Startup Companies Avoiding Key Legal Mistakes Checklist
A Checklist of key legal problems that commonly arise for startup companies and tips for how to prevent or handle them. This Checklist addresses issues including corporate formation, intellectual property (IP) acquisition and protection, securities laws compliance, labor and employment, executive compensation, social media, privacy and data security, and supplier and customer relationships. This Checklist identifies common legal missteps that can delay or complicate business operations, or negatively impact the founders’ ability to realize an appropriate return on their investment.
Many startup companies fail, often for commercial or business reasons. However, some startups fail because they do not properly address a variety of legal issues. One of the biggest legal mistakes startup companies make is not involving counsel early in the life of the business. This Checklist identifies some of the most common legal issues that get overlooked by startup companies.
Select the Appropriate Type of Legal Entity Early in the Company’s Development
- Select the appropriate entity type from the outset, planning for future growth and capital-raising to avoid unnecessary changes in entity type in the future, which can be costly and time-consuming.
- Choose the type of legal entity that best supports achievement of the company’s and founders’ goals from legal, tax, and early-stage investment perspectives.
- Be aware that entity types commonly recommended or chosen for other business types may not be a good fit for a growing startup
- Consider that limited liability companies (LLCs) and limited partnerships can be problematic for startup businesses that want to issue equity compensation or plan to get venture capital funding (in which case it is typically preferable to structure the business as a C-corporation).
- Avoid inadvertently exposing founders to personal liability. For example, partners in a general partnership have unlimited liability.
- Ensure that all business activities are conducted through the legal entity, once formed, and not by an individual founder or other third party.
Startup Companies Should Clear and Protect the Use of Brand Names, Logos, and Domain Names Before Creating Value in Them
- Clear the rights to the company’s business and brand names, logos, and domain names while the business is still in the conceptual stage.
- Protect the company’s right to:
- use these trade designations when and where the company wants to sell its products or services; and
- prevent other people or entities with a similar business concept from using them.
- Plan for growth and success by filing proactively for rights protection in the US and foreign jurisdictions where the company reasonably expects to do business in the future. Startup companies should:
- make a list of jurisdictions where the company plans to operate and decide where the company can afford to file;
- take advantage of intent-to-use US trademark registration, which allows the company to register a trademark before actually using it if the company has a genuine intent to use the mark in connection with the goods or services listed in the company’s trademark application; and
- keep in mind that the world generally works on a first to file basis. It is common practice in some areas of the world for third parties to register the trademarks of growing companies to extort cash from those companies by selling the rights to these registered trademarks back to them.
Clearly Agree on and Properly Document Founders’ Roles and Responsibilities
- Formalize relationships between the company’s founders and avoid acting through casual business relationships (even among friends and family).
- Set out in writing each founder’s role and responsibilities, including day-to-day operations of the business.
- Record ownership percentages among the founders and any other owners of the business.
- Specify how key decisions are to be made (for example, capital raises and sale of the business).
- Create a mechanism for dispute resolution between the founders (for example, how to break a tie if two founders disagree).
- Address the possibility of a founder’s exit from the business, including whether:
- the departing founder’s stock is subject to time-based vesting;
- there is any limit on the departing founder’s right to continue to hold an equity stock in the business;
- the departing founder has any voting rights on business decisions; and
- any restrictive covenants govern the departing founder’s conduct after leaving the business.
Develop and Implement a Comprehensive IP Strategy to Ensure that the Company Has and Retains Essential IP Rights
- A comprehensive IP strategy should cover IP creation, acquisition, and protection and anticipate business growth and expansion.
- Ensure that core IP contributed by founders, employees, and third parties are owned by or at least securely licensed to the business.
- Determine the appropriate kind of IP protection for technology developed by the company, taking into account:
- the likelihood of obtaining that protection;
- the time and costs required to obtain the protection; and
- the protection’s length and strength.
- Decide, for example, whether to seek trade secret or patent protection for the company’s inventions in light of these factors. For more information about the different kinds of IP protection,
- Protect the company’s IP in early-stage business activities. For example:
- safeguard confidential business information and trade secrets by using confidentiality and nondisclosure agreements;
- register copyrights and use copyright notices;
- clear and register trademarks and use appropriate notices;
- secure rights protections for any company proprietary software; and
- take steps to protect the company’s valuable data and databases;
- Balance IP protection against a desire to open source company technology.
- Adopt a company social media policy and educate employees on how to comply with it, including who owns works created by them and whether and how they may share those works outside of the company.
- Create a process for adequately clearing third-party content, considering what rights must be obtained, including for social media and other non-commercial uses.
Comply with Securities Laws When Raising Capital
- Be aware that federal and state securities laws and regulations apply to all offers and sales of securities, including to friends and family.
- Do not issue securities without a valid exemption from federal and state registration or proper qualification requirements.
- Take appropriate actions to avoid:
- facing potential regulatory action;
- incurring an obligation to offer investors a right of rescission; or
- harming the economics of a future investment in, or sale of, the company.
- Consult with qualified securities counsel before issuing any securities to non-founders. Counsel can help the company:
- identify an exemption from federal securities registration; and
- comply with state blue sky laws, which may require filings or notice.
- Proceed with extreme caution if issuing securities to non-accredited investors, even close friends and family. Rule 506 of Regulation D, the most commonly relied on exemption from federal securities registration, is generally only practical in securities offerings made solely to accredited investors.
Comply with Labor and Employment Laws
- From the outset, comply with state and federal wage and hour laws for all employees by:
- classifying employees as exempt or nonexempt from the federal minimum wage and overtime laws under the Fair Labor Standards Act (FLSA);
- compensating all non-exempt employees with payment for minimum wage and overtime;
- ensuring all exempt employees perform the job functions necessary to qualify for an exemption under the FLSA and are paid the minimum threshold on a salary basis; and
- complying with any state or local wage laws that may be more generous to employees than the FLSA.
- Classify independent contractors and unpaid interns properly. Failure to do so can lead to substantial liability in several areas, including:
- overtime pay;
- taxes and penalties; and
- employee benefits.
- Pay college students or recent grads performing services for the company at least minimum wage and overtime if applicable unless they meet the strict qualifications for unpaid interns under the FLSA.
- Be aware of state and local laws that govern the employment relationship. For example, some jurisdictions require employers to:
- provide paid sick leave or other benefits; and
- send certain wage payment notices to all new employees, for example stating their rates and dates of pay.
- Plan for payroll and benefits administration. However, do not assume that using a professional employer organization (PEO) or temporary staffing agency insulates the business from liability for employment law violations. For more information about state laws regulating PEOs.
- Specify in written offer letters, employment agreements, or workplace policies that the employment relationship is at-will, except for the most senior executives who may have a right to severance or other benefits if the employment is terminated without cause.
- Ensure that founders and owners understand that they may be personally liable for unpaid wages, even if the business fails.
Check out our blog on employment contracts for a more information.
Properly Structure Any Equity Plan for the Benefit of Executives and Employees of the Company
- Decide whether to use some form of equity (for example, options, restricted stock, or stock appreciation rights) to compensate employees when developing a compensation strategy.
- Understand the legal implications, tax consequences, and accounting treatment of granting each type of equity award, including any vesting requirements. Consider:
- how much equity should be designated for employees; and
- the consequences of an equity plan for future investors.
- Use caution if when in-house counsel negotiate with the board of directors on the terms of a bonus structure or equity plan in which counsel will participate.
- Be aware that the company must also comply with securities laws when issuing equity compensation.
Institute a Policy for Social Media, Data Collection, and Other Online and Mobile Activities
- Do not assume that because of the casual nature of social media and other online and mobile applications that these activities cannot cause significant harm.
- Secure the company’s rights in its website and other online assets.
- Become familiar with laws regarding endorsements, contests, and promotions.
- Pay close attention to privacy and data security laws governing the collection, use, security, transfer, and disposal of the personal information of employees and customers that is collected and maintained by or for the company.
- Train employees not to comment on or even mention prospective or ongoing funding rounds in social media posts.
- Ensure that employees understand that they must consult legal counsel before posting about material aspects of the business (for example, pending litigation or new product development) on social media.
- Consider the variety of legal issues surrounding early-stage e-commerce (for example, interstate commerce, business and tax payment mechanisms, privacy, sales tax, and data security).
Properly Document Customer, Supplier, Employee, and Other Key Third-Party Relationships
- Do not rely on oral arrangements with customers, suppliers, and employees, even with friends and existing business contacts.
- Do not assume that the company has to accept all of the terms proposed in contracts with more established companies. Understand how vendors and customers can allocate the risk of non-performance to the counterparty in a transaction through indemnification, exclusive remedies, limitations on liability, and warranty provisions.
- Create and use key form agreements for core business activities early in the company’s life cycle.
- Address company ownership of IP and use appropriate restrictive covenants in employee contracts to protect the company’s goodwill, customer relationships, and proprietary information. Restrictive covenants can be stand-alone agreements or incorporated into an employment contract, and may include: