7 Legal Blunders That Start-Up Companies Usually Make


Starting a new business is a stressful and complicated process. Legal mistakes can cause serious harm to a fledgling company. Most entrepreneurs commit the following legal mistakes due to ignorance more than intentional non-compliance.

1. Starting a New Venture while Being Employed by a Potential Competitor

A common mistake made by fresh entrepreneurs is working on their new idea for their business while still being employed by their current employer who may be a potential competitor. Employers can claim intellectual property rights to the business idea that was developed while the entrepreneur was in their employ. There could be certain clauses in the employee’s contract that prevent him from starting a related venture on his own. Entrepreneurs should first quit their jobs and then proceed with building their start-up company. They can even ask their former employer for funding if they deem fit to do so.

2. Not Hiring a Startup Lawyer

Trying to do everything on one’s own can worsen the situation. A lawyer who is experienced in dealing with venture capitalists and entrepreneurs should be hired. Such a lawyer can focus on the legal nuances of a new business venture and prevent the entrepreneur from falling into the not-so-obvious traps. Knowledge of contract law, employment law, corporation, commercial, and securities law, tax law, real estate law, franchise law, and intellectual property law is required. Since it is not possible for an individual to have expertise in all these fields, the entrepreneur should find a legal firm that hires competent lawyers dealing with some of these areas.

The cost of hiring a good lawyer should not dissuade an entrepreneur. The amount of money spent on the lawyer could potentially save millions that might otherwise be needed to clean up a legal mess.

Dealing with legal issues should not be the last item on the entrepreneur’s checklist. A small issue could snowball into a major problem if left unresolved.

3. Wrong Choice of Entity

Entrepreneurs should choose the legal form of their business with the help of their lawyer in order to save taxes and limit their liability. If the start-up company becomes bankrupt, the entrepreneur’s personal assets such as his house, car, or bank accounts are safe. He loses only the money that he had invested in the start-up company.

Investors prefer to invest in corporations, instead of limited liability companies or partnerships. Venture capitalists prefer C corporations to S corporations. As part of the United States federal income tax law, a C corporation is considered a separate entity from its owners. It is formed under the law of the state where the start-up company will first start. Since Delaware has sound corporate laws, entrepreneurs choose to incorporate their business in this state. The rewards of a C corporation are limited liability for its shareholders and tax benefits. The start-up company will not cease to exist even if the founder chooses to leave. There can be an unlimited number of shareholders. Thus, the corporation can potentially keep growing by selling stock to many investors.

4. Lack of a Proper Founder Agreement

A detailed founder agreement should be drawn up so that there are no disagreements over each person’s share in the business when it becomes successful. Some of the important points that should be dealt with in the agreement are: the names of the founders, each person’s percentage in the start-up company, whether the percentage interest is subject to vesting over time, the roles and responsibilities of each person, what happens if one of the founders dies or chooses to leave, how major decisions of the start-up company will be taken, and how will contributions to the start-up company be made.

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5. Not Complying with Securities Law

The sale of shares should comply with Securities Law that has certain requirements for disclosure, filing, and forms. Entrepreneurs make the mistake of selling shares to people who are not accredited investors without proper disclosure documents. They may hire a person who is not a registered broker-dealer to sell stock for a commission. These errors attract hefty penalties and could even lead to criminal prosecution.

6. Failing to Protect Intellectual Property

The name and logo of the start-up company, its processes, technology, products, and unique ideas form its intellectual property (IP) and should be protected from theft. Also, the start-up company should refrain from infringing on the IP rights of third parties.

There are several ways in which a start-up company can protect its IP. It can patent its products to prevent others from producing, using, or selling the patented object. In order to ascertain whether a patent can be obtained for a product, the following criteria should be met—the idea should have a tangible form, the invention should be new, the invention should not have been described in previous literature, and the invention should have utility. Since patents grant the owner exclusive rights for twenty years, they offer a competitive advantage to the start-up company.

Trademarks can be used to protect the name and logo of the start-up company, the brand names of its products, or its slogans. They prevent competitors from using similar names and logos that may fool consumers into thinking that they represent the original product. Service marks are used to distinguish between services.

A copyright exists from the time an original work such as a book or a music composition is created. However, for added protection, the U.S. Patent and Trademark Office allows for registration of copyrights.

Other forms of IP protection include non-disclosure agreements, trade secrets, and invention assignments.

7. Lack of Proper Employment Procedures

Proper employment documentation is necessary to avoid legal hassles in the future. Employee agreements, employee handbooks, employee authorization documents and withholding allowance certificates, stock option documents, benefit forms, and invention assignments should be available for every employee.

Entrepreneurs should ensure that the legal classification between employee and an independent contractor is properly made to avoid facing penalties. They should also hire a tax consultant to deal with tax issues related to payroll tax, sales tax, Section 83 (b), tax incentives, stock options, and qualified small business stock.

Avoiding legal issues can significantly reduce one’s chances of success, so it is important that the entrepreneur deals with them as soon as possible.