5 Legal Traps Start-Up Founders Should Avoid

Ever see the movie The Social Network? If you don't want to wind up playing Eduardo Sevarin's role, pay attention to these five legal pitfalls before you get involved with a start-up.

Ever see the movie The Social Network? If you don’t want to wind up playing Eduardo Saverin’s role, pay attention to these five legal pitfalls before you get involved with a start-up.

I’ve been fortunate enough to work with some of the best start-up companies in the history of technology. Each one is different, but successful company founders have several traits in common, including a boundless optimism that allows them to take the risks involved in starting a company.

Unfortunately, that optimism sometimes leads entrepreneurial personalities into taking too many risks, especially when it comes to protecting themselves (and their new companies) legally. For some, it’s a desire to conserve cash and not spend money on anything “unnecessary” like a good law firm that understands start-ups. And for others, it’s a simple lack of foresight. After all, nobody wants to think the unthinkable when they’re full of enthusiasm for a new venture – and some of the most important legal protections come into play when the unthinkable happens, and the start-up doesn’t follow a smooth road to success.

Here’s my list of the five things that start-up founders need to know about the law before they sign their first document, or make their first handshake deal. These are the things that individual founders need to think about – not advice on protecting your business, but rather advice on protecting yourself, your family, and your personal assets.

Execute Copyright & IP Agreements

I work primarily with technology startups, where intellectual property (IP) is the company’s most valuable asset. I can’t over stress this: have everything assigned to the company, and get it in writing. If a founder creates something before incorporation, make sure that the rights to the asset (code, prototypes, designs, process diagrams, and trademarks – ANYTHING the company needs) are assigned to the company at the time the company is formed.

Once the initial incorporation documents are done, have all founders and employees execute assignment agreements, and appropriate non-compete and non-disclosure agreements. No matter what else you do, this is the one legal protection a company can’t survive without.

Don’t forget to have all vendors – advertising agencies, designers, PR firms, freelance writers, technical writers, programmers, coders, anyone who creates something for the company – to sign “work made for hire” agreements. Don’t accept someone else’s assurances on this. Have them sign your agreement, every time.

Last, but hardly least, make sure that none of your new employees (including yourself and your co-founders) are subject to any pre-existing contracts that could make your great new invention or ideas the property of a former employer. This means reviewing all employment agreements that any of you may have signed for the last 5-7 years. Don’t leave this one to chance – have your attorney review the agreements, and if the employee or founder says no such agreement exists, verify it yourself via a written reference.

Some employment agreements may contain provisions that assign all inventions created to the employer, even if invented “off the clock.” This is especially important if you’re planning your start-up before giving notice at your “day job”.

Put Equity Agreements in Writing

I see a lot of good ideas that come out of start-up weekends, business accelerators, hackathons or competitions or even business school class assignments. Starting a company with someone you met through one of these venues is the equivalent of marrying that good looking person you hooked up with last night. It may be love at first sight, and it may be wonderful – but sign the pre-up before you say “I do” in either case.

I see even more great ideas that come together when co-workers or friends start tossing ideas around, especially when the initial founders are friends and family and everyone is sure that they’ll all get along smoothly.

Even if your co-founder is your best friend from elementary school, your relative, or your romantic partner, you may not be using the same vocabulary when it comes to setting up your new venture. So don’t leave it up to chance.

When things don’t go well, and there are bills to pay and obligations to meet, memories get hazy – and that “50% partner” may not be willing (or able) to come up with 50% of the dollars to settle a debt. If you are judged by a court to be the “deepest pockets” in an informal business partnership, you can wind up on the hook for 100% of costs or legal judgments.

When things go very well, large sums of money often cause even bigger problems. Memories get hazy, terms are misunderstood, and things get nasty. This is especially true when your contribution to the new company is primarily in intellectual property (the initial idea, for example) or sweat equity (the long, uncompensated hours you put in).

Protect yourself by making sure your equity deal is clearly stated in writing. (Note: founder’s equity – that is equity granted to the people who work on the project before it is funded or become part of the initial talent pool – is never granted as “options”.  Stock options are a different thing, and require a separate agreement.)

In the interest of full disclosure, I married my business partner after we’d worked together for five years. A couple of decades on, we still work smoothly together. But we took the time to spell out the expectations and agreements before we started our business – and when we did, we nearly scuttled the whole thing because we found out we had very different expectations for who would be in charge of different parts of the business, how equity would be divided, and how we would be raising capital. It took awhile to work out all the details for the business partnership – and even longer to work out the details before we got married. We took the time we needed, and enlisted outside help to get it done. You should, too.

Don’t Sign “Standard” Contracts

Recently, I helped a smart young entrepreneur review a development contract submitted to him by a close friend. It was, he told me, a standard contract for programming and coding services for the game he and his friend planned to develop.

It may have been completely unintentional, but the contract that the friend presented was anything but friendly in my opinion. Instead of being drafted by a competent attorney, it had been cobbled together from different sources, and the bulk of it was a contract for custom programming services intended to protect the developer from a corporate client who might lay claim to the developer’s work without paying for it.

The contract was accompanied by a beautifully slick proposal outlining the game.  The “friend” had prepared it so that the entrepreneur could show a potential celebrity endorser whose name would be on the finished game, as well as to potential investors. It was very well done, and filled with gorgeous images and well-written copy about how wonderful the finished product would be.  And every single page had the logo and contact information for the developer on it instead of the “branding” for the new company the two “friends” were planning to start together.

Worse, every single paragraph of the contract was filled with language that could have made some lawyer very, very wealthy if any of a number of common business occurrences had come up. I counted 117 problem phrases in the document – and I’m not even an attorney. A savvy lawyer would surely have found more.

The worst part about the document was that the “friend” was signing as the CEO of a development company – whereas the contract was presented to the entrepreneur to sign as an individual. In other words, he could easily have found himself on the hook for using his personal assets, including the money earned from his last successful start-up, to pay his friend’s company if his start-up failed to raise the money necessary to complete development on the new product. There was no “out” clause or contingent plan that covered the very real possibility that the new company wouldn’t have the money to pay several hundred thousand dollars in development fees.

I don’t think that the friend here had a clue of what was actually in the document he presented, and I don’t think he put it together with the intention of being unfair. I suspect that he’d cut and pasted it from multiple different contracts he’d seen or signed, thinking that by throwing in every clause he could think of, he was protecting himself. (If a lawyer actually wrote that contract, I wish I knew his name. I’d be telling every entrepreneur I run into not to do business with that law firm, or at least not to sign anything from that firm without having an attorney from another firm review it.)

The lesson for a company founder in this little story is simple: don’t rely on someone else to draft a contract, and don’t sign anyone’s “standard” contract if you can avoid it. Sit down with your own lawyer, tell them what you want to achieve with the agreement, and let them protect you.  This is especially true of the agreements between you and your co-founders or strategic partners.  (If your strategic partner is Apple or Microsoft, you may have no choice but to sign their “standard” agreement — but make sure your own lawyer has reviewed them, and explained them to you in plain English — so that you know what you’re agreeing to in this kind of David and Goliath scenario.)

And, by the way, if you are participating in a business accelerator or incubator program, don’t assume that the lawyer they recommend is the best one for your new company. Law firms are not all created equal, and one that’s a fabulous choice for an Internet retailer might not be the best choice for a company that plans to make a medical device. Don’t hire the first law firm you talk to — take the time to find the best fit for you. And talk honestly about fees before you sign.

Avoid Asset Mingling

It’s simple: don’t use your personal money to buy things for the company, and don’t use company money to pay your own bills. Not now, not ever.

The day you open your business officially, the first action your management should take is to authorize the new company to open a bank account and begin all the other activities necessary to run a business. (The corporate resolutions for this are included in every “articles of incorporation” package I’ve ever seen, including those do-it-yourself kits and online services — which I don’t recommend.)

Even if you are starting your business with cash from your own accounts, deposit the money as your capital contribution to the business account, and pay for things from that account and only that account. Deposit all funds you get in – investment dollars, capital contributions from other founders, monies from sales, and so on – into your business account.

Don’t even think about paying for something with personal money and then filing an expense report you know the business can’t pay “right now”.  Make an official capital contribution, and pay for what you need from that, documenting every dollar you contribute.  I am a shareholder right now in a company that may fail because the founder and CEO made the mistake of mingling family assets with business assets — or so says her husband’s business  partner in a failed business who is now suing to try to recover money he claims the CEO’s husband “improperly” channeled into his wife’s company.

What happened seems all too clear in retrospect. Hubby’s business was (at the time) doing well.  Wife’s business was a start-up strapped for cash.  He makes her a personal loan to cover some expenses.  She signs an agreement to repay him, and records the loan on her books as a personal loan from “Mr.  and Mrs.  Investor” (they used their real names, of course).  To make things even muddier, when she was sidelined for a couple of months due to complications from pregnancy, he stepped in and “helped out” as an interim CEO.  The salary he should have been paid for his work was recorded on the books as deferred compensation.

Several years down this road, the situation is reversed.  His business is dead and the bones are being picked over in the courts.  Hers is thriving, and was on the brink of an  investment  that could take it to the next level. During due diligence, those old entries n the books — the personal loan and the deferred compensation to the husband, plus the irregular way the loan and investment were recorded (as being from husband and wife, not just one or the other) — came to light. Someone at the investment firm leaked the details to hubby’s former business partner.

Now the successful business is embroiled in the failed businesses’ legal problems, and, of course, the investment firm didn’t go through with its buy-in due to the ongoing legal challenges.  Don’t let it happen to you. Keep your personal assets (and problems), and those of your spouse, far away from your start-up.

Ignore “corporate formalities” like how assets are recorded, what names are used in the legal paperwork, and the clear separation of personal vs. business assets at your own peril. I’ve known several company founders who’ve fallen into the trap of paying bills for the company (or worse, staving off foreclosure or a cell phone cut-off by having the company pay a personal bill for them). The outcome of mingled assets isn’t pretty.

Why? Because courts (and the taxing authorities) have a tendency to view any co-mingling of assets as a sign that your corporate form (and the limited liability you thought you had to protect yourself from a judgment against the company) isn’t real, and should be disregarded. Don’t do it – it’s not worth the risk.

Protect Against a Co-Founder’s Personal Problems

In the euphoria and excitement of a new venture, no one wants to think about potential disasters in the excitement of a new venture. But disasters do happen.

I know of a tech company that imploded after one of two co-founders got married, and shortly thereafter was killed in a plane crash. The widower of the deceased co-founder decided to “step up” and try to replace his wife. She was an amazing businesswoman with lots of experience in building technology companies. He was a pro athlete who knew nothing about software.

Because there was no agreement that said that a significant shareholder couldn’t take an active role in the business or that a surviving spouse couldn’t assume their deceased spouse’s seat on the board of directors, the other co-founders found themselves unable to rid themselves of his well-meaning but unwanted presence and constant meddling.

Not all those who inherit a co-founder’s shares are well-meaning.  Think about what can happen when a divorce turns nasty – especially if your co-founder used community property assets for his/her capital contribution.

And it can be equally unpleasant if one of your co-founders simply decides to leave the company. I once worked with a start-up that was growing nicely but hadn’t yet turned a profit – which meant that none of the founders was taking home a full salary.

One of the co-founders suddenly announced that he was leaving for a new job because his wife was expecting twins. Her income had been supporting the family while he pursued his entrepreneurial dreams, and he needed a steady paycheck immediately.

So our fledgling company not only had to replace a key, senior person who had been contributing a lot to our growth, we had to spend a lot of time resolving the issues around his equity. We didn’t have a transition plan in place, and there was no vesting schedule for founder’s equity.

The departing co-founder demanded that he be given the full number of shares he’d been “promised” even though he was no longer putting in the work to earn them. It got nasty (and expensive, in time and dollars) before it got resolved.

Now I insist on a vesting schedule, which grant certain percentages of stock to founders on a set schedule, as well as rights of first refusal or repurchase rights, with survivorship and assignment clauses that define what happens to the shares in the event the founder dies, becomes disabled, or divorces. (Yes, you need this even if all of the founders are single at the time the company is founded. Single people’s estates can be even messier than those of married people.)

Make sure to protect yourself from your investors, too. Did you see that movie about Facebook, The Social Network? Watch it before you start a new business. Your personal interests are not always aligned with the startup’s interests – and they certainly don’t always align with your investor’s interests. If you don’t want to wind up playing Eduardo Saverin’s role, make sure that your own lawyer reviews whatever documents the company’s lawyer prepares for your signature.

Play By (and Enforce) the Rules

Yes, I know. You’d never break the law, you plan to pay your taxes promptly, and you will never, ever do anything that will get you in trouble with any of the innumerable local, state, and national regulatory agencies who might somehow take note of your new business. Of course you wouldn’t.

But can you say the same of every employee you’ll ever hire? Every subcontractor or temporary worker who sets foot on your premises? You’d better be able to, because that’s exactly what the CEO, COO, and CFO of a corporation have to be able to do.

A lot of time, entrepreneurs are under time and money pressure. And skirting a few regulations, or failing to publish “big company” documents like social media policies, acceptable use policies, and employee handbooks that outline the rights and responsibilities of employees and the company as it relates to hiring, firing, promotion, overtime and the like can seem like acceptable short-cuts. They aren’t.

If you don’t follow the rules and regulations precisely (no matter how picayune they seem), and you don’t train your employees on the rules they’re expected to follow and then enforce the rules fairly throughout the company, you’re simply asking for a big legal bill down the road.

This extends to the purchase of insurance products for your business, too, including things like cyber insurance (to protect your digital assets), errors & omissions insurance, worker’s compensation insurance, and general business liability insurance. Talk to your trade association or attorney about what kind of coverage you need in your state – and while you’re at it, make sure you’re aware of specific regulatory agency permits and guidelines, as well as any state licenses that may be required for your business.

I’m not trying to scare anyone away from opening a small business, just pointing out the legal pitfalls that can become traps for the unwary. As long as you know where the traps are, it’s easy to get around them as you start down the road to making your dreams come true.

(Disclaimer: I am not an attorney. Nothing in this blog post is intended to be legal advice.  Always consult a competent attorney licensed in your home state before making any legal decisions about a start-up company, and have all documents reviewed by an attorney experienced in your type of business.  The information contained here is my opinion, based on 29 years experience as a high-technology company executive, founder, consultant, board member, or investor.)

Image credit:  This image from the 2004 presentation that Eduardo Saverin used to solicit advertising for “The Facebook” was offered on Flickr under a Creative Commons License.

About debmcalister

I'm a Dallas-based marketing consultant and writer, who specializes in helping start-up technology companies grow. I write (books, articles, and blogs) about marketing, technology, and social media. This blog is about all of those -- and the funny ways in which they interesect with everyday life. It's also the place where I publish general articles on topics that interest me -- including commentary about the acting and film communities, since I have both a son and grandson who are performers.
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3 Responses to 5 Legal Traps Start-Up Founders Should Avoid

  1. Pingback: Startup Legal Problems: Pitfalls for Founders - Rosten Law

  2. Excellent blog, I just posted on Founder Agreements and included a link to your blog. You can check out: http://brillson.wordpress.com/2012/12/03/a-founders-agreement-in-hand-is-better-than-a-lawsuit-in-the-bush/

    • debmcalister says:

      Thanks, Paula! So glad you liked it enough to share it! I learned some of these lessons the hard way…and others from the advice of good mentors along the way. Hope they help others just starting their journey towards success. Regards, Deb

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