Ten Legal Pitfalls for Startups and Emerging Companies
#1 Delays in Seeking Legal Advice
First and foremost, invest in good legal help from the onset! Many startups think they can save money on a lawyer entirely. Alternatively, they hire a lawyer that lacks experience dealing with the issues commonly faced by startup businesses. Finding a lawyer that is adept at drafting and reviewing common business contracts and incorporating companies is especially useful.
Trying to cut legal corners early on will likely lead to headaches later. Many startups pay the price down the road. For example, it would be dangerous to have a lawyer that tells you it is alright to sign a deal contract with a 16% convertible note. Inexperienced lawyers may not fully appreciate the fine print when reviewing contracts because of a lack of experience with the types of agreements customary to startups. In addition, they may draft contracts without full protections built in.
#2 Lacking Proper Contracts
Relying on informal agreements or understandings is not is sustainable way of operating a business. The terms of such informal agreements must become formal, signed legal documents. It is often hard to imagine what could possibly go wrong in the future, especially when it comes to startups founded by close friends. However, if relationships become fraught and disputes arise, you will not have much in the way of legal recourse by citing a mutual understanding between the parties.
#3 Not Entering into an NDA
Startups need to spread the word about their company in order to help it grow. This entails sharing business ideas, some of which may be sensitive information. At a minimum, all employees should sign a confidentiality agreement with the company. It is a good idea for startups to have nondisclosure agreements (NDAs) with professional advisors and other people more broadly that the startup shares significant information with.
#4 Insufficient Intellectual Property Protections
Getting proper copyright, patent and trademark protections early on can be a gamechanger later on. This is especially true if your startup hinges on a novel invention or a unique trademark. An inventor can register patents and copyrights are registered at the federal level. In contrast, the holder of a trademark can register it at either the state or federal level. If an invention is not made in-house, and the IP is not assigned to the startup, the inventor can assert IP rights in the event of a legal dispute.
#5 Not Adhering to Employee/Human Resources Procedures
There are a number of employment laws that all companies must adhere to across the United States. States have implemented additional employment laws. Startups may view this administrative paperwork superfluous and distracting time away from the main business mission, but failing to follow proper employee protocols can lead to problems.
Such requirements may include paying a minimum wage, implementing an anti-harassment and discrimination policy, and filling out proper human resource documentation. For example, all employees at the company must complete the Form I-9 at hiring to prove their eligibility to legally work in the United States. Companies usually must have an employee handbook that contains the company’s various policies and code of conduct.
#6 Noncompliance with Tax Laws
Violations of tax laws frequently arise inadvertently due to a lack of proper legal guidance or planning. One way startups can reduce tax issues down the road is by submitting an 83(b) election form with the IRS. Startups must declare the date, purchase price, and amount of shares purchased by a shareholder in a corporation on an 83(b) election form.
#7 Issuing Equity on Schedules that Lead to Wrong Incentives
Equity awards keep founders and loyal employees motivated. They also promote dedication to the company’s long-term growth and development. However, vesting schedules that are structured so that the equity vests too quickly may actually work against this goal.
#8 Having the Wrong Legal Name
It is probably already too late to address this issue, but choosing the right name for your startup can avoid potential legal problems. This often takes the form of trademark infringement issues. It is advised to do an online search of the US Patent and Trademark Office website to make sure there are not federal trademark registrations that have your company’s name. Aside from trademark issues, legal risk can stem from choosing a name that is offensive or creates the wrong public perception.
#9 Exaggerating to Investors
Startup founders are enthusiastic about the businesses they built and naturally will strongly pitch it to investors. However, startups need to be careful of falling into breach of the law. Specifically, making exaggerated claims to investors can lead to liability under U.S. state or federal securities laws or other anti-fraud laws. Stretching growth projections or making promises to investors that are materially misleading can lead to legal issues.
#10 Lacking Legal Permits and Licenses
Last, but not least, make to have the right permits and licenses in place to avoid legal problems. Figuring out permit and licensing requirements can be a pain, so having a lawyer to assist can be a value-add.