Five Legal Pitfalls That Sink Many Good Startups

Although every startup is unique, there are certain common avoidable mistakes that can lead to legal complications which jeopardize the long-term success of the business. I’m not suggesting that every startup needs a lawyer, but you should definitely pay attention, and not be afraid to consult legal counsel if any of these raise qualms for you.

Like other environments, most legal issues don’t result from fraud, but from ignorance on specific requirements, or simply never getting around to doing the things that common sense would tell you to do. Here are five of the most common examples:

1. Failure to document a Founder agreement at the beginning. This oversight can lead to the so-called “forgotten founder” problem. Early partners or co-founders often drop out of the picture early due to disagreements, and you forget about them, but they don’t forget about the verbal or email promises you made.

   Later, when your venture is trying to close on financing, or even going public, that forgotten partner surfaces, demanding their original share. This problem can be avoided by incorporating immediately after early discussions, and issuing shares to the founders, with normal vesting and other participation rules.

2. Trouble with the IRS over Founders stock value. Many startups delay incorporation until the first formal round of financing, which is too late. At this point your entity may already have several million in valuation, so the IRS will tax your shares at that value immediately as income, just when your cash flow is at its lowest.

   The solution again is to incorporate early, when Founders shares clearly have trivial value, and filing an “83(b) election” with the IRS within 30 days of the agreement. Then you will only have pay tax on the increasing value of your shares when they are sold.

3. Disclosing inventions before the patent application is filed. Entrepreneurs often put off the hassle and the cost of filing a patent until first funding. Then they realize that they have talked to many people without signing non-disclosure statements, precluding a patent, or someone else has now beat them to the filing docket.

   There is no excuse for not filing at least a provisional patent early. This will hold your place in the patent line for a year, and the costs and time for this filing are much less. Even trade secrets need to be documented, and reasonable steps taken to keep them secret. Business plans and other documents should always be labeled as confidential.

4. Founders ignore non-compete clauses from former employers. If your new business is even remotely similar to that of your current or former employer, think hard about any written or implied non-compete agreements you might have. Do the same for every business partner or employee you may hire.

   The best way to short-circuit this problem is to have a frank and open discussion with former employers, perhaps under the guise of asking them to invest in your venture. This is a smooth way to end the relationship, and get some money, or get their lack of interest documented in a note back to them. If a lawsuit is inevitable, better sooner than later.

5. Taking money from unknown or non-professional investors. Investment fraud continues to be a hot subject, even though Bernie Madoff is safely behind bars. It’s not a good idea to take money from anyone, even friends and family, without an experienced investment attorney drafting or reviewing the agreement to make sure it complies with federal and state securities laws.

   This works to protect you from unscrupulous investors, as well as non-professional investors who may later say that your business plan was misleading. The best advice is to only take investment funds from people who can financially afford to lose, and who qualify as accredited investors.

Overall, the biggest legal mistake that a startup can make is to assume that any legal problems can be resolved later. Finding a lawyer early is easy these days, through local networking or even online services like LegalZoom. In reality, it will cost you much less to get it right the first time, when the stakes are still low, compared to the heartache and cost of correcting it later.

Marty Zwilling