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Startup legal mistakes

10 Common Startup Legal Mistakes

Startup companies live their life on the edge. The men and women starting and running a venture work countless hours with the hope that their efforts will pay off in a near future. The worst thing that can happen to a founder is a simple mistake at the early stages of the company, which could have been easily prevented rather than turning into a costly legal battle draining the company resources. Below, is the list of 10 common legal mistakes that startup companies can avoid as they move towards becoming a successful business.

1. Selecting an appropriate form of business entity

This is the first step any business owner and founder must take in formulating a plan towards success and profitability. No matter what the business idea is, there are some important factors to consider before forming a particular business entity. The main objective of the business, the ownership structure, the tax consequences, and protective measures against future liability of shareholders are among those important factors. For most startups a Delaware C Corp has been the number one choice. A wrong entity formation at the outset can deter future fundraising from venture capital firms as well as accredited angel investors.

2. Not Properly licensing technology patented by others

Licensing an invention requires some initial steps including determining the validity, scope, and the potential value of the patented invention to the company. Once the initial steps have been taken, the company can implement a strategy for a specific type of license, be it exclusive or nonexclusive, a simple paid-up license, a right to-use agreement, and whether a technology research and development is needed in consideration of improvement to the patented technology that may later be developed by the licensor or the licensee.

3. Incautiously hiring former employees of a competitor

In today’s thriving technology world it is very common for a founder to meet an employee of a competitor and after grabbing a drink at a bar, the competitor’s employee is on the verge of joining the founder’s team. The most important factors to consider in scenarios like this are the claims for misappropriation of trade secrets, restrictive covenants on the new hires, the employees’ non-compete agreement with his former employer, and nondisclosure issues. These are just some examples of being smart about what to do when thinking about hiring your competitor’s employee.

4. Not conducting a timely trademark search

Before you build a business around a mark, you need information about whether the proposed mark is likely to be protectable, and whether its use might conflict with rights held by an existing business. A search provides information on these two issues. Searches can be conducted at various depths to provide different levels of risk reduction. How much you should search depends on a balance of several factors, including (1) the level of risk you are willing to accept, (2) the amount you will invest in developing the mark; and (3) budget limitations. But not conducting the search at all can prove to be destructive to the core of your business.

5. Not properly maintaining organizational records

Failing to properly maintain the corporate records means jeopardizing the protections that a particular entity formation will provide to your business, as well as reducing the chances of fundraising when the company needs it most. Future creditors can attempt to pierce the corporate veil for lack of following the corporate formalities. The potential investors will be dissuaded if they see lack of compliance with corporate and security statutes. And finally, high risks of future conflicts among the existing shareholders for lack of proper exit strategies agreed upon at the outset.

6. Selling securities to non-accredited investors

Despite the new SEC approval of equity crowdfunding rules, there are important points to remember when deciding to inject funds through angel-investors. Some of these points are the conditions and disclosure requirements when dealing with unaccredited investors in offering over $1 million; knowing the definition of accredited investor; preventing recession rights for all investors in the transaction or enforcement proceeding. A quick step in preventing such mistakes is preparing a comprehensive investor questionnaire and following the requirements closely to avoid future troubles with the law.

7. Blowing the Section 83(b) election

Section 83(b) – of the tax code – is a letter that must be sent to IRS if you are issued equity in a company, which is subject to vesting. The letter simply states that you ‘d like to be taxed on your equity on the date the equity was granted to you rather than on the date the equity vests. This must be done within 30 days of the equity being granted, or else it will be expired and as such you may not benefit from this tool in order to accelerate your ordinary income tax.

8. Not adopting an appropriate employee stock option plan

Stock option plans can be a flexible way for companies to share ownership with employees, reward them for their performance, and attract and retain motivated staff. Stock options give key employees the opportunity to benefit from the increase in company’s value by granting them the right to buy shares of common stock at their fair market value and allow them to sell their shares over a period of time (vesting schedule) ranging between 2 to 5 years, most commonly set at a 4 years vesting cycle.

9. Failing to institute a trade secret protection program

This means protecting company’s secret souse from involuntary disclosure and use, most of the time at the hands of a previous employee who is no longer with the company. Trade secret and confidential business information must maintain its secrecy and therefore its strongly recommended that invention and secrecy agreements be prepared and submitted to employees, which explicitly set forth the company’s rights and the employees’ obligations with respect to inventions and trade secrets to protect against unwarranted future claims.

10. Failing to obtain good title to intellectual property

Who owns the company’s intellectual property assets? Often this is the threshold question when a key employee who made a significant contribution to the invention is leaving the company. To answer this question one must first answer many underlying questions such as when did the employee made his contribution to the IP work? During the business hours or on the employee’s own time? Was there any agreement between the company and the employee in order to eliminate opportunistic behaviors? Who supplied the equipment throughout the process? At times assignment of inventions conceived on-the-job can help avoid the company’s main value walk out the door freely.

We hope that you found these tips helpful. Keep in mind, the above points are just a handful of things to consider for any new startup company. Obviously the list is not exhaustive. Questions? Contact Eikon lawyers by phone, email, skype, or even facetime. You can also use the calendar on our website at eikonlaw.com to book a free consultation with us. It takes 30 seconds to schedule an appointment with our lawyers. We are easy to talk to.

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