Top 8 Legal Mistakes Made by Startups

Entrepreneurs should avoid these 8 legal mistakes when setting up a startup.

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Rudri Bhatt Patel is a former attorney turned writer and editor. Prior to attending law school, she graduated with an MA in English with an emphasis in creative writing. She is the co-founder and co-editor of the literary journal, The Sunlight Press, and her work has appeared in The Washington Post, Business Insider, Civil Eats, Saveur, Dame Magazine, Brain, Child Magazine, ESPN, Phoenix New Times, and elsewhere. Find her work at www.rudribhattpatel.com.

1. Lacking a solid operating agreement

“One of the biggest legal mistakes I see startups make is that they fail to create a detailed operating agreement among business partners," Evan Tarver, a former director of finance at a technology startup, says. "If you create a robust operating agreement that outlines everyone's roles and who has what decision-making power, you can build a business with harmonious relationships with your business partners."

An operating agreement should address:

How founders will share profits
An agreement on how key day-to-day decisions will be made
What occurs when one founder isn't complying with the agreement
How salaries are handled among founders
How to handle selling the business
How to remove a founder

2. Failing to have contracts set up to protect the startup

Entrepreneurs may “sometimes fail to pursue standard contracts beforehand," Christian da Costa, the founder of Gadget Review, says.

“A standard business contract, an NDA, a noncompete, a contractor agreement—these things are crucial to doing business in a way that can't be absolutely demolished by the legal team of someone choosing to go against you," he says.

Here are standard contracts a startup should have:

Employment agreement
Nondisclosure contract
Employee contract

Services agreement

3. Not knowing when to incorporate

It is crucial to understand when your business is ready to incorporate. “A lot of people think that the first thing they need to do is incorporate," Davis Nguyen, founder of My Consulting Offer, says. So much time is spent putting together the documentation that there is little focus on the product or service the business will offer. By the time the company launches, some realize there is no market fit. Focus on honing your mission, and then incorporate.

Others do the opposite and incorporate too late. In this case, your business is finally making money and you are about to enter tax season, or you're thinking about selling your company. “You incorporate way too late and by that time, you are hit with legal fees and expenses you didn't even know about because you didn't file the paperwork right at the same time," Nguyen says. Ideally, a business should incorporate before signing contracts and hiring employees to limit personal liability.

4. Failing to understand tax considerations

“Many startup entrepreneurs don't realize how complex taxes can be and the impact of taxes on their businesses," Shawn Plummer, the CEO of The Annuity Expert, says. They may struggle with handling franchise taxes, sales taxes, or calculating the correct amount of payroll taxes and determining if people working in the business are employees or freelancers.

“Unanticipated tax liabilities, penalties and fines can kill a startup," adds Plummer. Be sure to also consider tax implications of stocks, implications of taxation based on the entity chosen, and documentation of expenses and deductible income.

5. Not maintaining proper HR documentation

During hiring, founders are often too busy with other parts of the business to think about proper HR documentation. “However, this can cause a startup to be liable during regulatory checks, lawsuits brought by employees, and any due diligence undertaken by another company during an acquisition," Plummer says.

Focus on the following in terms of HR documentation:

Signed contracts
Employment letters
Personnel files
Employee complaints and resolutions
Compensation and bonuses

6. Not understanding intellectual property implications

One of the more common mistakes in startups is a failure to protect intellectual property rights. “If the business is based on an innovation, the startup should seek patent protection as soon as possible. Filing for patent protection will not only tell the startup whether the innovation is considered patentable but also protect the innovation from infringement from rivals," says Robert Bird, an attorney and professor of business law at University of Connecticut. Other IP issues you may want to consider are trademarking your business name and looking into copyright issues of any material in your company.

7. Failing to get necessary licenses and permits

The following licenses and permits should be obtained depending on the nature of your business:

Industry-specific permits for regulated businesses
State qualification to do business
Home-based business permits
City and county business and zoning permits or licenses
Sales tax license
Seller and health department permits
Federal and state tax/employer IDs

Many businesses open without conducting this due diligence and end up facing fines, shutdowns, and high administrative and legal costs for which they did not properly budget.

8. Lack of overall preparation

Lack of preparation can be a serious impediment to a startup's success. Entrepreneurs should ask these questions to determine if they are prepared to launch their startup:

Have you chosen the correct business entity (i.e., sole proprietorship, LLC, corporation)?
Are you personally liable if the startup fails?
Have you double-checked your business vision to determine if you've addressed all legal implications?

Basic mistakes startups make

Ben Reynolds, the CEO and founder of Sure Dividend, an investment advising platform, says startups often make the following general mistakes:

1. Not identifying target customers with absolute certainty. No matter how good your marketing material or products are, marketing to the wrong target audience can hurt your business before it starts.

2. Hiring too quickly. Having employees is expensive. Be sure to grow your team slowly.

3. Coasting on intuition. Don't go it alone. With a mentor's guidance, you can learn from their experience—and mistakes—and get a start on solid ground.

4. Investing too much money in equipment or other unnecessary expenses. To reduce the risk of debt, make do with less.

5. Not taking customer feedback seriously. Do not ignore customers' concerns. Use their feedback to improve your products, increase sales, and maintain customer loyalty.

6. Not building an emergency fund. Having an emergency fund to all back on can help you through financial hurdles to keep your business afloat.