9 Common Legal Mistakes Made By Startups and How To Avoid Them
When launching a new startup, many founders make big legal mistakes that can be hugely costly down the road. Startups that make these mistakes can find their companies embroiled in lawsuits and, in some cases, will be unable to raise money from venture capital firms to get the capital they need to grow their business.
Personally, as a startup founder, advisor and angel investor, I have seen these mistakes repeated at early stage startups over and over again. Unfortunately, in some cases these mistakes can be fatal for a startup and prevent a company from raising the capital required to build the business.
The following are some of the more common and problematic legal mistakes that startups make. These issues typically arise at either the initial formation of the business, in the early stage of the company’s growth, or when dealing with employees.
Mistake #1: Using Informal or Non-Written Agreements With Co-Founders
To be blunt, a simple agreement on a napkin dividing up the equity with your co-founders is not going to suffice. When you are working with co-founders on your startup, you will want to incorporate and do your founder share purchases as soon as possible. This can have other advantages as well, such as setting the clock on founder vesting — if you don’t have a vesting schedule on your founder equity, your investors will typically demand that you add this when negotiating your first priced round).
Here are some of the issues you will want to discuss with your co-founders before you get started on your startup.
- How are you going to split equity among the co-founders?
- Is each founder’s equity ownership in the company subject to vesting based on continuing to work on the business?
- What are the roles and responsibilities of each member of the founding team?
- What time commitment is expected out of each co-founder? Will you impose any constraints on outside commitments, like moonlighting at another company?
- How will you make key decisions for your business? Majority vote? Unanimous vote? Will some decisions be solely in the hands of the CEO?
- What assets or cash will each co-founder invest into the startup at the start?
- Under what circumstances will you consider selling the business?
Chances are, if you don’t have the difficult conversations around these important questions with your co-founders before you get started, your startup will likely fail for the reason that a majority of startups fail: co-founder disputes. It is only in the rare cases where a startup is a huge success — like Facebook and Snapchat — that the investors will be willing to ignore unresolved co-founder equity disputes.
Capbase makes it easy to incorporate your company, divide up equity with your co-founders and set vesting schedules for share grants.
Mistake #2 Not Starting the Business as a C Corporation
One of the first decisions you make as a founder is what entity to use for your startup. Because founders often start businesses without seeking guidance first on legal and financial issues, they incur higher taxes and can become subject to significant liabilities which could have been avoided altogether if they had structured the business as a C Corporation.
Most startup investors will not invest in an LLC or S Corp, and converting over to a C Corp later (after the company has already started doing business) can present thorny tax problems and be quite costly. Companies that are not registered as C Corps from day one are not eligible for Qualified Small Business Stock (QSBS) exemption, which allows investors, founders and early employees to be able to potentially write off 100% of the proceeds of their investments into startups from their taxes.
Mistake #3: Choosing a Company Name That Has Trademark Issues, Domain Name Problems, or Other Issues
When picking a company name, it is important to do your research up front to identify potential trademark infringement issues and other legal concerns that may prevent you from using your chosen company name to do business. Before you make a final choice as to what to call your startup, here are some steps you can take to avoid common naming issues:
- Do a Google Search on the name to see if there are other companies already using the same name or a similar one
- Search on the US Patent and Trademark Office site to see if there are any federal trademark registrations containing your proposed name
- If you are registering in Delaware, do a Business Entity search on the Delaware Secretary of State website to see if your name is already taken by an existing company registered in Delaware.
Outside of these name conflict concerns, you will want to pick a name that is easy to spell, distinctive and memorable. Learn more about choosing the right name for your startup.
Mistake #5: Not taking care of important tax issues
As a founder, you will want to make sure that your company stays compliant with all federal tax regulations as well as those in any state where your company is registered to do business.
There are a few specific areas where startups typically mess things up.
Section 83 (b) elections. Founders and employees can potentially mitigate any future tax obligations by filing an 83 (b) election with the IRS. This notifies the IRS of the date, purchase price and amount of shares purchased by a shareholder in a corporation. This information will be used by tax authorities to determine the price and date basis for calculating whether any future proceeds from selling the stock are subject to long-term capital gains tax. Failure to file this form can cause a huge tax headache for founders, as the proceeds from selling their company will be taxed as income instead of long-term capital gains (15% or 20%). Read more filing your 83(b) election with the IRS.
Qualified Small Business Stock or QSBS. Holders of stock in qualified small business corporations may be able to write off 50% (or even up to 100%) of the proceeds from selling their shares in certain circumstances under Internal Revenue Code, Section 1202. The tax savings can be quite substantial, both to investors and founders. Only C Corporations are eligible for this tax exemption; LLCs are not, nor are LLCs that convert into C Corporations.
Federal R&D Tax Credits for Startups. Many startups may be able to offset their R&D costs (such as server costs, employee payroll for software engineers, and so on) using R&D tax credits from the US government. Capbase partners with NeoTax and Mainstreet to help customers get access to these valuable tax credits.
Failure to Price Stock Options Accurately. Many startups offer employees equity as part of their compensation package in order to attract, motivate and retain key employees, especially when the company cannot afford to pay market rate salaries. Startups are only allowed to grant stock options in the company at what is known as “fair market value”. Any startups that have raised a priced round from investors will need to obtain an external valuation of the company’s common stock, pursuant to Section 409A of the Internal Revenue Code (IRC). Capbase partners with trusted, third-party valuation experts to obtain 409a valuations for our customers at a discounted rate.
Employee vs Independent Contractor Classification Issues. It is critical for tax and compliance reasons that a company correctly determines whether individuals providing services to the startup are employees or independent contractors in the eyes of the law. Startups run the risk of improperly characterizing independent contractors if they offer benefits to contractors or exercise significant control over when the contractor works.
The IRS and states are paying more and more attention to independent contractor misclassification issues. For example, California Assembly Bill 5 went into effect in January 2020, requiring that many workers previously classified as independent contractors had to be reclassified as employees.
At the end of the year, companies must send full-time employees IRS Form W-2 documenting their compensation for the previous year, as well as any taxes that were deducted. Independent contractors must be sent IRS Form 1099 by February 1 of each calendar year.
Mistake #6 Using the wrong legal counsel
Before I started building Capbase, I talked to over a hundred founders about their experiences starting their first companies. I heard dozens of horror stories from founders about hiring the *wrong lawyers* and paying the price down the road. Like a lawyer telling a founder that it was ok to sign a convertible note with an 18% interest rate.
The reality is that startup law is a niche, and very few lawyers, even the ones that understand corporate and business law in general, understand the nuances of venture financings and startups. You should work with only top-tier startup law firms like Orrick, Cooley or Wilson Sonsini.
Just don’t use your uncle’s cousin who is a lawyer and offers to do it for free! 🤷
Mistake #7: Not Maintaining Proper Corporate and HR Documentation
Many startups do a sloppy job with maintaining the required corporate and employee-related documentation. This can raise red flags later when the company is going through due diligence related to a venture financing or is trying to sell to an acquirer. Here is a list of the types of documentation that startups should consider maintaining carefully to avoid issues in the future:
- Board and shareholder resolutions and minutes
- All contracts that the company has entered into
- Stock and option award agreements, including stock plan, executed purchase and option agreements, proof of payment, 83 (b) election forms, and related state & federal filings
- Job applications & resumes for all candidates that you hire
- Employee offer letters and employment agreements
- Form I-9 completed by all employees, proving the eligibility of the employee to work in the US legally
- Anti-harassment and discrimination policy
- Benefit plans
- Employee personnel files, including records of any disciplinary proceedings, warnings, employee termination notices and severance agreements
- Employee compensation and bonus history
- Confidential information and intellectual property assignment agreements
Capbase makes your job easy as a founder by keeping track of all state forms, stock agreements, employment contracts and other essential corporate documents in your document room.
Mistake #8: Not Using a Good Form of Employment Agreement or Offer Letter When Hiring Employees
If you plan on hiring an employee, use a carefully drafted offer letter and encourage the prospective employee to review it thoroughly before signing. For a senior executive hires, a more detailed employment agreement often makes sense, since C-Suite and VP level employees will typically expect additional protections regarding issues such as termination conditions, severance payment, and double trigger stock acceleration in the event of being made redundant after an acquisition.
A good offer letter or employment agreement will cover the following key terms:
- The job title and the responsibilities of the employee
- Whether the job is full-time or part-time, as well as whether the service provider is working as a consultant or W-2 employee
- The start date for employment
- How long the offer is valid for — some companies will send offer letters with tight deadlines for signing to compel the employee to make a decision quickly
- The salary, potential bonuses and benefits (including vacation / paid time off, relocation expenses, and so on)
- Whether the job position is “at will”, implying that both parties are free to end the relationship at any time without penalty (there are legally prohibited reasons for which employers may not terminate employees, such as age discrimination, retaliation due to sexual harassment allegations or other HR complaints, etc.)
- Confirmation that the employee will sign a separate confidentiality and invention assignment agreement, assigning the intellectual property from their work output to the employer
- Any arbitration clauses concerning the forum and method for resolving any workplace disputes. In some states, employer must offer the employee the ability to opt out of the arbitration provisions within two weeks of signing their employment offer letter; California and other state laws have carved out exceptions where specific types of claims are excluded from such arbitration and dispute resolution provisions common in employment contracts.
- Any stock or stock options that will be granted by the employee, subject to approval by the company’s board of directors.
- The employee’s supervisor, e.g. who they will report to
Companies should ensure that new employees sign the letter prior to beginning their employment. In addition, it is important to take care of other paperwork, such as the IRS W-4 Form for tax withholding and the I-9 form verifying the employee’s legal status to seek employment in the United States (this form must be completed on the employee’s first day!).
Mistake #9: Not Requiring All Employees to Sign a Confidentiality and Invention Assignment Agreement
Startups pay employees to brainstorm ideas, build software or products, and develop innovations that may be useful to the growth of the company. To do their job, employees are privy to the startup’s confidential information and trade secrets — this information can be very valuable, especially in cutting edge technology companies.
One way that startups protect their intellectual property and proprietary information is by having employees sign confidentiality and invention assignment agreements. This agreement addresses confidentiality obligations on the part of the employee to protect and keep confidential any company inventions and trade secrets. It also ensures that the work product, inventions and other intellectual property that the employee creates related to the startups’ business belong to the company, rather than the employee.
Confidentiality and invention assignment agreements typically include clauses addressing these key points:
- The employee may not use or disclose any of the startup’s confidential information without authorization from the company. The employee must bring to the company’s attention any inventions, discoveries or work product related to the business that are made when employed by the company.
- The company owns any such inventions, ideas, discoveries or work product and all rights to this intellectual property is assigned to the company by the employee
- If the employee is terminated, they must return any and all confidential information in their possession, as well as any company property
- During the course of employment at the startup, the employee will not work for any competing companies or otherwise perform any service for a competitor
- The confidentiality and invention assignment provisions in the agreement are obligatory even after the employee is no longer employed by the company
- The agreement does not constitute any guarantee of continued employment at the company
VCs and startup investors in startups expect to find confidentiality and invention assignment agreements signed by any employees and service providers that the startup has employed. In an M&A transaction, the buyer’s due diligence team will also expect to find these agreements signed by all employees. Typically, it would be expected that consultants doing work for the startup also sign this agreement.
Making these mistakes can put your startup at risk
Startups that avoid these common legal pitfalls are far more likely to succeed at raising capital and scaling into successful businesses. Companies that fail to anticipate and plan for these issues from the beginning run the risk of failure. Invest in building your company on the right legal and financial foundation by using a platform like Capbase to incorporate, issue equity and keep your corporation compliant with state and federal laws.