Avoid these Legal Problems for Startups

Startup legal problems add to the very long list of issues that founders need to deal with even before they create the company. This article is about some of the traps that lie in wait for unwary founders. Remember that any startup has numerous administrative issues to deal with starting on day one of the formation of the new business. I recently gave a talk before a group of startup mentors, one of whom asked me what should be the priority for the startups. My answer was simple, that a new business owner who fails to be ready on day one proceeds at his or her own peril.  It is not like you can delay setting up a bank account or buying workers’ compensation insurance.

Related article: Checklist for Starting a Business

And as the startup founder is trying to tackle these administrative anchors, he or she is also faced with a number of legal issues that simply should not be ignored. I recently came across this blog from Deb McAlister, a self-described “high technology marketer and PR person.” She says that she has handled product launches for 129 successful products. Her insights on the start-up process are a good read for anyone who is thinking about starting a new business.

Although she is not a lawyer, she gives an excellent summary of the legal traps founders should try to avoid. She describes what many startup attorneys have seen time and time again. At the beginning, optimism abounds and understandings are not reduced to writings. If the company fails, these looming issues never rear their ugly head. But if the company is successful, then the problems begin.

I’ll summarize some of the things that she thinks that every founder should know about legal pitfalls before going live with their start-up and getting into bed with their partners, investors, family and friends. Although this is my summary, you should read her post for the perspective of an entrepreneur and consultant about what start-up founders frequently forget in all the excitement in forming a new business.

The intellectual property for the startup belongs to whom?

You better know who or which entity owns the trademarks, copyright and patents for any business that you are about to launch. If your business is a tech company, then there is no more important asset than the intellectual property (IP). Sorting out the IP at an early stage, preferably before the company is even formed, is essential if you want to avoid problems down the road. Written agreements assigning all rights to the IP to the new company certainly help clarify matters and avoid misunderstandings.

Reduce investor or partner agreements to writing

You may have heard that some agreements do not need to be in writing to be enforceable. Under many state laws, operating agreements for limited liability companies don’t need to be in writing. Similarly, an oral partnership agreement may be enforceable if you can prove its essential terms. But that is the point, each party to the oral agreement may have a different idea of what the terms are and you need to go to court to determine what are the terms of the agreement. This can be a very expensive proposition. If you think you have an agreement with someone putting money into your new business, or someone you are going to go into business with, you should reduce it to writing. Save the headache later on.

Related article: Investors for Startups: Terms of Engagement

“Standard” agreements may cause heartburn

There is nothing like a “standard” agreement. What someone is trying to tell you is that they are unwilling to negotiate terms. If you are dealing with a Fortune 500 company or the government, then you probably are not going to be able to negotiate various terms. If you want to do business with them, you are stuck with their unreasonable demands and you should read the contract to make sure you know what you are getting into. But if you are negotiating the terms of an operating agreement with your partner who says that he or she picked up the operating agreement on the Internet and that it is standard fare, you should definitely think again. Every investor or LLC member has different priorities and may have a different tax situation and the terms of the agreement should be negotiated.

Related article: Negotiating LLC Operating Agreements

One agreement that gets founders into trouble very quickly are lease agreements. The business terms, such as the term of the lease or the amount of rent, are familiar to you, but other “standard” terms such as responsibility for repair or maintenance, or obtaining a certificate of occupancy, are terms that can cause you trouble if you don’t understand what you are getting into.

Piercing the corporate veil

Many startup founders think that once they have set up their corporation or LLC that their personal assets are protected. Then they start paying their personal expenses from their business checking account. Or because they are running short on funds, they write a check to their employees or pay for a company expense from their personal checking account—and then fail to record this transaction in the company books. Intermingling personal with business assets or debts exposes your personal assets to business creditors. It does not take much time to observe the corporate formalities, which will go a long way to protect the founders’ personal assets.

Investor problems become the business’ problems

Many times in the rush to get an agreement done, partners will forget that they will disagree on certain key issues. They should make sure that they have terms in their agreement on how to break a deadlock if they cannot agree to certain issues such as a buyout offer. And they need to take into account how the business will be affected if one of the partners has a major change in status, like death, or divorce or bankruptcy. Particularly in the case of a LLC operating agreement, you can provide for terms what to do if one of the members dies, or is divorced or files for bankruptcy. Do you want someone you don’t know to come in to the LLC with the same voting rights (and other so-called non-economic rights) as your original partner?

Cutting corners can come back to haunt you

The major theme in all of these issues is that forming a company is easy but you need to observe the corporate formalities to protect you and your business. And unless you confirm in writing your understanding with all of the interested parties in your business, you may face challenges down the road, especially if you are successful. That means that you should memorialize in writing who contributes what to the company, and clarify what partners or investors get for their contributions, make sure that employees and contractors have a signed contract with your company. You should work with your small business attorney to create agreements that you can use with your customers or clients. The contracts not only protect your company from a legal standpoint, they also provide good guidance and best practices of how you should treat your partners and investors, and what you need to do to serve your customers.