Top 3 Legal Mistakes That Startups Make

 

Many startups fail within their first year.

 

People want to introduce the next big thing but will often overlook the legal obstacles that will prevent them from bringing their ideas to life.

 

Frequently, startups will make mistakes such as not cutting a clear deal with their cofounders, forming the wrong type of business entity, or not considering intellectual property protection. Without careful guidance or an understanding of legal obstacles, many startups end up being a statistic. 

 

 

Cut a clear deal with your cofounders early on to prevent problems of ambiguity in the future. A written founder’s agreement is recommended to address issues surrounding ownership, roles and responsibilities, and terms of employment; Putting the terms in black and white allows cofounders to refer back to the agreement in the event that problems should arise.

 

Therefore, in the written founder’s agreement, the founders should address as many current issues as possible as well as problems that can be foreseen in the future.

 

Some sample topics that the written agreement may address are: 

 

 

Choosing the right form of entity eliminates legal hassles for the startup early on and is an essential part for a startup to operate as a business.

 

Oftentimes, founders who start businesses without the guidance of a lawyer usually results in paying higher taxes and more liability issues.

 

There are many different types of business forms such as sole proprietorships, general partnerships, C corporations, S corporations, limited partnerships, and limited liability companies (LLCs).

 

It is highly recommended for startups to form C corporations. Forming corporations come at a higher cost than partnerships or sole proprietorships but there are significant advantages for founders like tax savings, reduced liability, and efficiency in capital raising.

 

C corporations are formed under state law and are generally not required to pay federal income taxes which lessens the tax burden on the corporation in the long run. However, it is important to note that C corporations’ income or losses are divided and shared among its shareholders.

 

Another important issue to discuss is: where is the ideal location to incorporate? It is recommended that startups incorporate in Delaware (with a license to operate within California, if your startup is based in California).

 

The reasoning behind incorporating in Delaware is that the Delaware court system is efficient and caters toward business and corporate law, which works to the advantage of startups.

Also, certain investors will require corporations to incorporate in Delaware. By choosing the right type of entity and the right place to incorporate, it reduces issues for your startup and exhibits credibility with potential investors. 

 

Another common mistake that startups make is not taking steps to protect their intellectual property. Developing a unique product is great for the market but it is also a chance for competitors to grab that idea if it is not protected.

 

Founders and investors should ensure that their intellectual property is protected in addition to avoiding infringement on the intellectual property of others.

 

 

The moonlighting problem and the Zuckerberg problem are two common examples that come to mind when discussing intellectual property protection. The moonlighting problem occurs when a founder is working on the development of a unique product while under the employment of another company.

 

The employer may have rights over the intellectual property or product. The Zuckerberg problem is where the product or intellectual property is not assigned to a company by the founders and there is no clear deal with the other founders.

 

Things get problematic in the future when an entrepreneur waits until a lot of money is at stake to convince a founder, that has no future in the company, to give over their rights of the intellectual property. One protective measure for the startup is to cut a clear deal with the cofounders at the start.

 

Other legal protective measures for intellectual property are patents, copyrights, trademarks, and confidentiality agreements. Intellectual property protection is important because investors will not invest in companies that do not have ownership over the invention or product. 

 

These top 3 legal mistakes that startups make are not the only mistakes that occur. Hiring the right legal counsel can help prevent other liability issues that may occur as well as provide advice for the future of the startup.