5 Legal Mistakes to Avoid When Launching and Growing Your Business
Launching and growing a startup can be a legal minefield, and if you don’t know what to look out for, you’re likely to make some costly legal errors. Labs mentor Tricia Meyer, attorney and founder of Meyer Law, hosted a Labs session on the common legal mistakes that early-stage startups make and how they can be avoided. Here are five to keep in mind.
Mistake #1: Failing to get a founders agreement in place
You and your cofounder (or cofounders) may be completely in sync now, and it may feel like you’re jinxing things by planning for what would happen if the relationship goes south, but it’s necessary, Meyer says. “Nobody thinks anything could go wrong and if it does, everyone will get on the same page. In reality, it’s rarely that easy. In my experience, 65 percent of startups fail due to cofounder conflict.”
The official name of a founders agreement varies based on the type of company you’ve set up, but it’s “like the pre-nup for the founders of the company and governs the internal affairs and provides a framework around various business, financial, and functional issues that may need to be addressed. It gets all of the founders on the same page from the start,” Meyer says.
“Founder disputes are the norm, not the exception,” Meyer says. “Many of these arguments stem from the fact that startups move at a rapid pace. You come up with a business idea before you figure out who owns what.”
How to avoid the mistake: “The best way to avoid conflict is to set clear written expectations in the beginning,” Meyer says. The four key areas to focus on are:
- Ownership - Who owns how much of the company? What happens to a cofounder’s ownership if they leave the company?
- Roles and responsibility - Who’s responsible for what part of the business
- Decision-making - How will important decisions be made? Will there be a voting system, and if so, are votes tied to ownership? Can two cofounders vote out a third?
- Operating procedures - Do cofounders need to consult each other on purchases? Does the company have an exit strategy?
Mistake #2: Giving away equity in your company without properly documenting it
Not having processes and guidelines in place for how you distribute equity is a recipe for disaster. And things get even more complicated if you’re not keeping track of who you’re giving equity to. “Are you giving equity in exchange for services? Giving equity to an advisor? You have to document this properly,” Meyer says. “Many startups, especially in the tech space, decide to share the wealth by compensating third parties such as service providers like developers and designers, employees, and advisors with equity in their company. Very rarely should companies give equity outright, and instead should make it subject to vesting.”
How to avoid the mistake: Make sure you’re making any equity you’re giving subject to vesting. “Vesting basically means that they don’t get the equity up front, but instead earn it over time or upon the occurrence of certain milestones,” Meyer says. “This can be structured specifically for each situation. A common structure is a one-year cliff, meaning a portion of the equity does not vest until after one year, and then thereafter over a 3-to-4-year period, but each situation should be analyzed and structured in relation to it.”
Mistake #3: Misclassifying your hires
It’s incredibly important to accurately classify your early hires, with the main distinction being between employees and independent contractors. “If you classify them incorrectly, you could face fines, penalties, and possible repayment of back taxes,” Meyer says. “The distinction between employee and contractor often depends on the level of control the company has over the particular hire”, Meyer says.
There’s also the question of interns. “They need to be paid in most instances,” Meyer says, but there are six criteria you have to meet in order to not pay them: they’re receiving similar training that they would get in an educational environment, the experience benefits the intern, the intern isn’t a replacement for an employee and is highly supervised, your company gets no immediate advantages from the intern’s services, the intern isn’t entitled to a job at the end of the internship, and both you and the intern agree that they’re not entitled to wages.
How to avoid the mistake: Put your relationship with any hires, whether they’re employees, contractors, or interns, in writing. And make sure you have the proper contracts filled out, like contractor agreements, intern agreements, employment agreements and offer letters and non-disclosure agreements. (Read more articles about hiring here.)
Mistake #4: Not getting written agreements in place with every entity you work with
Don’t let things get murky with what belongs to your company and what doesn’t. “Make sure that your agreements specify what is considered work product versus pre-existing materials, and make sure that you are aware of any third party products or services incorporated into your product,” Meyer says. “It’s important to know what you own, what you’re licensing, and what other terms you need to abide by (and perhaps have your clients or users abide by as well.)”
Even if the other party is a relative or friend, you need agreements in place. “You still need to get a contract in place because if you don’t, your friend or relative owns your product,” Meyer says. “Another one we often hear is ‘We’ve worked together in the past,’ or ‘I just want to close the deal.’ Or sometimes it’s ‘They gave me their standard contract to sign.’ The worst is when someone comes to us after the fact and didn’t realize they signed a contract that is very one-sided or lacking so much detail that they barely have a leg to stand on.”
How to avoid the mistake: Get everything in writing. “Contracts not only protect you if things go wrong,” Meyer says, “They keep things from going wrong in the first place by clarifying expectations and preventing misunderstandings. We work with a ton of startup technology companies, so we are constantly dealing with issues with developers, such as, ‘It’s been six months and our developer is way behind and the product still isn’t finished.’ We ask, did you have a clear scope of services defined with milestones? Did you make the payment contingent on acceptance testing? These are things that you may not know if you don’t deal with contracts regularly. It only takes one misunderstanding to cause financial and emotional stress, not to mention a drain on your time.”
Mistake #5: Using a one-size-fits-all customer contract
“Each relationship is unique and each has different considerations that should be taken into account,” Meyer says. “It should be tailored for the situation and very rarely are two deals the same.”
“Contract language that works for one situation may leave you unprotected in another. Different businesses have different needs and the devil is in the detail,” Meyer says. “The effectiveness of a contract is often determined by its details and specificity, and you want it to take into consideration your specific business. An agreement for a SaaS product versus a mobile applicable would contain different terms. If you’re using a ‘standard’ form you found on the internet, chances are the agreement is not tailored to your specific business. In addition, you don’t know what you don’t know. Many contract provisions are intertwined and if there are contradictions or certain key provisions missing, you could be taking on more risk than you realize.”
How to avoid the mistake: If you’re dead-set on using forms you found online in an effort to minimize expenses, “at the very least, have an attorney do a risk assessment of the document so that you know what you’re signing,” Meyer says. But Meyer strongly recommends enlisting an attorney to help you create a contract you can use with clients that’s tailored to your company. “The money you spend now to get an appropriate client contract in place to cover the scope of services or scope of use, payment terms, remedies in the event of a breach, and so on, will likely save you a great deal of money later on.”
Want to know about more costly, common, and avoidable mistakes? Read our article about the four legal and financial mistakes one CFO sees startup founders make all the time.
This post is based on content from a WeWork Labs programming session.
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