5 Startup Legal Pitfalls You Need to Avoid

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Starting your business is an exciting time. But as you focus on the big picture, it’s easy to ignore the minutiae of organizing your company. But those details matter.

Legal

Curtis Smolar is a partner at Ropers Majeski Kohn & Bentley. He submitted this column to VentureBeat.

There are plenty of pitfalls startups can fall into, but here are five of the most common – and most dangerous:

1. Choosing the wrong entity

 There are numerous corporate structures, including (but not limited to) sole proprietorships, partnerships, Limited Liability Corporation and C-Corporations. Each of these has strengths and weaknesses. For sole proprietorships and partnerships, the core strength is that income is only taxed once – as personal income. The weakness is that there is no protection for liability in a sole proprietorship. In a partnership, not only is there no protection for the corporation, but also the one partner could be liable for the unscrupulous acts of another.

The C-corporation (“Corporation”), which is the most common corporate entity, offers protection for its shareholders. However, the income may be taxed twice—once on the corporate level and once on the individual level. Corporations also have the benefit of having a clearly definable structure. Shareholders own the corporation. Officers run the corporation. And directors oversee the officers.

The percentage of ownership is clearly defined by shares (though these can be different classes and can have different voting rights). Overall, the Corporation is a very stable entity that investors and people outside the corporation understand.

The Limited Liability Corporation (LLC) is a hybrid of the Corporation and partnership, but it has the downside of being a newer creation. These have been around for only about 20 years, which means the law is still evolving.  LLCs are created and controlled by the operating agreement, which is just a complex contract. It is extremely important, therefore, that the operating agreement be particularly well written – and that means higher attorney’s fees. So, while this entity might appear to be the most attractive, getting it right will likely be more expensive.

2. Poor due diligence

 I’ve seen several clients say they’ve chosen a corporate name only to later learn that an existing entity has a similar name. The problem is the client didn’t do their homework to see if the name was taken – and it inevitably leads to problems (specifically, disputes arise about ownership of the name) and sometimes results in a lawsuit.

At that point, it may be too late and the company and/or you the individual could be liable. This situation is avoidable if appropriate due diligence has been conducted. This can be done on several different levels. Counties and States often have databases that can be searched to see if names are available. Additionally, the United States Patent and Trademark Office has a searchable database online. A little prevention can avoid big headaches down the line.

3. Mixing funds

If you decide   to create a formal corporate structure, it’s extremely important to abide by the formalities. In other words, make sure your corporation has sufficient capital and never, ever co-mingle business assets with your own. Doing so can open up your corporation to claims that it is a fictitious entity and should be disregarded. So, if you’re sued, you could be individually targeted – which defeats the entire purpose of incorporation.

4. Inadequately guarding IP

One of the most important steps you’ll need to take from day one is to adequately protect your company’s intellectual property. You can do this by copyrighting, trademarking, and/or patenting your work. Also, make sure that all work done for you by employees and/or contractors is a “work for hire” as this ensures the results belong to the company.

5. Failing to acknowledge corporate mortality

 No one wants to plan for failure, but the reality is that most startups don’t go the distance. If you later find yourself heading for membership in that unfortunate club, it’s important to have a mechanism that will allow the owners of the company to euthanize it. The reasons for shutting things down may be other than financial troubles, of course. The founders may want to go in different directions – or it might just be time to move on.

I once saw an LLC agreement that gave both founders a 50-50 vote – and there was no termination clause in the document. When one founder wanted to leave and the other didn’t want to have sole ownership of the company, it caused a lot of problems. So, while it might seem defeatist, it’s still best to plan for the worst and hope for the best.

 

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.

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