Monday, November 14, 2011

Ten Legal Mistakes Made By Start-Ups: Failing to Select Competent Counsel (#10)

The previous posts have detailed nine common legal mistakes made by start-ups.  While there are certainly other issues facing entrepreneurs starting new businesses, mistake number ten focuses on the failure to retain experienced professional advisers.  It may sound (a bit) self-serving for a business lawyer to raise the issue of engaging experienced legal counsel, but the reality is that the serious mistakes often made by start-ups can easily be avoided by engaging competent legal, tax and perhaps other professional advisers.

Myth #10:  "I don't need a lawyer or other professional adviser at the start-up stage as they are costly, and I can get all the information and documents I need on the Internet."     

When starting a business, entrepreneurs need to focus on numerous business issues and often are operating on a shoestring budget.  However, the potential liability arsing from the failure to obtain competent legal and tax counsel fair outweighs the perceived cost savings from a do-it-yourself strategy.  Here are some examples:

1.  Choosing the Proper Business Structure.  The first post in this series explained the risk of failing to choose the proper corporate structure for your business, stressing the importance of engaging professionals that can advice as to proper tax planning and the formation of the best legal structure to protect your business.

2. Drafting the Operating Agreement/Shareholder Agreement.  The second post in this series explained why it is a serious mistake to not adopt a Operating Agreement (for an LLC), Shareholder Agreement/By Laws (for a Corporation) or a Partnership Agreement (for a Partnership) or to simply use one found on the Internet.  In addition to the fact that New York LLC law requires the adoption of an Operating Agreement, these agreements set forth the financial and management rights and obligations of the partners and therefore should address the interests of the partners.  Mistakes include adopting 50-50 management control without realizing it, failing to detail buyout rights and mechanisms, and mistakenly choosing a member-managed entity instead of a manger-managed entity, to name just a few common issues.

3. Failing to Address Intellectual Property Issues.  The monumental mistake of failing to protect intellectual property rights from the outset is addressed in the third post, noting that experienced corporate counsel that understands your business can ensure this common error is avoided.  You need to make sure not to miss your opportunity to timely file patent applications, that you properly protect trademarks, you do not allow employees to claim rights in intellectual property, and focus on the legal issues relating to your website (including properly drafted website policies).

4. Employment Issues.  If you are hiring even an at will employee or a consultant, the fourth post details the importance of at least requiring the employee/consultant to sign a Confidentiality and Invention Assignment Agreement.  Properly drafted, the agreement can ensure that not only your proprietary information remains protected but also that the business owns any inventions/intellectual property created by the employee/consultant.  You don't want to find out later, for example, that a former employee is claiming rights in a key software program.

5. Don't Just Give Away Equity.  The fifth post in the series discusses the need for founders to consider carefully the ramifications of using equity in the business as currency.  Even the cash-strapped start-up should discuss with legal counsel the pros and cons of using equity as currency, and if the decision is to proceed then the issuance of the equity for products or services, then it should be properly documented.

6. Tax Issues/Section 83(b) Election.  Just as experienced legal counsel is a must, as discussed in the sixth post there is no substitute for good tax advice from an accountant well-versed in working with start-ups.  Among the issues is making sure shares vest over a period of time and that persons receiving restricted shares understand the importance of the the Section 83(b) Election to reduce tax liability.

7. Vendor/Customer Agreements.  The seventh post in this series discusses the problem that small businesses often think that they don't need contracts with their customers or that a very simple order form is sufficient.  However, many costly issues can arise without a properly drafted customer agreement.

8. Bringing in New Business Partners.  As explained in the eighth post on common start up mistakes, don't bring in a new business partner without proper legal documentation.  Start-ups understandably feel the pressure to attract new partners who can offer financing, professional services, or even play an advisory role.  However, the desire to attract such a partner may lead you to put aside execution of documents detailing the rights and obligations of the partner.  The additional legal costs, or simply feeling that asking the potential partner to sign an agreement will scare the partner off, are not reasons to delay obtaining experienced legal assistance -- the time and legal costs to resolve a potential dispute with the partner will far outweigh the cost of properly documenting the rights and obligations from the outset.  

9. Don't Violate the Securities Laws.  The ninth post in this series outlines the civil and potential criminal exposure from violating the securities laws with respect to the offer and sale of securities in your company.  The bottom line is that even innocent mistakes and "friends and family" investments can lead to corporate and individual liability under federal and state securities laws.  Therefore, you absolutely should consult legal and tax counsel when the company is initially considering offering any equity interests or debt in the company to third parties.    

 10. Experienced Legal, Tax and Perhaps other Advisers, is a Must.  OK, you are convinced about the need to engage legal and tax advice, now make another smart decision and engage advisers who have extensive experience working with new businesses.  Just like it is a mistake to ask your general practitioner/internist to perform brain surgery, don't assume your lawyer is qualified to assist with the myriad legal and tax issues facing start-ups.  Engage a seasoned business lawyer and a experienced tax adviser as these trusted advisers will assist in proper structuring of your business, prevent unnecessary disputes, protect your key business assets, avoid potential liabilities, ensure a good tax strategy, and help you plot a course for well-structured business operations.   

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