By Richard Harroch, Lynne Hermle, and Ellen Ehrenpreis
When launching a new startup, you can face significant business and legal challenges. We have seen plenty of mistakes made by entrepreneurs and startup companies.
The following are some of the more common and problematic legal mistakes made by small and growing companies. These mistakes are made at the initial formation of the business, in the early stages of growth, and when dealing with employees.
Mistake #1: Not Making the Deal Clear With Co-Founders
If you start your company with co-founders, you should agree early on about the details of your business relationship. Not doing so can cause significant legal problems down the road (a good example of this is the infamous Zuckerberg/Winklevoss Facebook litigation). Think of the founder agreement as a form of “pre-nuptial agreement.” Here are the key deal terms your written founder agreement needs to address:
- How will the equity be split among the founders?
- Is each founder’s percentage ownership in the company subject to vesting based on continued participation in the business?
- What are the roles and responsibilities of the founders?
- If one founder leaves, does the company or the remaining founders have the right to buy back the departing founder’s shares? If so, at what price?
- What time commitment to the business is expected of each founder? What constraints will be imposed on outside commitments?
- What salaries (if any) are the founders entitled to? How can that be changed?
- How will key decisions and day-to-day decisions of the business be made? (by majority vote, unanimous vote, or are certain decisions solely in the hands of the CEO?)
- Under what circumstances can a founder be removed as an employee of the business? (usually, this would be a Board of Directors decision)
- What assets or cash does each founder contribute or invest into the business?
- How will a sale of the business be decided?
- What happens if one founder isn’t living up to expectations under the founder agreement?
- What is the overall goal and vision for the business?
Similar mistakes are sometimes made with employees, through email or oral promises such as “you’ll get 5% of the company” without vesting schedules, role definitions, decisions about what happens on termination, etc.
Mistake #2: Not Starting the Business as a Corporation or LLC
One of the very first decisions founders must make is in what legal form to operate the business. Because founders often start businesses without consulting lawyers, they incur higher taxes and become subject to significant liabilities that could have been avoided if they had structured the business as a corporation or a limited liability company (“LLC”).
The types of business forms that are generally available to a startup business are as follows:
- Sole Proprietorship. Generally speaking, a sole proprietorship requires no legal documentation, fees or filings other than state and local business permits. On the other hand, there are disadvantages to operating in this form: (1) a sole proprietorship only has one owner and if additional capital is required from other investors, the form is not available and a partnership or other entity form is required and (2) a sole proprietorship provides no protection for the founder against creditors of the business (in other words, creditors can directly sue the founder), in contrast to corporations and LLCs where, generally speaking, the founders are insulated from creditor and other third-party liability. We don’t recommend sole proprietorships.
- General Partnership. A general partnership is sometimes chosen as the legal form of business entity if there are multiple founders. Preferably, the founders will execute a partnership agreement to “set the rules” among themselves; however, if the founders do not enter into a partnership agreement, most (if not all) states have existing laws that will step in and supply the rules of engagement. In addition, the income of a partnership is taxed directly to the partners generally on a pro rata basis (e., according to percentage ownership of the business). Finally, each partner is generally liable for the debts of the business such that the personal assets of each partner are exposed to the full extent of the business’ obligations. We don’t recommend forming a general partnership for a startup business.
- C corporations. These are formed under state law (usually in the state where the business will first operate or, commonly, in Delaware, which is known for its well-developed body of corporate law). Most venture capital-backed companies are C corporations.
- S corporations. These, like C corporations, are formed under state law. An S Corporation is a closely held corporation (not more than 100 stockholders) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. The election results in the corporation becoming a pass-through entity for tax purposes (meaning that the S Corporation itself does not pay income tax; rather, profits and losses are passed through and divided among the corporation’s stockholders).
- LLCs. These are formed under state law, are a hybrid form of corporation and limited partnership, and have certain tax advantages over C corporations. They provide limited liability protection to the owners, in keeping with the corporate form, but they also provide for flow-through taxation to the members (as with an S Corporation) If you plan on bringing in venture capital investors at some point, it is best to avoid starting the company as an LLC (which generally can’t invest in pass-through entities).
- Limited partnerships. These are formed under state law, often to hold investment real estate, and also are often the investment vehicle of choice for private equity firms, venture capital firms, and hedge funds.
Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax and accounting issues. Each can offer advantages for founders (and subsequent investors) not available in the case of sole proprietorships and general partnerships, including liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital. The C corporation (formed in Delaware) is by far the leading choice for technology startups across the country.