By Richard Harroch and Richard N. Frasch
As lawyers and venture capitalists involved with start-ups, we have seen plenty of legal mistakes made by entrepreneurs and start-up companies. The following are some of the more common and problematic legal mistakes we have seen.
1. Not making the deal clear with co-founders
You absolutely have to agree with your co-founders early on what the deal is among you. Not doing so can cause enormous problems later (see, for example, the Zuckerberg/Winklevoss Facebook litigation). In a way, think of the founder agreement as a form of “pre-nuptial agreement.” Here are the key deal terms you need to address in some kind of written founder agreement:
- Who gets what percentage of the company?
- Is the percentage ownership 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 other founder have the right to buy back that founder’s shares? At what price?
- How much time commitment to the business is expected of each founder?
- What salaries (if any), are the founders entitled to? How can that be changed?
- How are key decisions and day-to-day decisions of the business to be made? (majority vote, unanimous vote, or 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 decision)
- What assets or cash into the business does each founder contribute or invest?
- How will a sale of the business be decided?
- What happens if one founder isn’t living up to expectations under the founder agreement? How is it resolved?
- What is the overall goal and vision for the business?
2. Not starting the business as a corporation or LLC
One of the very first decisions that founders must make is in what legal form to operate the business, but founders often start a business without consulting a lawyer and, as a result, often incur higher taxes and become subject to significant liabilities that could have been avoided if the business was started as a corporation or as a limited liability company (“LLC”).
The types of business forms that are available to a start-up business are as follows:
- Sole Proprietorships. 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 the form of a sole proprietorship: (1) it only has one owner and if additional capital is required from another investor, 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 creditors of the business cannot successfully sue the founders and other investors. We don’t recommend sole proprietorships.
- General Partnerships. If there is more than one founder, a general partnership is often chosen as the legal form of business entity. Preferably, the founders will agree on a partnership agreement to “set the rules” among the founders; however, if the founders do not agree on a partnership agreement, most (if not all) state laws will supply the rules in the absence of an agreement. The income of a partnership is taxed directly to the partners generally on a pro rata basis. Finally, each partner of a partnership is generally liable for the debts of the business and thus exposes the personal assets of each partner to the business’ creditors. We don’t recommend forming a general partnership.
- C corporations. These are formed under state law (usually of the state where the business will be first operated or in a state such as Delaware that is known for its well developed corporate law). Most venture capital backed companies are C corporations.
- S corporations. These are formed under state law like C corporations but have favorable tax treatment for closely held (not more than 100 shareholders) corporations under federal and state tax laws.
- LLCs. These are formed under state law and are a hybrid form of corporation and limited partnership and have certain tax advantages over C corporations.
- Limited partnerships. These are formed under state law and are often formed to hold investment real estate and also are often the “investment vehicle of choice” for private equity 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. However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital in contrast to sole proprietorships and partnerships.
Sole proprietorships and partnerships can later convert to a C or S corporation, LLC, or other legal entity but keep in mind that the conversion costs can be significant.
3. Not coming up with a great standard form contract in favor of your company
Almost every company should have a standard form contract when dealing with customers or clients. But, there really isn’t a “standard form contract,” as every contract can be tailored to be more favorable to one side or the other. The key is to start with your form of contract, and hope the other side doesn’t negotiate it much. Here are some key items to come up with your form of contract:
- Get sample contracts of what other people do in the industry. There is no need to re-invent a contract.
- Make sure you have an experienced business lawyer doing the drafting, one that already has good forms to start with.
- Make sure you make it look like a standard form pre-printed contract with typeface and font size.
- Don’t make it so ridiculously long that the other side will throw up their hands when they see it.
- Make sure you have clearly spelled out pricing, when payment is due, and what penalties or interest is owed if payment isn’t made.
- Try and minimize or negate any representations and warranties about the product or service.
- Include limitations on your liability if the product or service doesn’t meet expectations.
- Include a “force majeure” clause relieving you from breach if unforeseen events occur.
- Include a clause on how disputes will be resolved. Our preference is for confidential binding arbitration in front of one arbitrator.
4. Not complying with securities laws when issuing stock to angels/family/friends
If the founders form a corporation, limited partnership, or LLC, the sale of stock, limited partnership interests, or LLC interests to the founders and later investors will be subject to federal and state securities laws. Most securities laws require that the sale of shares must comply with certain disclosure, filing, and form requirements unless such sales are exempt. Failure to comply with such requirements can result in significant financial penalties for the founders and the start-up company including requiring the start-up company to repurchase all the shares at the original issuance price even if the company has lost most, if not all, of its money. Consequently, in order to avoid such fines, penalties, and repurchase requirements, founders must hire knowledgeable lawyers to document the sales of shares in compliance with such laws.