sooner as opposed to later that’s going to to have a dramatic impact on what type of business structure to use.

In addition to the timing of when a company is going to make money the next question is what is the company going to do with that money? Is it going to be reinvesting the profits internally for growth or does it intend to distribute those profits out to the owners of the business? Who are your investors going to be? Are your investors going to be friends and family or are you going to be taking money from institutional investor such as venture capital firms or angel investors?

The type of investor that you’re choosing for your business is going to have an influence on the structure of your business, and last but certainly not least, I also asked my founder clients do you expect to issue equity incentives up to your employees. Often times start up companies that don’t have the that the money in their bank to pay their employees fair market wages and as a result they have to bridge the gap by paying some salary but also paying their employees with stock options or equity incentives to get those employees excited about the business and incentivized work hard to grow the value of the business. If the founder thinks of the really not going to need to engage in that sort of activity, then that’s also going to determine perhaps the structure of the business.

Protecting Intellectual Property

Another vital issue for start up companies to consider it a mistake that for better for worse I often see start up companies make is being very careful with protecting intellectual property. A typical scenario that I see with the nascent stage company is they have done some some proprietary software development or develop other sort of intellectual property. Those individuals that have developed intellectual property have not properly assigned rights and intellectual property to the business in writing.

This could again be an independent contractor or consultant who’s been engaged by the business-to-business development work or could be an employee him or herself so again very very important to make sure that these people have in writing assign the rights in this intellectual property to the business so there’s no question down the road for example when the business is going to raise money from investors that the company actually owns the intellectual property that is some of the biggest drivers of the value of the business

It’s All In The Name

Another mistake that I often see startup companies make, and I can share a war story or two with you about this, is companies not properly vetting or checking the name they choose for their company and the domain names they wish to use. I represented a very promising startup company that shows a name for its business, not only chose a name for its business, but went so far as to print up T-shirts, other knickknacks, market marketing giveaways that they were providing to people at job fairs and other sort of industry events.

After investing a substantial amount of money in this marketing collateral, they got a nasty cease-and-desist letter from another company letting them know that they were using that name already, and in fact they already had a federal trademark of protecting their use of that name and as a result, the startup company really had to start from square one rebrand itself with a new name lost a lot of time money money energy and resources using a name that found out that it couldn’t use because there’s competing uses out there in the marketplace. So always important when you’re starting a business to do obviously something is easy as a Google search to see if there’s any conflicting uses out there. Perhaps check on the US patent and trademark office’s website to see if there’s any pending applications for registration or actually registered marks with the same were somewhat similar names to what you want to use for your business.

You might also consider engaging a lawyer to do a more professional background search on the market you’re intending to use to really search on the federal state and even local town levels throughout the country to make sure there’s no competing uses.

Engaging Employees

Another area where I see start companies often make mistakes deal with employment issues and how companies engage their workforce. As I said earlier employees of can be hard to find the start up companies because oftentimes start companies don’t have the financial resources to pay their employees what the market rate for that employee might be employees can be expensive in other ways. You have to pay them benefits and so oftentimes companies will tend to want to try to contract with outside consultants are independent contractors and move using employees because is a little more flexibility for companies in in approaching the workforce in that way.

The reality is that just by calling an individual  an employee working 40, maybe even more than 40, hours a week, and showing up for work in the office every day, they really don’t have any control around the work product that they’re providing an independent way. For all intents and purposes, they are employee that sort of an individual just by virtue of calling the consultant or independent contractor that’s really not going to change the reality of the situation.

In fact, employee misclassification issues is often an issue that I see with startup companies. Be very very careful in how you’re engaging your workforce and make sure you’re characterizing. Directly mischaracterizing a employee as an independent contractor can result in severe tax consequences if you haven’t withheld taxes from their wages correctly or in some instances can be damages and attorneys fees awarded in situations where employee is been misclassified in such a manner.

Financing a Business

Another issue that I see with start up companies deals with how you finance a business typically at some point in time I start a company needs investment capital to grow. So notwithstanding the fact that crowdfunding has been in the news quite a bit recently, typically what we recommend is that start up companies only take on money from accredited investors. An accredited investor someone who at least has million dollars net worth that’s not including the value of their home or they have income $200,000 in the last few years or $300,000 combined income with their spouse. By issuing stock and taking money from non-accredited investors, there’s a host of regulatory issues.

The other issue that I see with start up companies raising money is using non-registered brokers or dealers in sourcing investment capital for them. There is often times people in the industry who will come to start up companies and say “I have a great network of investors that I can introduce you to. If I introduce you to investors, and help you raise money I’ll get paid by taking a percentage of the proceeds from the capital that you raise.” Investment capital and raising money is a private company in the United States is a heavily regulated industry at both the federal and state levels. This is why start up companies need be really really careful about engaging unregistered brokers and dealers and helping them raise money because it’s illegal and can result in major issues for companies down the road,  including having to make a recessionary offer to your investors where you agree to give them back their money because you use a broker or unregistered broker-dealer raising money from those individuals, so again very careful of for start up companies raising investment capital to make sure you raise money from people who work accredited investors and also that you raise money either on your own or only with a registered broker-dealer.

Seeking Professional Advice

The last mistake that I’m going to talk  about really briefly and I apologize this is going to sound a little self-serving, is making sure that you choose the right professional advisors when your startup company.  That can be of course lawyers like myself but also CPAs and other professional advisors. Often times when I love working with start-up companies, I see that they’ve been using from the early stage a lawyer or maybe a friend of the family who does divorce law or real estate law and  isn’t really well-versed in the issues that start up companies address. In fact, often time some of the mistakes that we just been covering in this video happen specifically because they did not have the appropriate type of professional advice early on, and so it’s important to choose your professional advisors wisely.

If you’re working with a lawyer make sure that your lawyer regularly advises startup companies, is aware of the issues that start up companies need to be knowledgeable of, because it’s important for companies to not be penny wise and pound foolish by not having the right sort of legal advice or other professional advice for that matter that can come back to bite you in the long run.