The Legal Lowdown of Starting a New Business: A Startup Lawyer Explains More than 5 million new U.S. businesses were started in the U.S. last year — and startup founders need to be wary of the legal obstacles that could derail their success.
By Mital Makadia •
Key Takeaways
- Startup founders often encounter legal issues, such as IP ownership conflicts and improperly documented equity arrangements, leading to potential lawsuits.
- Proper legal groundwork, understanding of cap tables and employment law are critical for new business survival and growth.
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Last year, more than 5 million new businesses were established in the U.S. While that may be great news for innovation and the American economy, startup founders face a unique set of legal challenges that could inhibit their success.
Some common issues include:
- Starting a company while still employed elsewhere
- Offering shares at different prices to investors
- Not understanding capitalization
- Misusing form documents
- Ill-documented relationships
- Not paying employees or treating everyone as contractors
Imagine the following scenario: Jack and Jill were both employed at BigTechCo, but Jack left several months ago. He contacted Jill and asked her to leave BigTechCo to start a new company, HillCo (Jack may have violated a non-solicitation agreement with BigTechCo by inducing Jill to leave).
Jill says no but agrees to work with Jack on HillCo, which will pursue a line of business competitive with BigTechCo: a SaaS product. Because Jill is still employed by BigTechCo, BigTechCo probably will own any IP she purportedly makes for HillCo while still employed with BigTechCo.
Additionally, Jill is probably violating a conflict of interest policy and her duty of loyalty to BigTechCo.
Jack and Jill agree verbally to a 60/40 (Jill/Jack) equity split, but they never document it.
Related: Ask a Startup Lawyer: How Should You Manage Co-Founder Equity?
Jack and Jill copy and paste BigTechCo's terms of service and privacy policy onto HillCo's website. BigTechCo has privacy and security protections that HillCo does not offer, and HillCo is eventually sued in a class action by website visitors.
Jack leaves six months into working with Jill. Jack claims he owns 50% of the company, but Jill says he is owed 40%, and only part of that should have vested. But there is no documentation about equity and no agreement on vesting.
Further, Jack says he never signed any agreement with HillCo. He concluded that he is free to use any IP he created; that he's not bound by any confidentiality provision in favor of HillCo; and that HillCo is not authorized to use IP he created.
Jill decides to dissolve the entity, as it's too expensive and burdensome to fight with Jack over it.
Starting a company while still employed elsewhere
First, there may be a conflict of interest with Jill's employer and/or there may be an ambiguity as to who owns the IP she created for HillCo while still employed elsewhere. To avoid the issue altogether, Jill should have first reviewed an employee handbook or other moonlighting/conflict policy to see what consent she may have needed from BigTechCo.
Reviewing her employment agreement would have enabled Jill to see what scope of IP her employer will own that she created while employed there.
Typically, she'd have been safe if she created the IP outside of work hours; if she didn't use employer facilities, equipment or confidential information in creating the IP; and if the IP is unrelated to her employer's current or anticipated business or R&D.
Offering shares at different prices to investors
Some founders try to bring in early investors by issuing common stock at different prices. This can create tax and other problems for the company, as stock cannot be issued for $1/share to an investor and then to an employee for free.
The best way to ameliorate this is to use convertible securities (i.e. SAFEs, convertible notes), which avoid tax problems and are simple and cheap to implement.
Related: 4 Intellectual Property Mistakes Startups Make and How to Avoid Them
Not understanding capitalization
Founders sometimes do not understand how they will be diluted as they issue more shares or convertible securities.
To avoid this, Jack could have used a cap table management platform, where he'd have seen how he was diluted with different instruments. He also could have conducted due diligence on appropriate documents to sign when he issued securities.
Finally, Jack could have created a model cap table for his next priced round to see how he would have been diluted by convertible securities.
Misusing form documents
While the bottom line is always top of mind for business owners, founders sometimes find ways to cut costs, including saving money by using online forms (e.g. copying terms of service or privacy policies). However, without understanding the documents, there may be agreements that cannot be fulfilled. For example, with a privacy policy, they could get sued for misrepresenting their privacy stack.
To avoid this, it's wise for founders to invest in basic forms. A good startup lawyer can draft typical forms and explain how they can be used going forward. This can prevent issues from popping up later.
Ill-documented relationships
While drafting contracts may be tedious, it's a necessary precaution. Bringing on co-founders and advisors without a formal agreement in place, for example, can result in disputes over terms; failure to get IP assigned; failure to have people subject to confidentiality obligations; and not actually issuing equity to people to whom it was promised.
To avoid this, it behooves founders to research and complete inexpensive templates for advisor agreements, consulting agreements or stock purchase agreements as early in the relationship as possible.
Related: Covering All the Bases: How to Set the Legal Framework for Your New Business
Not paying employees or treating everyone as contractors
In the beginning of a company's life, there are typically insufficient funds to pay early employees a salary. As such, founders often hire everyone as contractors. However, this practice may be in violation of state and federal law, and it can even lead to personal liability on the part of the founders.
To prevent this, founders should be judicious by hiring people who they are able to pay. Then, they can gain an understanding of the applicable law regarding wages and who can be considered a contractor.
It's important to note that signing a consulting agreement does not mean the signer is a contractor. State and federal law both have standards that override any agreement.
Founders should understand the risks associated with not paying people. They should also take it a step further by implementing a separation agreement, even if that employee was considered to be a contractor.
The bottom line
Establishing a business requires work. It also requires due diligence to prevent avoidable legal issues as the business matures and as founders bring on co-founders, employees and advisors.
