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Ten Legal Pitfalls Startups Should Avoid

Posted by attorney Mark Britton

The etymology of the word "entrepreneur" is well established. Since the earliest of French times, it has meant "someone who breaks into hives when coming within 20 feet of a lawyer." While I'm joking regarding the word's origins, I'm quite serious (albeit figurative) regarding the entrepreneurial response to lawyers. Most young entrepreneurs see themselves as an unrivaled visionary and the last thing they need is some old dude in a three-piece pulling on the handbrake. Until something else does. Nothing will grind the entrepreneurial party train to a halt faster than a big lawsuit, nasty contract dispute or some other legal circus animal that no one bothered to stop from coming on board. The lawyer-averse entrepreneur suddenly finds himself begging for a hug from the old dude. So, before you need to beg for that hug, here are 10 pitfalls that often cause startups legal trouble. A penny of legal proactivity in each of these areas will offer a pound of protection as your business matures.

  1. Not Hiring a Startup Lawyer: There are a lot of lawyers that represent small businesses, but there are only a few that regularly represent startups-particularly when it comes to fundraising from sophisticated angels and venture capitalists. There is a "market" around angel and VC funding and if your lawyer is not immersed in that market you can get fleeced.
  2. Not Having Founders' Agreements: How do you split the equity pie? Who contributes what? Who acts as CEO? What if a founder stops performing? There are so many questions that founders never think through because everything is going to be "awesome." However, when cash and humans are involved, things are seldom uniformly awesome.
  3. Choosing the Wrong Corporate Entity: While this sounds mundane, it is actually quite important. Whether you want to run your business as a C Corp, S Corp, LLC, LP etc. is wholly dependent on your long-term objectives. Different structures offer different opportunities and restrictions, and changing your structure years later is administratively painful and expensive.
  4. Using Someone Else's Trade Name: Many entrepreneurs will lock on a company name without researching whether someone else owns that name. They will put up a web site, print a bunch of advertising collateral, and then they get a letter from some Malaysian conglomerate that says, "Quit using our name and pay us $1 million in damages."
  5. Comingling Accounts: When money first starts coming in - either from investors or sales-it is easy to mix personal and business accounts. Don't do it. The more you do, the more that someone can pursue your personal assets for any unpaid corporate liabilities.
  6. Failing to Protect Intellectual Property: Most great ideas are supported by a product or process that should be patented. If you are telling people all about your idea without a NDA or a patent application on file, you run the risk that your great idea will soon be your competitor's great idea. Identify your core pieces of intellectual property and patent them.
  7. Failing to Have Adequate Employee Agreements: While these are less extensive than the founders' agreements, you need at least a standard agreement in place for all of your employees and consultants that covers confidentiality, ownership of things they develop, etc. The agreement will not feel that important early on, but it will come in handy when your first employee is hijacked by a competitor.
  8. Failing to Check for Employee Agreements: If you are hiring someone from a company that has followed step No. 7, failing to investigate their former employee agreements can cause problems - especially if you are hiring them for their technical knowhow. If their "knowhow" is owned by their former employer or is blocked by a non-competition agreement, you may be getting less value than you bargained for.
  9. Failing to Comply with Federal or State Securities Laws: If you are asking even a couple of people for money - whether it is an investment or a loan - you must make sure you are observing the various securities laws. While you may not need to "register" your securities, you may need to file for an "exemption." An improper offering can lead to regulatory fines and, maybe even worse, unwinding of a transaction.
  10. Understand Key Contracts: If a third-party is important to a core part of your business, you need a contract with that party and you need to understand the core terms of that contract. In a breach-of-contract lawsuit, ignorance is not a defense.

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