Many entrepreneurs think of legal representation as a luxury to consider only after their business gets off the ground or raises sufficient capital. But resolving neglected legal problems costs at least five to 10 times more than if they had been addressed early on. Following is a list of the seven top mistakes entrepreneurs make and how they can be avoided.
1. Choosing the wrong entity. It’s critical to select an entity that optimizes the company’s financing, growth and tax needs. Many business models are well suited to operating as limited liability companies (LLCs) or S-corporations, where investors and owners benefit from one level of tax, including pass-through tax losses to offset other taxable income. Entrepreneurs seeking venture capital are typically best served by incorporating. Almost all VC firms invest in C-corporations exclusively. Double taxation (where the C-corporation is taxed on its income, and then shareholders are taxed on their dividends received unto themselves and are completely separate from their owners) is a necessary burden. An entity formed as an LLC or S-corporation can convert to a C-corporation, but adverse tax consequences and additional legal costs may apply.
2. Choosing the right entity too late. Entrepreneurs often start ventures informally and without adequately documenting the participants’ contributions and ownership expectations. Two potential problems can result: Parties who drop out early may reappear years later to claim a stake in the company; and parties who stick around but fail to carry their weight may assert an absurdly rich claim to the company before they’ll walk away. To avoid this, founders should form the entity early in the process and judiciously issue equity that vests over time. Also, all inventions and other proprietary work developed by founders and early participants prior to incorporation need to be contributed to the entity as part of the formation. Otherwise, you might find out too late that the company only partially owns original inventions or trade secrets.
3. Overlooking securities law requirements. Federal and state securities laws apply whenever equity is sold. Securities either have to be registered (usually too expensive an option for start-ups) or be issued in compliance with applicable exemptions under federal and state law. These exemptions may be based on investor suitability standards that have criteria such as net worth (which, as of 2010, excludes equity in primary homes) and annual compensation. Investors need to be properly vetted, because just one non-accredited investor can destroy the entire exemption. Also, adequate and proper disclosures are required, regardless of whether the securities are registered or exempt. Failing to comply with these requirements can expose a company and its principals to serious implications, including return of the investors’ original investment (with interest), fines, penalties and criminal sanctions.
4. Ignoring the reality that founders often part ways. Having ownership interests vest over time aligns the founding team’s interests because, if the founders and other sweat equity holders remain productive, their equity vests. If they leave early (on their own volition or are asked to leave), their unvested equity can be repurchased at cost and subsequently issued to a replacement. As an alternative, owners of traditional, closely held entities should execute a buy-sell agreement that limits ownership to a small circle of owners and provides for repurchase in the event of death, disability, disagreement, divorce or termination. Both ar-rangements share the virtue of allowing actual producers to control who shares in the company’s ownership and management.
5. Developing new inventions while still employed. Often, entrepreneurs nurture their new ideas or businesses while still em-ployed by someone else. However, an employer might have full ownership rights over the invention or idea by law or contract. Many employment agreements provide that anything developed using the employer’s materials or on company time is the employer’s property. Some contracts also apply to anything created six to 12 months after an employee’s departure.
6. Inadequately planning intellectual property protection. Entrepreneurs need to proactively protect their ideas, names and logos. Before devoting substantial funds to a company or brand identity, confirm that the proposed name and logos are registrable trademarks and/or service marks. Budget appropriately to register those marks in the relevant markets. Also, assess patents early on, taking into account the different protections afforded under United States and foreign laws. In the United States, a patent application has to be filed within one year after the invention is sold or made public; however, in most other countries, a sale or public disclosure can render the invention unpatentable there.
7. Disregarding your own confidential information and exposure to others. To maintain protection over a trade secret, the owner has to prove it’s taken reasonable steps to maintain its secrecy. A conversation with one person who doesn’t have a confidentiality obligation can be fatal. A nondisclosure agreement (NDA) should, at a minimum, require the recipient to acknowledge actual or potential disclosure of proprietary information and agree not to disclose or use the information without the trade secret owner’s consent. All materials or communications containing confidential information (including business plans, presentations and budgets) should be marked clearly as confidential.
Most VCs refuse to sign NDAs. In that situation, monitor the scope and timing of disclosure strictly. Also remember that newly recruited employees might owe their former employers nondisclosure, invention assignment, nonsolicitation and noncompetition obligations. Entrepreneurs should review applicable documents and otherwise confirm that those restrictions don’t subvert the new employment relationship.
Build confidence
Laws and legal documents may appear intimidating at first, but, given the potential consequences, you can’t afford to shy away from them. With experienced legal counsel, you can become comfortable with legalese, effectively maneuver around and through legal limitations, and learn to use laws to add to the bottom line and enterprise value.
Cara Lowe is a corporate partner in the business de-partment of Stein & Lubin LLP in San Francisco, where her practice consists of representing high net worth individuals and acting as outside counsel to startups and middle market companies. You can reach her at (415) 981-0550 or clowe@steinlubin.com.
