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.   

Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)

Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.

Myth #8:  "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."  

If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role.   All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off.  So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business.  In no uncertain terms, this is a serious mistake for a number of reasons, including the following:

    1.  If this is an LLC, do you have an Operating Agreement?  If this is a corporation, do you have detailed by laws/shareholder agreement?  If this is a partnership, do you have a partnership agreement?  If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law.  Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)?  If not, you may be very surprised later if a dispute arises, at which point it will be too late. 

  2.  What if the new partner fails to do what was promised, dies or becomes disabled?  You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html).  If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.

  3.  The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both).  Can the partner do this?  It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.

  4.  The new partner just signed a contract binding the entity, one which you would not have approved.  In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity.  Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity.  (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html).  Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.

  5.  You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners.  If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees.  While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.

  6.  The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property.  In fact, the partner is filing patent claims and then plans on licensing the rights to third parties.  You could have avoided any issue with an  invention agreement agreement assigning the rights to the inventions and intellectual property to the business.  (See  http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).                      

  7.  You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island.  You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your  lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs.  You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example.  It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.  

While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity.  If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious.  There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners. 

Disclaimer:  The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship.  There is no substitute for legal advice from an experienced business/corporate lawyer.

Ten Legal Mistakes Made By Start-Ups: Failing to Protect Intellectual Property

For the 3rd installment of my posts regarding the Ten Legal Mistakes Made By Start-Ups, I highlight the issue of the need to protect intellectual property.

Myth #3:  "I can wait until later to address intellectual property issues as the costs are very expensive."

While it is understandable that start-ups are often strapped for funds and need to preserve financial resources, it can be a monumental mistake if you fail to protect your intellectual property rights from the outset.

First, if you have a product or service that itself, or any element thereof, may be patentable, you need to speak to a patent attorney to determine if a patent application is warranted in the US and/or any other country.  The risk is that if you wait too long you could lose your patent rights in the invention. A U.S. patent is invalid if no application is filed within one year of the first time the invention is offered for sale, sold, publicly used or publicly disclosed.  Determing when the clock begins to run requires the advice of a patent attorney, but understand that if you violate the rule, the patent is stautorily barred.  (Note, you should also consider whether you want to file a trademark application relating to your business name, products/services).

Second, make sure all employees/consultants sign an Invention Assignment Agreement.  Without an Invention Assignment Agreement, any person who worked on the development of the product or service can try to claim that they own rights to any ideas they contributed -- and you can imagine the claims the company will face if the business is successful.  The Invention Assignment Agreement is a clear acknowledgement that anything contributed by an employee/consultant is owned unconditionally by the company.

Third, and a related to the Invention Assignment Agreement, make sure that any intellectual property (which includes domain names, patents, trademarks, copyrights) contributed to the company by a shareholder/member are assigned to the company.      

Fourth, check to see if the domain you want is available and then purchase it.  You do not want to create marketing materials and begin promoting your business and then later find out someone else owns the domain name because the costs of rebranding or obtaining the name could be quite significant.

Fifth, as per my previous postings, do not just copy and paste your website policies from another website -- aside from the copyright issues, you need to make sure your policies are consistent with your product/service offering and your business policies.

There will be seven more installments of the Ten Legal Mistakes Made by Start-Ups so stayed tune.