August 6, 2013. I have advised many startups and entrepreneurs that form new companies. From my experience these are legal traps that often catch entrepreneurs in their business dealings. Maybe the next entrepreneur can learn from their mistakes. It is almost always better financially to prevent than to problem solve.
1. Pay your taxes and employees.
We all know we must pay taxes. Most entrepreneurs plan to make money and are optimistic they will do so. However, a lot of startups struggle for cash flow. Timely pay the IRS and pay your employees or shut down. If you find yourself getting behind on your taxes or wage payments, shut down the business. If you do not pay your taxes and wages on time you will probably end up personally liable for these debts and the corporate entity you formed to limit your liability will not shield you.
Generally if the problem begins it will only get worse. The company will be held liable for back taxes along with penalties and interest. The company can also be liable for attorney’s fees and multiple damages for wage claims. If the company did not have the money to pay the employees, then the company should not have let the employees work; it should have laid off the employees instead.
2. Plan to put in money.
Hard work is often called sweat equity and it is not worth much. In many startups the people with the idea forgo salary while they work the business and get investors to put in the cash. The founders work hard for the company and expect to be paid back when the business turns a profit. This equity is often not documented by the company and if it is then it is usually just accumulating as debt on the books. Meanwhile, investors put in cash or property and hold stock. Investors that put money in will be sure that they are paid back first, before any sweat equity holders. If the company folds and everyone is fighting over the assets, or the company is sold and everyone is fighting over the proceeds, the people who only have sweat equity will find they go unpaid for their hard work. When cash is tight, new investors may insist on erasing sweat equity debt to invest in the future. If you are working for deferred compensation be weary of the risk. While discussing investors, anyone selling stock or other securities must comply with both the federal and state securities laws by either registering the securities or meeting all the requirements for an applicable exemption. This can be a significant legal expense but failure to comply is extremely risky. Ignorance is not bliss.
3. Avoid Conflict.
Of paramount importance when starting and managing a new company is to avoid ending up in a legal dispute. Litigation is very expensive and it comes with a great opportunity cost. You only have so many hours in the day. Be sure you are not starting your business on someone else’s time or using your employer’s resources to start your new venture.
4. Put it in writing.
All of your major agreements should be in writing. Pick a dollar amount and value all your deals. If the deal is over the dollar amount, be sure it is in writing. If the deal is over another threshold be sure your lawyer reviews the agreement before it is signed. Many agreements are never put in writing and a lot of agreements are not reviewed until there is a problem. If you do go to all the work to get it in writing then be sure it is signed by the parties.
Start with the basics. First you need to incorporate and get a limitation on liability. When a company has two or more owners there should be a written shareholder or operating agreement among the owners. Often people go into business with friends or family. This is even more of a reason to have it in writing. People change and people die. When money is involved relationships change. Do not disclose an invention without a nondisclosure agreement or before a patent application is on file.
5. Review Agreements.
Read all agreements before you sign them. Have your attorney review all major documents. Too often, entrepreneurs sign whatever is put in front of them. They think they are dealing with more sophisticated businesses and people with lawyers that have done this before so they must sign what is presented. There is always time for review. This does not mean that you are trying to kill the deal. Review a potential employee’s non-compete before you hire them. You can and should look after your own interests.
6. Be careful who you trust.
Someone who can be trusted has nothing to hide and they will also want it in writing. If they don’t want it in writing or don’t want you to have your lawyer review the document, your red flag should go up.
7. Plan for the unexpected.
Positive thinking is wonderful. It is healthy to be positive when starting a new company, and entrepreneurs are inherently optimistic people. Yet things do go wrong and you need to be prepared and plan for the unexpected.
Approximately fifty percent of all marriages end in divorce. The divorce rate among business partners is probably much higher. You may think this business is going to be a wild success and you will work out any differences when they arise. Plan for the unexpected now while you still respect each other.
This is another reason to hire attorneys to help you get started. Clients usually only call their attorney when something goes wrong. My most successful clients call me on the front end of the deal. Your attorney can help you anticipate problems and plan to avoid them.
8. Be specific in agreements.
Watch out for vague almost meaningless terms and be specific on dates and triggering events. Phrases like ‘profits’ and ‘percentage of the company’ can be interpreted differently depending on who is reading the document and at what date in time. The amount of profits in a company can be manipulated by the CPA. Use terms like revenue and define the terms in the document.
9. Hire your own attorney.
Don’t expect another party’s attorney to look out for you. You need your own independent legal counsel. You may be hesitant to hire an attorney because you do not want to spend the money or kill the deal. A good attorney will look out for your interests in a way that helps the transaction come together. Be sure to hire a business lawyer. Your sister’s divorce attorney will not be able to provide you with the counsel you need. The attorney you select will reflect back on you. Be clear with your attorney on your goals and expectations and communicate openly with your attorney.
10. Face your problems.
Avoiding a problem will not make it disappear. The problem usually just gets worse. Most startups are short on time and tight on cash. The founders can focus on only so many problem areas at once. Work with an experienced attorney who can help you anticipate problems and will advise you when you should take various steps. A good attorney will advise you through your issues. Make problem solving part of your business strategy.
Another Article on this Subject: Top Ten Legal Mistakes Made by Entrepreneurs by Harvard Business School Professor Constance Bagley