10 Legal Mistakes That Can Destroy Your Small Business And How To Avoid Them Ross Kimbarovsky | September 14th, 2009
Prior to co-founding crowdSPRING, I spent 13 years practicing law (representing small, medium and Fortune 500 clients around the world). Along the way, I advised many small businesses and startups. Entrepreneurs and small businesses often ask me about legal problems facing most small businesses and startups and for tips on how to avoid those problems. Here are the top 10 mistakes and tips on how to avoid them:
1. Choosing The Wrong Ownership Structure. This is your most important first decision when starting a business. The decision you make will impact whether or not you’ll be able to accept investors, how many and what types of investors, whether you’ll easily be able to sell your company, what your personal legal liability will be, what your tax liability and benefits will be, and many other significant issues.
Why This Is A Problem: If you’re going to be looking for outside investment, you’ll want to create an ownership structure that’s friendly to those investors. For example, most outside investors prefer the stock structure of a corporation (or limited liability company) as opposed to a partnership. If you select the wrong ownership structure, you might expose yourself to unlimited personal liability for your company’s debts. Keep in mind that you should create your ownership structure BEFORE you enter into any agreements/contracts.
How You Can Avoid This Problem: Consider the following issues when deciding on what type of entity to start: what are the potential liabilities/risks? What are the anticipated tax benefits from being taxed as a partnership as opposed to a corporation? Do you intend to have outside investors? Do you anticipate selling your company in the future? Are you pursuing a risky business where you might be sued?
If you’re a sole proprietor, you are personally liable for your business debts. While this is generally the simplest form of ownership, it is also risky.
In a partnership, the partners can be personally liable for the debts of the business. One benefit of both sole proprietorship and partnership is that the income/loss from the business flows directly to you (the corporation doesn’t pay a separate corporate tax).
To insulate yourself from legal risk, you can form a corporation. Corporations have the most demanding record-keeping requirements and are subject to a separate corporate tax (in additional to your personal liability for your share of the money distribute by the corporation). As long as you follow all corporate formalities (hold periodic meetings, keep good corporate records, etc.) you’ll generally insulate yourself from personal liability for the debts of your company. Because of the expense involved in maintaining corporate records, many small businesses don’t use the corporate ownership structure (although many startups do – because that structure often makes it easier to sell the company).
You can get the tax benefits of a partnership and the legal protection benefits of a corporation by organizing as a limited liability company (LLC). LLCs are subject to annual taxes or reporting fees (typically, hundreds of dollars) but have far fewer corporate records requirements than do corporations. After considering our own situation, we organized crowdSPRING as an LLC.
2. Lack of or Poor Organizational Documents. It’s not enough to decide on the right ownership structure for your business. If you decide on a structure that requires documentation – such as a corporation – you must follow the formalities and create/maintain such documents.
Why This Is A Problem: If you don’t have solid organizational documents or fail to follow corporate formalities (such as for a corporation), you expose yourself to personal risk because courts may “pierce the corporate veil” and find you personally liable if they believe that the corporation wasn’t properly established or maintained. You also will lose credibility before your investors if they believe you don’t know how to properly maintain your entity.
Similarly, if your entity is an LLC, you generally aren’t required to have a written LLC agreement (that explains the rights and liabilities of the members of the LLC) but it’s a good practice to have one so that if you and your co-founders (or investors, or employees) every get into a dispute, you can refer to that document.
How You Can Avoid This Problem: Once you decide on the organizational structure, research (or consult an attorney) to understand what organizational documents you’ll need to prepare to properly document that structure. For example, you’ll need to file incorporation documents (simple) for a corporation of articles of organization for an LLC. You’ll also need to register your partnership or sole proprietorship. For corporations and LLC’s you’ll need to determine how many shares (corporations) or units (LLCs) of stock to issue and how to allocate them. Make a list of everything you need to do and make sure you’ve complied with all of the formalities.
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3. Lack of Proper Corporate Records. More often than not, founders of startups and small businesses know very little about keeping good corporate records (including general corporate, tax, employment, human resources, etc.).
Why This Is A Problem: If your corporate records are a mess, you may face personal liability for the debts of the company. You also could create problems for any acquisition because anyone conducting due diligence to determine whether your assets/liabilities are as you say they are, will have difficulty understanding whether you’ve properly protected your rights if appropriate legal documents required of corporations, for example, don’t exist.
How You Can Avoid This Problem: Familiarize yourself with the types of documents you have to create and maintain based on the organization structure you pick. For example, there are very specific requirements for the documents that must be maintained by a corporation. Create a list of these requirements, create a binder (or electronic document that takes the place of a binder), and keep a careful and complete set of all corporate documents. Make sure you pay all annual taxes/file annual reports with your state (or you risk having your corporation or LLC dissolved).
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4. Accepting Money From Investors Without Considering Securities Laws. Investors invest in your company hopeful to return a healthy profit on their investment. And while they’ll sometimes consult their own advisers, it’s up to you to make sure that your investment documents comply with securities law. If they don’t, you expose yourself to tremendous risk.
Why This Is A Problem: If an investor loses money in an investment, they’ll often ask their attorneys to investigate whether appropriate disclosures were given and documented under the securities laws. If they were not, investors may sue – and seek treble damages (three times the amount of damages). Securities laws are complicated and it’s important that you consult an attorney when dealing with investors.
How You Can Avoid This Problem: Consult an attorney. Period. If you can’t afford an attorney, consider hiring an attorney who’d be willing to counsel you in exchange for a small equity stake in your company. To give you a frame of reference about costs – the legal bill on an investment round can run from $20,000 – $50,000 or more (depending on complexity).
There are good resources only that could help you get started. For example, Y Combinator, an early stage venture firm that has funded over 100 startups, has open sourced the legal documents they give their startups to use as they seek additional funding. You can download copies of those documents here. I’ve not studied those documents in detail, but I have looked at them and they offer an outstanding starting point (you will still want an attorney to modify them for your use, but this will provide a great starting point).
You may also be interested in one of my earlier posts – tips for raising money from angel investors.
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5. Failing To Check Founders’ And Employees Non-Compete Agreements. Many employment agreements contain non-competition clauses that prohibit an employee from competing with their employer (even for a period of time – typically years – after the employment ends). This is a risk for the founders, and for every employee that the founders hire who may be restricted by a non-compete clause in their prior employment agreement.
Why This Is A Problem: If your former employer (or your employee’s former employer) believes that your new business is competing or will be competing with them, they won’t like it. Depending on the risk they face from you or your employees competing against them, they may threaten legal action and at times, file suit. Litigation can be expensive (both in time and money). It’s also very distracting.
How You Can Avoid This Problem: If you are starting your own business, carefully read your employment agreement to see if there are any restrictions on competition. If your startup is going to do something completely different from what your current employer is doing, that’s a good thing but not a definitive answer. Once you’ve read the agreement, it’s a good practice to talk to your former employer and disclose what you plan to do. Often, this is sufficient. Alternatively, you can consult an attorney to make sure that you are not bound to a non-compete agreement.
If you have co-founders, you should read each other’s employment agreements to confirm that none of you are bound by non-compete provisions. An angry former employer can seriously damage your small business if they decide to flex their muscles and enforce a non-compete.
Similarly, ask every employee you plan to hire whether they are bound by a non-compete in their employment agreement and request to review a copy of that provision (so that you can be satisfied that you won’t be exposing yourself/your company to legal risk).
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6. Weak or Non-Existent Employment/Options Agreements. Many startups and small businesses fail to create appropriate employment and/or options agreements for their employees. This is a huge mistake and can only result in trouble.
Why This Is A Problem: If you don’t protect your rights with an appropriate employment agreement, you risk having your employee later leave to compete with you, or you risk not acquiring intellectual property rights to your employees’ inventions (related to your business). You also create the potential for disputes because your employees’ and your company’s respective rights and responsibilities will not be clearly defined in writing.
How You Can Avoid This Problem: From day one, create a form employment agreement that you’ll use with every employee. You’ll end up using nearly the same agreement for everyone, so if you incur some legal expenses for that first agreement, know that it’ll come in handy over and over again. Do the same for a form independent contractor agreement (if you plan to hire consultants) and for an options agreement (if you plan to give out options). Have your attorney create appropriate form agreements and then consult your attorney when you need to vary the terms of that form agreement.
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7. Weak Or Non-Existent Vendor/Client Written Agreements. One common mistake many small businesses make involves vendor and/or client contracts. Small businesses often believe that a handshake is sufficient. It is not.
Why This Is A Problem: It is very difficult to uphold a verbal agreement in court. A properly written agreement can protect your interests and rights. A properly written agreement will also typically save you a lot of aggravation and legal expense of having to enforce your rights.
How You Can Avoid This Problem: If you are able to seek legal counsel, do that. A good attorney should be able to quickly review a written agreement and provide feedback/suggested revisions. For those deals where the legal expense would be prohibitive (most small business agreements fall into this category), ask your attorney whether they would recommend any form agreements for you to use. You can also review and purchase certain form agreements online, such as at Findlaw or LegaZoom. (I’ve never used either service, so I can’t speak to the quality of the agreements).
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8. Ignoring Intellectual Property. Many small businesses – especially non-tech small businesses, believe that they don’t have any intellectual property risk. They would be wrong. I’ve represented many clients in non-tech industries in numerous patent, trademark and copyright disputes dealing with mundane non-tech products and services.
Why This Is A Problem: If you ignore intellectual property, you may fail to protect your rights and may not properly acquire ownership to intellectual property that may be critical to the future success of your business. For example, if your employees typically invent new technologies or processes in your business, you may want your employment agreements to clearly specify that they would assign those inventions to you. If you’re licensing your trademark or software to another company, you want to make sure that you’re giving away appropriate rights – and not all your rights.
How You Can Avoid This Problem: Intellectual property is a complex area and it’s highly unlikely that you’ll gain a solid understanding by reading – but you should at least understand the basics. You can take a look at two free e-books that I’ve written (both are focused on contracts, but have sections devoted to intellectual property and copyright: Contracts for Designers Who Hate Contracts and Contracts For Software Developers Who Hate Contracts. And of course, you should consult an attorney on any issues that you don’t understand. For example, if you plan to trademark your company’s name, you’ll want to be sure that the name could be trademarked before you invest time and money in acquiring a URL and promoting your brand.
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9. Litigation. Litigation is expensive. VERY expensive. Typically, the only people who make out well in litigation are attorneys.
Why This Is A Problem: Your small business can hardly afford to have you spend a big portion of your time focused on litigation. Moreover, legal fees can quickly mount in litigation. It’s not unusual for a company to pay MORE in legal fees than it would have cost to settle the dispute. And while juries tend to be sympathetic to small businesses, the risk and cost of litigation is hardly ever justified (and remember that this is coming from an attorney who spent 13 years trying cases).
How You Can Avoid This Problem: Do your best to avoid getting involved in litigation. You can help yourself by seeking legal advice BEFORE you make important decisions that could lead to litigation. You can also help yourself by insisting that every agreement include a mediation and/or binding arbitration provision (in lieu of litigation).
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10. Failing To Get Legal Advice When Appropriate. Many small businesses and startups try to save on legal costs by simply avoiding hiring an attorney. Some try to get by on their own by cutting and pasting from legal documents found online. This is a very dangerous practice. You don’t know whether the sources are credible or whether the documents that you’ve put together are appropriate and/or complete.
Why This Is A Problem: If you make the wrong decisions or enter into legal agreements that don’t protect your interests, those actions might end up costing you MANY times more than what it would have cost you to seek legal counsel. In the long run, you threaten the existence of your business if you neglect to ask for legal advice when appropriate.
How You Can Avoid This Problem: Attorneys are expensive. Good attorneys are often (but not always) absurdly expensive. However, smart attorneys who regularly counsel small businesses and startups understand that their clients have very limited budgets. Not all attorneys understand this, so always ask for references and talk to their regular clients (ideally, businesses like yours). Ask them whether they’re happy with the advice, their views about the costs of that advice, and whether they believe the money they spent on legal counsel is money well spent. Experienced attorneys can save you time, aggravation and money by providing the right advice at the right time – don’t compromise your business by failing to get legal advice when necessary.
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I’d love to hear from you. What suggestions can you add to this list? Can you share a story from your experience?
And incidentally, if you wondered whether I can “speak” like a lawyer, I can:
Disclaimer: Legal information is not the same as legal advice. This post does not address all relevant business or legal issues that are unique to your situation. You should seek legal advice from a licensed attorney in your state (or country) to confirm that the information in this post and your interpretation of it is appropriate to your specific situation.