Building your startup is a wholesome choice, but it’s equally important to build a smart and formidable foundation for your company.
That’s why you need to avoid making serious legal mistakes that could impede your growth from day one. From creating a founder’s agreement to tax compliance, here are some legal mistakes that startups make and how to avoid them.
1) Failure to give co-founders a clear picture of the deal
There is absolutely nothing wrong in beginning your company or business with co-founders. However, ensure you mutually agree with them on the full details of the business or company. Failure to do this could result in great legal issues in the future.
A well-drafted founders’ agreement could make things much better and easier. You, as the founder, can view the founder agreement as a “prenuptial agreement”. There are some sensitive deal terms that need to be tackled by your founder agreement. Here are some of them:
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- It should state the roles and responsibilities of the founders.
- It should state the amount of salary, if any, that each founder is entitled to, and the possible changes that can be made to it.
- It should also state the conditions that are required to remove a founder as an employee of the business. (Normally, the Board of Directors should make such decisions).
- The comprehensive role and vision of the business should be stated.
- Splitting of equity among founders should be stated.
- The amount of time each founder is meant to put into the business should be stated. The constraints imposed on outside commitments should also be stated.
- The approach for determining the percentage each founder has in the company.
- It should state how the everyday decisions and major decisions of the company are made. (Whether by unanimous vote, majority vote, or whether certain key decisions are made mainly by the CEO).
- The consequences of a founder not living up to expectations regarding the founder agreement should also be made clear.
- The amount of cash or assets each founder is meant to invest in the business should also be stated.
- It should make clear of situations such as where a founder leaves, if the company or other founders have the right to buy off the leaving founder’s shares? If yes, at what price?
- It should state how the sale of the business is to be decided.
In the same vein, just like you have a founder agreement, it is good to have an employee agreement. The agreement should state the salary structure, benefits, and so on, for every employee. By doing this, you save yourself from potential legal issues.
Read more: 9 top reasons business partnerships fail
2) Failure to have the right legal counsel
Perhaps the biggest legal mistake that startups make is failing to get a good lawyer. You shouldn’t run a business without having appropriate legal counsel to guide you. Fortunately, some lawyers today can offer their services without requiring that you pay retainer fees. Nevertheless, be sure that the lawyer you seek counsel from has experience in some or all of the following areas:
- Real Estate Law
- Tax law
- Franchise law
- Corporation, commercial or securities law
- Contract law
- Data security, cyber and privacy laws
- Intellectual Property Law
- Employment law
Read more: Ultimate guide to starting a small business
3) Failure to take into account vital tax considerations
It is vital for startups to be attentive to the various sensitive tax problems that are relevant to their type of business. If founders don’t do good planning, they may find themselves or their startups prone to unwanted and unseen taxes, penalties, and fines. Below are some of the sensitive tax issues you should consider:
Choice of Legal Entity
You may have good reasons to select a pass-through tax entity like S corporation or LLCs. For instance, pass-through entities permit business losses to pass through to shareholders’ individual tax returns. These further permits shareholders to offset losses against any gains in that same fiscal year. However, most venture capitalist and institutional investors prefer that their invested entities be in C corporations (this is generally due to tax exempt limited partners who are not permitted to get active trade or business income because of their tax-exempt status).
All income and deductible expenses should be appropriately documented: It is vital for your business to have a good record-keeping system, which will appropriately and totally record all income and deductible expenses. Although some businesses make use of merely a checkbook for such recording purposes, a lot of businesses make use of electronic software programs, like QuickBooks, for such recording purposes. You can check the IRS website to see the list of the types of records a small business should keep by category.
Startups are meant to pay federal and state payroll taxes on employee compensation. It is the percentage of what the company pays to their employees. So, the taxes are removed from the pay of each employee, by the employer, and then paid on behalf of the employees and the company. The federal income tax withholding owed by employees is part of U.S. federal taxes, and the tax is calculated from the amount the employee writes on IRS Form W-4 at the point of hire. FICA taxes are also part of U.S. federal taxes, the amount paid for social security and Medicare. The employer normally deducts half of the due amount from the employee’s paycheck, then the employer will pay the other half.
Your business might probably be subject to taxes from the sale or lease of goods and services, which is mostly referred to as “sales tax”, and in other instances as “use tax”. The amount of sales tax is obtained by multiplying the purchase price rate by the applicable tax rate. Additional sales tax is being levied by some states, cities, and counties.
Qualified small business stock
People that hold stocks in qualified small business corporations could be entitled to a lower rate of tax on gain from the sale of “qualified small business stock”.
Obtaining tax ID
Generally, you will be required to get a tax ID from the IRS for your company. The tax ID is also called “Employer Identification Number” (EIN), which is similar to a social security number, but for businesses. Your EIN will be demanded from you when opening a company bank account. You can simply get your EIN online through the IRS website, the process is swift and you will get it instantly.
Different tax incentives are available, though it depends on the nature of the business. For instance, there are tax incentives like investment tax credits and renewable energy tax credits.
Employee versus independent contractor issues
Due to tax and other reasons, it is vital for a company to find out if the people delivering services for the business are employees or independent contractors. Wrongly classifying independent contractors is what main employers are prone to. To avoid paying social security, Medicare taxes, unemployment taxes, and health insurance coverage, most startups prefer using independent contractors. But what the IRS and states are most concerned about are misclassification issues. Most companies that treat their workers as independent contractors are heavily scrutinized. For workers that their employer has huge control over, the IRS or the state may scrutinize the employer for not having considered such a worker as an employee. Currently, it is a must for companies to give their employees IRS Form W-2 setting forth their compensation for the year. Meanwhile, independent contractors should be given Form 1099 by the 1st of February, yearly.
Most times, when a company is unable to pay huge salaries, they use the Stock options plan. This plan is used to lure, motivate, and keep employees. It gives the company the ability to award stock options to directors, consultants, officers, employees, and advisors. These sets of people can buy company stocks when the options are being exercised.
4) Not paying attention to possible company name, domain name and trademark issues.
Before you select a company name, it is essential for you to carry out research. This research would help you to avoid domain name and trademark infringement issues. Ensure that any name you select is unique and available for you alone. The mark used by you can also result in you having trademark issues, if the mark confuses customers about who renders the goods and services. Some steps are given below to guide you, so that you don’t encounter naming problems.
- Before naming your company or business, first do a Google search, to find out other companies that might be using that name or a name similar to it.
- Ensure that the name is unique and easy to remember.
- Also consider international implications when choosing a name. For instance, you do not have to choose a name that has a negative meaning in another language.
- You should also research on the U.S. Patent and Trademark Office site for federal trademark registrations on your desired name.
- Also do a search on GoDaddy.com or other name registrars to find if your desired name is still available. If you notice that the “.com” domain name is already in use, then it serves as a warning, it will be best to avoid the name.
- Make sure that you do not make the name to be so limited to an extent that, in future, you will be required to change the name as your business changes or increases.
- Unusual spellings of the name should be avoided. Because, it can result in confusion and problems as you progress. (Although, there are exceptional situations where some companies have succeeded with unusual names).
- You can also engage your intellectual property lawyer to conduct a professional trademark search.
- Carry out a search on the Secretary of State corporate or LLC records in the state where the company will be running its business to find if someone else is using the name or something similar.
- Generate 5 names that you like, and test market them with potential customers, employees, investors, and partners.
5) Failure to start the business as a corporation or LLC
As a founder, one of the first things you need to consider is how to operate your business legally. It is important you do so, because most startup businesses that the founders never consulted a lawyer or looked for ways to make their businesses legal, incurred a great amount of taxes and liabilities, which they could have avoided if they had positioned their businesses as a corporation or limited liability company (“LLC”).
There are various types of business forms that are mostly available for startup businesses. They are:
Most times when a business has several founders, a general partnership is selected as the legal form of business. In this situation, founders will create a partnership agreement among themselves, that states the rules that govern them. However, if the founders do not establish a partnership agreement, most of the states have existing laws that will automatically intervene to establish the rules of engagement for the business. Also, the income of the partnership is taxed straight to partners, based on the percentage of ownership of the business per partner. It is good you also know that if the business owes any debt, every partner is liable for the payment of the debt. This implies that the personal assets of each partner is exposed to the entire obligations of the business. Forming a general partnership for a startup business is not advisable.
Basically, a sole proprietorship will need no fees, legal documentation, or filings, except for state and local business permits. Although, there are some disadvantages operating a sole proprietorship:
(1) There can only be a single owner of a sole proprietorship, and if the business needs extra capital from other investors, there is no form for it and a partnership and other entity form will be needed.
(2) A sole proprietorship gives no coverage for the founder against those that are creditors to the business, (meaning that the founder can be sued at moment by the creditors). When compared to LLCs and corporations, the founder is mostly protected from creditors and other third-party liabilities. It is not advisable to go for sole proprietorship.
C Corporations are mostly formed under state law, especially in the state where the business will commence functioning. Many of the venture capital-backed companies are C Corporations.
S Corporations are also formed under state law. Each S Corporation does not have more than 100 stakeholders, this makes a good election which would be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. The election results then serve as a flow-through entity, to avoid paying double tax. That means S corporations do not pay income tax. Instead, profits and losses flow through and then split among the various stakeholders of the corporation.
LLCs are also formed under state law, though they are a unique form of corporation and limited partnership. They have some tax advantages more than C corporations. Owners operating LLCs have limited liability protection. Although, they give all members involved flow-through taxation coverage. However, if you have any future plans involving venture capital investors, then there is no point in you starting the company as an LLCs. Because, investing in flow-through entities would be hindered.
They are formed under state law, just like the others above. They are meant to keep investment in real estate. That is why most private equity firms, hedge funds, and venture capital firms choose it as their main investment vehicle.
To create corporations, LLCs, and limited partnerships, all you need to do is to fill out forms with the right state authorities.
6) Disregarding securities law when giving stock to family, friends, or Angels
One of the greatest legal mistakes that startups make is failing to comply with securities law when giving stocks to family.
When people come together to form a corporation, LLC, or limited partnership, it is vital they know that the sale of stock, LLC interests, or limited partnership interests to the various founders and future investors various founders and future investors will be subject to the federal and state securities laws. In many cases, the securities laws need such sales to follow or comply with some filing, disclosure, and form requirements, except the sales are exempt.
If you disregard these securities laws, it might lead to facing huge financial penalties for the founders and the startup company. One of such penalties is that the company would have to re-buy shares sold to all investors in the unlawful offering at the main insurance price of the shares, regardless whether the company has lost most or all of the money it raised from the investors. Fines and other penalties (criminal or civil) can also be imposed on the company if they fail to comply with securities laws.
So, to avoid such severe penalties, founders are meant to hire professional lawyers to do the documentation regarding the sale of shares in accordance with such laws.
7) Failure to find the permits, documentation, licenses, registrations, needed for your business
Your type of business will determine the following kind of permits, licenses, or qualifications you will require. Here are some of them:
- Sales qualification to do your business
- Zoning permits
- City and county business licenses or permits
- Industry-specific permits for regulated business, such as agricultural, alcohol, aviation, and so on
- Federal and state tax/employer IDs
- Sales tax permits or licenses
- Health department permits for businesses such as restaurants
- Home-based business permits
- Seller’s permits.
8) Not keeping the appropriate corporate and HR documentation
Avoid being sloppy about your employee/HR related documentation. They come in handy if ever there’s a legal dispute with employees or regulatory agencies. They are equally important for audits of diverse kinds. You should especially store the following documents carefully:
- Employee offer letters
- Employee agreements
- IRS W-9 forms
- Forms I-9 completed by employees
- Job applications and resumes
- Stock and options records
- Signed contracts
- Boards and shareholder resolutions and minutes
- Benefit plans
- Employee personnel files
- Employee complaints and the responses to these complaints
- Workers’ compensation documents
- Emergency contacts for employees
- Workers’ compensation documents
- Versions of company and employee polities including but not limited to current and historical employee handbooks (as well as employee acknowledgements of receipt), codes of conduct, anti-discrimination and harassment policies, data security and privacy policies, and whistleblower and other policies relating to the reporting of employee misconduct
- Records of disciplinary processes
- Employee compensation and bonus history
- PTO tracking records, etc.
9) Taking time to consider intellectual property issues
Intellectual property is highly important to your company. That’s why you want to take great care about protecting it. Be sure to get the appropriate documents for your intellectual property such as your company name, domain name and product. Don’t forget protective measures such as patents, copyrights, confidentiality agreements, trade secrets, invention assignment agreements for employees, and trademarks
10) Not coming up with a great contract
No matter how small your startup is, you must always have a standard form contract for dealing with clients and customers. If ever your customer’s needs deviate from the normal, always personalize that contract to include every other crucial detail.
But preparing your standard contract needs a careful approach.
Fortunately, you don’t have to start from scratch, you can always get sample contracts from other companies or industries and adopt them as necessary. Don’t forget to spell out the basic terms including agreement on pricing, when payments will be due, description of the deliverable among others. You should also always include a ‘force majeure’ clause which releases you from breach if unforeseen circumstances occur. A dispute resolution clause is also important.
12) Asking interview questions that are not permitted by law
Federal and state laws prohibit employers from asking or making hiring decisions on disability, religion, color, age, race, medical conditions, political affiliations, home ownership, or gender. Asking such questions might lead to a discrimination claim even if your decisions weren’t based on them. So, you should avoid asking such questions entirely.
13) Failure to ask employees to sign a confidentiality and invention assignment agreement
As a startup, you are paying your employees to come up with ideas, products and inventions that might be useful to the business. Your employees equally have access to confidential information which is useful to your company. Hence, you must protect all that proprietary information by ensuring that your employees sign a confidentiality and invention assignment agreement. A carefully drafted employee confidentiality and invention assignment agreement will guard against breaches and stop employees from sabotaging the company if their employment were terminated.
14) Failure to apply the right steps before firing an employee
Although your employee agreement might include stipulations that you can fire ‘at will’, you should always follow the proper steps to avoid a lawsuit. Laws equally prohibit firing employees based on their marital status, race, age, disability, gender, ancestry, national origin, color, sexual orientation, absenteeism due to jury duty or military service and lots more. To ensure you take the right steps, here’s what you must do:
- Have an employee handbook or set of policies that confirms you are acting lawfully
- Adopt an employee reference policy
- Ensure to investigate situations correctly and have complete facts
- If an employee is found wanting, ensure they’ve been coached, or warned and that documentation of all communications is filed correctly. A warning is often better than outright firing for a first-time offence, except in notable cases
- Review offers letter or employee agreement
- Consider consulting employment counsel to ensure you are not violating any law
- Conduct an exit interview
- Be respectful, truthful, accurate and brief about termination
- If you are offering severance package, ensure you get a full and complete release form from the employee duly signed and in writing to cover all known and unknown claims
- Don’t forget to revoke all of the employee’s access including access to voicemail, email, and computer network
- Make sure the employee knows that they will continue to be bound by the confidentiality and invention assignment agreement
- Have the terminated employee leave the premises immediately but provide ample time for them to pack up their belongings privately and discreetly.
- If you are anticipating litigation, ensure that all important documents concerning that employee are preserved.
15) Failure to use a good form of agreement or offer letter when hiring employees
Relying on oral employee agreements is one of the biggest legal mistakes that startups make. No matter how small your business is now, you need a carefully drafted offer letter and a subsequent employee agreement that stipulates their job title, role, and responsibilities, when the job will commence, salary and benefits, and other legal details.