Starting a new business is exhilarating. It can also be filled with several common startup legal mistakes. From the outset, there are three critical items to attend to. Each of them feels like revisiting the old chicken-and-the-egg problem. Which should come first?
- Forming a legal structure.
- Fundraising, including the amount, the instrument, the terms, and (of course) finding the investor.
- Putting a financial function in place to watch over the capital raised, revenues coming in, and expenses going out.
You can establish a legal entity in minutes using do-it-yourself (DIY) internet services. Examples include LegalZoom, Stripe/Atlas, and Clerky. However, these services are best used for incorporating sole proprietorships with simple structures.
If you’re ultimately looking to raise funds from professional investors, there are several common startup legal mistakes to be avoided that can help lead to significantly better outcomes. Some legal mistakes are easily fixable. Others can prove costly and hard to unscramble. Simple startup legal mistakes may set you back in time and money. You can get things back on the right path with some extra attention. Other errors can prove to be much more challenging. Those you want to avoid.
Failing to choose your corporate entity wisely.
Determine at the outset how to organize your business. Will it be a partnership and LLC, an S Corporation, or C Corporation? LLC, S Corps, and Partnerships are pass-through entities. This implies that owners being taxed are the ones dividing profits and losses amongst them.
Also, think about your potential exit strategy. Will it involve the sale of shares or an IPO rather than an asset sale? Organizing as a Delaware C Corp is often the preferred approach despite the risk of double taxation.
Emailing or texting promises of equity.
When casually considering giving equity in your company, think twice. This can be one of the costliest of startup legal mistakes.
Never casually mention via text message or email a promise of equity. A few years later, your startup is months away from financing, acquisition, or IPO, and just like that, your friend or family member pulls up the conversation and asks, “Where’s the stock you promised me?”
Resolving these types of disputes can be costly and often contentious. Be careful with any offer to give company stock. Have a binding agreement in place if your intention is genuine.
Failing to pay attention to securities laws.
Issue stocks carefully. Make sure stock issuance is done in compliance with securities laws. Making a mistake with stock could create expensive penalties down the road for your company.
This may be one of the things you talk to a lawyer about to abide by the required disclosures, filings, and forms. Talk to your lawyer first.
Not hiring employees correctly.
Startups focus on hiring talented employees. Getting the right employees on board is critical when starting up.
However, it’s equally essential that you have all documentation in order when you hire. These documents include USCIS Form I-9, IRS Form W-4, offer letters, NDA’s, as well as operating procedures and employee benefits.
Ignoring important tax considerations.
Entrepreneurs need to pay attention to various crucial tax issues that, without proper planning, can leave founders or their startups liable for unintended and unanticipated taxes, fines, and penalties. Startups, like all businesses, need to keep records that wholly and accurately capture all income and deductible expenses.
One of the big ones to keep ahead of is that stock received for services is taxable as ordinary income.
Neglecting intellectual property issues.
Getting copyright, patent, and trademark protection should be first-line protection put in place to safeguard your company’s intellectual property. It will be a herculean task to find an investor willing to invest in a startup if there is ambiguity as to who owns the company or where there is no transparent chain of title to the intellectual property.
Therefore, it’s imperative that your startup owns its intellectual property and has written releases from individuals who helped with its creation. This includes employees, founders, consultants, advisors, or any other person contributing to the business.
Employees that haven’t signed a confidentiality agreement.
Companies pay employees to innovate. They give them access to confidential information, oftentimes beneficial competitive information for technology companies.
Protecting proprietary company information is a must. Companies must put confidentiality and invention assignment agreements in place at the outset. Once implemented, an employee is prohibited from using the company’s confidential information for personal benefit or another employer without authorization.
Flawed fundraising instruments.
Raising funds definitely feels like a chicken-and-the-egg problem. How can you form a company without money but how can you raise money for a company that doesn’t exist yet?
You may need to use some of your savings to get started. Scrape together enough cash to form your legal entity and do a minimum amount of structuring.
Once you have a legal entity, you still have no revenues. Most often have no minimum viable product, no legally registered intellectual property, nothing to demonstrate a valuation. It’s the worst possible time to attempt establishing the value of your business.
One possible solution to consider.
Many years ago, startups solved this problem. They would offer investors a convertible note that would convert into equity at the first round that established a valuation, usually at a discount to the equity price, with some accrual of interest during the intervening period. They can even have a cap on the valuation upon which the conversion could take place.
Convertible notes that stay pending for longer than a year or more can have punitive effects on the growth and development of new startups.
Along came the “simple agreement for future equity,” or SAFE, brainchild and invention of Carolynn and Jonathan Levy who are lawyers for Y Combinator, an eponymous San Francisco Bay Area accelerator. A SAFE has no interest and no maturity date, and thereby takes away the punitive effect of needing time to develop. While initially confined to west coast companies, the SAFE has become the ubiquitous form of startup financing around the world.
Another problem with startup instruments is disparate caps on valuation, disparate discounts, disparate terms, requests for “most favored nation” treatment — does this apply retroactively? — and innumerable other strategic and financial questions about how much to raise, from whom, and on what terms.
It’s important to insource or outsource a basic financial function as soon as possible. You need someone to track and safeguard your funds and budget how long they will last.
Should engineering talent be classified as an employee or a consultant? Is a permanent establishment created by having an employee in a distributed location? Are sales taxes due? Are research and development tax credits available and, if so, how long will the money last?
Avoiding legal, fundraising, and financial pitfalls from the outset will avoid significant problems later. Partnering with a strong legal counsel, raising from a supportive group of investors, and creating an intelligent financial function that has years of experience navigating these issues and avoiding startup legal mistakes pays off in spades.