5 Big Legal Mistakes Made By Startups
1. Not making the deal clear with co-founders
You absolutely have to agree with your co-founders early on what the deal is among you. Not doing so can cause enormous problems later (see, for example, the Zuckerberg/Winklevoss Facebook litigation). In a way, think of the founder agreement as a form of “pre-nuptial agreement.”
Here are the key deal terms you need to address in some kind of written founder agreement:
Who gets what percentage of the company?
Is the percentage ownership 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 other founder have the right to buy back that founder’s shares? At what price?
How much time commitment to the business is expected of each founder?
What salaries (if any), are the founders entitled to? How can that be changed?
How are key decisions and day-to-day decisions of the business to be made? (majority vote, unanimous vote, or 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 decision)
What assets or cash into the business does each founder contribute or invest?
How will a sale of the business be decided?
What happens if one founder isn’t living up to expectations under the founder agreement? How is it resolved?
What is the overall goal and vision for the business?
2. Not starting the business as a corporation or LLC
One of the very first decisions that founders must make is in what legal form to operate the business, but founders often start a business without consulting a lawyer and, as a result, often incur higher taxes and become subject to significant liabilities that could have been avoided if the business was started as a corporation or as a limited liability company (“LLC”).
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.
However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital in contrast to sole proprietorships and partnerships.
Sole proprietorships and partnerships can later convert to a C or S corporation, LLC, or other legal entity but keep in mind that the conversion costs can be significant.
3. Not coming up with a great standard form contract in favor of your company
Almost every company should have a standard form contract when dealing with customers or clients. But, there really isn’t a “standard form contract,” as every contract can be tailored to be more favorable to one side or the other. The key is to start with your form of contract, and hope the other side doesn’t negotiate it much.
Here are some key items to come up with your form of contract:
Get sample contracts of what other people do in the industry. There is no need to re-invent a contract.
Make sure you have an experienced business lawyer doing the drafting, one that already has good forms to start with.
Make sure you make it look like a standard form pre-printed contract with typeface and font size.
Don’t make it so ridiculously long that the other side will throw up their hands when they see it.
Make sure you have clearly spelled out pricing, when payment is due, and what penalties or interest is owed if payment isn’t made.
Try and minimize or negate any representations and warranties about the product or service.
Include limitations on your liability if the product or service doesn’t meet expectations.
Include a “force majeure” clause relieving you from breach if unforeseen events occur.
Include a clause on how disputes will be resolved. Our preference is for confidential binding arbitration in front of one arbitrator.