Essential Legal Tips for Startups
Launching a startup is an exciting and often challenging time for entrepreneurs. Founders and leaders of startups tend to focus primarily on the "business" aspects of the company, such as building products, establishing a customer base, and obtaining funding, while often overlooking many of the legal considerations that come into play. Although the business elements are obviously important to establishing a successful company, so too are the legal considerations, which can make or break a business regardless of how comprehensive the business plan may be.
Navigating the legal landscape of a startup can be overwhelming. While there are myriad legal issues that must be considered, the following are some of the more essential legal tips for startups.
1. Choosing the Right Legal Structure
Choosing the right legal structure–e.g., a C corporation, S corporation, LLC, public benefit corporation, partnership, or non-profit–is critical and will impact the company's legal and financial framework, including tax implications and liability exposure of the owners. Additionally, different business structures impose different and more or less stringent rules as to certain issues, such as equity ownership and the types of equity holders that are permitted. Speaking to an experienced corporate attorney can help founders of a startup determine which legal structure is best for their particular situation, and will help ensure that all legal requirements, such as drafting and filing of corporate documents, are satisfied.
2. Executing Founder Agreements
Frequently, founders of a startup are friends and may be under the impression that no founder agreements are necessary given the pre-existing relationship and trust between them. However, misunderstandings and disagreements between founders arise all too often and can lead to lawsuits. A good founder agreement will establish each founder's specific role in the company and their respective responsibilities and incentives. Founder agreements should also set forth important terms governing voting rights and procedures for founders, non-compete and confidentiality covenants, and exit protocols in the event one or more founders decide to leave the company.
3. Identifying and Protecting Intellectual Property
Startups need to identify and take appropriate action to protect their Intellectual Property (IP). Further, as IP laws have changed over time, it is important to review the rules governing ownership of IP, as they can vary depending on the specific IP in question. For instance, simply inventing a product first does not establish patent rights; instead, the startup must be the first to file for a patent, and must do so before discussing the product in public, in order to protect its invention. By contrast, trademark rights are often based on who is the first to use the trademark in a market. Even where no product has been developed, startups need to establish and implement an IP strategy for the ownership and use of their trademarks, trade secrets, copyrights, and patents, including contracts capturing IP that may be developed by employees or contractors.
4. Establishing Proper Contracts for Investors, Employees, and Contractors
Often, particularly with respect to smaller startups, many deals and transactions between a startup and its investors, employees, or contractors are done orally or with a "handshake." Putting these agreements in writing is a critical business practice, even if they are with friends or family, to commemorate the terms agreed upon, avoid disputes as to what the parties intended, and address important issues not considered during the parties' oral discussions. All new employees, including founders who are employees, should be required to enter into standard employment agreements that contain customary provisions governing at-will employment, confidentiality, IP, and non-competition restrictions.
5. Implementing Equity Vesting Schedules
Founder and employee equity should typically vest over time (e.g., 48 months or some other specific time period) in order to protect the company and incentivize long-term commitment. Doing so will help to deter founders and employees from leaving prematurely with large ownership stakes in the company.
6. Keeping Clean Corporate Records and Updated Cap Table
Investors will expect a business to have clean books and clear ownership records. All company actions (e.g., shareholder approvals, board resolutions, and tax filings) should be properly documented in writing and maintained within the company's records. Creating and regularly updating a capitalization table is also an important way to maintain a clear and accurate record of the ownership of the company.
7. Complying with Securities Laws When Issuing Equity
Compliance with federal and state securities laws is critical, even when granting equity to a family member, friend, or trusted advisor. This includes using proper documentation, such as subscription agreements and accredited investor questionnaires, and filing all necessary federal and state notices when raising funds.
8. Securing the Right Licenses and Permits
Depending on the industry and location of the startup's business, obtaining the right federal, state, and local licenses and permits may be necessary to legally operate a business. Many entrepreneurs may delay obtaining licenses and permits required to operate the startup's business, failing to recognize that obtaining some licenses and permits could take weeks and even months. For example, seeking a zoning variance could lead to disputes with community members who are against the proposed variance, which could lead to time-consuming legal proceedings. Failing to obtain necessary licenses, permits, and approvals prior to commencing business operations could lead to serious penalties or shutdown of the business, or both. The best approach is to seek and obtain all necessary licenses and permits early.
9. Ensuring Data Privacy and Security Compliance
Addressing data privacy and security is a critical step that requires creating and implementing privacy and security policies to protect sensitive information concerning customers, employees, and the company. Startups should work with IT professionals and legal counsel to ensure compliance with all data protection laws and regulations and to develop protocols for responding to a security breach. A startup that conducts business through a website should also prepare and publish on its website appropriate privacy policies and terms of use and service for its users.
10. Planning for Fundraising Early
Investors are unlikely to invest in a startup that is not legally sound. Failing to execute proper legal documents and attempting to correct legal gaps while pitching to investors signals poor management and increased risk, which could deter potential investors. Additionally, fundraising almost always involves due diligence, and any legal red flags identified during that process could slow down or even result in termination of a financing transaction. Therefore, before seeking investors, a startup should invest the time and effort to get its legal house in order.
11. Obtaining Legal Advice from the Beginning
Competent legal counsel can help ensure that a startup is successfully following the legal tips described above and other important legal considerations that may be appropriate for any particular business. Many entrepreneurs tend to delay obtaining legal counsel, often avoiding engaging with a knowledgeable attorney until a crisis arises or relying on DIY form documents and templates without a full understanding of their legal implications. Ultimately, it is best for founders to retain competent legal counsel from the start, as waiting to address legal issues later or trying to fix legal mistakes after they have occurred is generally much more expensive and time-consuming than avoiding them in advance through skilled legal guidance.
Final Thoughts
No checklist, no matter how comprehensive, guarantees startup success, and the important legal issues to consider may vary depending on the unique circumstances and/or stage of a particular startup. Nonetheless, addressing the legal issues described above will help to reduce risk and provide a basic legal foundation to allow a startup to grow while protecting it from a potentially wide assortment of legal issues that are better to avoid in the first place than to try to correct after the fact. Investing in the right legal counsel and other professional advisors (e.g., accountants and IT professionals) early is important and will save founders and startups time, money, and potential legal battles in the future.