By Richard Harroch, Lynne Hermle, and Ellen Ehrenpreis
The following are some of the more common and problematic legal mistakes made by small and growing companies. These mistakes are made at the initial formation of the business, in the early stages of growth, and when dealing with employees.
Legal mistake #1: Not making the deal clear with co-founders
If you start your company with co-founders, you should agree early on about the details of your business relationship. Not doing so can cause significant legal problems down the road (a good example of this is the infamous Zuckerberg/Winklevoss Facebook litigation). Think of the founder agreement as a form of “prenuptial agreement.” Here are the key deal terms your written founder agreement needs to address:
- How will the equity be split among the founders?
- Is each founder’s percentage ownership in the company subject to vesting based on continued participation in the business?
- What are the roles and responsibilities of the founders?
- If one founder leaves, does the company or the remaining founders have the right to buy back the departing founder’s shares? If so, at what price?
- What time commitment to the business is expected of each founder? What constraints will be imposed on outside commitments?
- What salaries (if any) are the founders entitled to? How can that be changed?
- How will key decisions and day-to-day decisions of the business be made? (by majority vote, unanimous vote, or are certain decisions solely in the hands of the CEO?)
- Under what circumstances can a founder be removed as an employee of the business? (usually, this would be a Board of Directors’ decision)
- What assets or cash does each founder contribute or invest into the business?
- How will a sale of the business be decided?
- What happens if one founder isn’t living up to expectations under the founder agreement?
- What is the overall goal and vision for the business?
Similar legal mistakes are sometimes made with employees, through email or oral promises, such as “you’ll get 5% of the company” without vesting schedules, role definitions, decisions about what happens on termination, etc.
Legal mistake #2: Not starting the business as a Corporation or LLC
One of the very first decisions founders must make is in what legal form to operate the business. Because founders often start businesses without consulting lawyers, they incur higher taxes and become subject to significant liabilities that could have been avoided if they had structured the business as a corporation or a limited liability company (“LLC”).
The types of business forms that are generally available to a startup business are as follows:
- Sole Proprietorship. Generally speaking, a sole proprietorship requires no legal documentation, fees or filings other than state and local business permits. On the other hand, there are disadvantages to operating in this form: (1) a sole proprietorship only has one owner, and if additional capital is required from other investors, the form is not available and a partnership or other entity form is required; and (2) a sole proprietorship provides no protection for the founder against creditors of the business (in other words, creditors can directly sue the founder), in contrast to corporations and LLCs where, generally speaking, the founders are insulated from creditor and other third-party liability. We don’t recommend sole proprietorships.
- General Partnership. A general partnership is sometimes chosen as the legal form of business entity if there are multiple founders. Preferably, the founders will execute a partnership agreement to “set the rules” among themselves; however, if the founders do not enter into a partnership agreement, most (if not all) states have existing laws that will step in and supply the rules of engagement. In addition, the income of a partnership is taxed directly to the partners generally on a pro rata basis (i.e., according to percentage ownership of the business). Finally, each partner is generally liable for the debts of the business such that the personal assets of each partner are exposed to the full extent of the business’ obligations. We don’t recommend forming a general partnership for a startup business.
- C Corporations. These are formed under state law (usually in the state where the business will first operate or, commonly, in Delaware, which is known for its well-developed body of corporate law). Most venture capital-backed companies are C corporations.
- S Corporations. These, like C corporations, are formed under state law. An S corporation is a closely held corporation (not more than 100 stockholders) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. The election results in the corporation becoming a pass-through entity for tax purposes (meaning that the S corporation itself does not pay income tax; rather, profits and losses are passed through and divided among the corporation’s stockholders).
- LLCs. These are formed under state law, are a hybrid form of corporation and limited partnership, and have certain tax advantages over C corporations. They provide limited liability protection to the owners, in keeping with the corporate form, but they also provide for flow-through taxation to the members (as with an S Corporation). If you plan on bringing in venture capital investors at some point, it is best to avoid starting the company as an LLC (which generally can’t invest in pass-through entities).
- Limited Partnerships. These are formed under state law, often to hold investment real estate, and also are often the investment vehicle of choice for private equity firms, venture capital firms, and hedge funds.
Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax and accounting issues. Each can offer advantages for founders (and subsequent investors) not available in the case of sole proprietorships and general partnerships, including liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital. The C corporation (formed in Delaware) is by far the leading choice for technology startups across the country.
Sole proprietorships and partnerships can be converted to a C or S corporation, an LLC, or another form of legal entity, but keep in mind that the costs of conversion can be significant and, depending on the manner of initial formation, can result in a lengthy process.
Legal 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 research to help you avoid trademark infringement or domain name problems and to ensure that the name you choose is actually available to use. You may be infringing on someone’s trademark if your use of a mark is likely to cause confusion among customers as to the source of the goods or services. Here are some steps to take in order to avoid naming issues:
- Do a Google search on the name to see what other companies may already be using the same or a similar name.
- Do a search on the U.S. Patent and Trademark Office site for federal trademark registrations on your proposed name.
- Do a search of Secretary of State corporate or LLC records in the states where the company will do business to see if anyone is using the same or a similar name.
- Do a search on GoDaddy.com or other name registrars to see if the domain name you want is available. If the “.com” domain name is taken, this could signal the potential of prior use and is therefore a red flag.
- Make sure the name is distinctive and memorable.
- You might consider having your intellectual property lawyer do a professional trademark search.
- Don’t make the name so limiting that you will have to change it later on as the business changes or expands.
- Come up with five names you like and test market them with prospective employees, partners, investors, and customers.
- Think about international implications of your chosen name (for example, you don’t want to choose a name that could turn out to have embarrassing or negative connotations in another language).
- Avoid unusual spellings of the name. This can cause problems and confusion down the road (although some companies like Google or Yahoo have been successful with unusual names, such success is often the exception rather than the rule).
Legal mistake #4: Not complying with securities laws when issuing stock to angels, family, or friends
If founders form a corporation, limited partnership, or LLC, the sale of stock, limited partnership interests, or LLC interests to the founders and later investors will be subject to federal and state securities laws. Most securities laws require that such sales comply with certain disclosure, filing, and form requirements unless the sales are exempt.
Failure to comply with applicable securities laws requirements can result in significant financial penalties for the founders and the startup company, including a requirement that the company repurchase all shares sold to all investors in the unlawful offering at the original issuance price of the shares, even if the company has lost most, and perhaps all, of the money it raised from the investors. There can also be fines and other penalties (civil and criminal) imposed for failures to comply with the securities laws. To avoid such damaging (potentially fatal) consequences, founders should hire knowledgeable lawyers to document the sale of shares in compliance with such laws.
Legal mistake #5: Not adequately taking into account important tax considerations
Startups need to pay attention to a variety of key tax issues germane to their businesses. Without proper planning, founders can find themselves or their startups liable for unintended and unanticipated taxes, fines, and penalties. Here are a number of the key tax issues to consider:
- Obtain a Tax ID. In most instances, you will need to get a tax ID from the IRS for your company. This is also known as an “Employer Identification Number” (EIN), and it’s similar to a Social Security number, but for businesses. Banks will ask for your EIN when you open a company bank account. You can get an EIN online through the IRS website (the process is simple and quick and an EIN is issued immediately). In some states, a state tax ID may be necessary as well (for example, California, New York, and Texas require a state ID, which can also be obtained online).
- Choice of Legal Entity. There may be valid reasons to choose a flow-through tax entity, such as an LLC or S corporation (see explanation of entity types in legal mistake #2 above). For example, flow-through entities allow for business losses to flow through to the shareholders’ individual tax returns, which allows the shareholders to offset the losses against any gains in the same fiscal year. As noted above, most venture capitalists and institutional investors prefer (indeed, may require) that the entities they invest in be C corporations (generally due to tax exempt limited partners that cannot receive active trade or business income due to their tax-exempt status).
- Section 83(b). Founders and employees need to consider whether they can mitigate potential tax issues by an IRC Section 83(b) election. A Section 83(b) election relates to when someone receives stock or options subject to vesting and can minimize the amount of income deemed taxable at ordinary income tax rates to the recipient.