When starting a business, it’s easy for owners to make legal mistakes that can prove costly down the road. Avoiding these missteps will keep your new venture on the path to prosperity.
- Over-complicating the Formation. Don’t try to structure your business to accommodate every future contingency. Instead, design the business to address what you expect will work best for you at startup and in the near future. Too often, entrepreneurs waste precious resources assuming they need to be ready to “go public” before they’ve even begun operations. Others overcomplicate things based on what they think some theoretical investor might or might not want. While it is important to plan for the future, don’t allow potential remote events to dictate the formation process over what is best for your company’s current and expected operations.
- Using Online Websites for Incorporation and Contracts. The internet is filled with websites that offer boilerplate formation services and contracts. Unfortunately, the “one size fits all” approach too often fails to fit anyone. If your formation documents aren’t properly drafted and filed, your corporation won’t offer you the protection you need and it won’t be respected by the IRS. Plus, filing the Articles of Incorporation is only the first step. You still need to prepare bylaws, organizational minutes, issue shares of stock, develop key employment and intellectual property documents and make the necessary IRS elections. What may work for an ice cream parlor in Carmel won’t work for the medical device company in Santa Barbara, yet that is typically what is offered from online formation websites. Similarly, pulling “form” contracts off the internet can be a recipe for disaster. Contracts are intended not only to formalize an agreement between parties but to provide for certain unknown contingencies. A well-drafted contract (meaning one that is tailored to your unique business needs) helps protect you against hidden pitfalls and legal loopholes. The internet template might be based on laws in a different jurisdiction or contain clauses that unknowingly favor the party on the other side of the transaction.
- Contractors v. Employees. The potential cost of attempting to use independent contractors instead of employees can be tempting to any startup. Taking into consideration potential unemployment benefits, Social Security, Medicare and other employment-related taxes and expenses necessarily added to an employee’s base salary, an employee can be substantially more expensive. However, the penalties and potential legal costs associated with misclassifying an employee as an independent contractor can far outweigh these attempted savings. This is a complicated and confusing area of the law for even the most experienced businessperson. There is no set definition of an “independent contractor” among the numerous government agencies and court cases. In California, the Department of Labor Standards Enforcement starts with the rebuttable presumption that your worker is an employee. From there, they look at numerous factors, none of which is controlling by itself. Using the “economic realities” test adopted by the California Supreme Court, the most significant factor to be considered is whether the person to whom the service is rendered (i.e., your business) has control over the manner and means in which the work is performed. Even where there is an absence of control over work details, an employer-employee relationship will be found if (a) the business retains pervasive control over the operation as a whole, (b) the worker’s duties are an integral part of the operation, and (c) the nature of the work makes detailed control unnecessary. Getting this worker classification wrong can cost a startup precious resources that otherwise could be devoted to growing the business.
- Protect Your Intellectual Property. A company’s intellectual property (their formulas and recipes, software codes, business plans, customer and vendor lists, pricing information, etc.) is the lifeblood of the company. Similarly, your name and logo are more than just a graphic image – – they represent your company’s unique brand. As your business grows, the value of your company’s intellectual property will grow as well. It is critical you take meaningful steps to legally protect this information from the beginning so competitors can’t use it to gain business and customers that should have gone to you. Furthermore, anyone provided access to your confidential intellectual property should be required to execute a carefully drafted non-disclosure agreement that protects you both during and after their employment or engagement. Your company name and logo should be trademarked (and the contract with your contractual graphic designer should be clear that you own all rights to the logo!). Guard your intellectual property just as diligently as you would guard cash in your bank account.
- Do Not Use Stock or Membership Units in Your Company as Currency. It is too easy for startups to offer ownership interests in the company in lieu of paying vendors or employees. While this might seem like an easy way to reduce costs or save cash early on, those “meaningless” shares could cost you dearly down the road. By making someone an owner of the company, no matter how small their share, you create fiduciary obligations to those individuals in terms of how you manage and operate the company. Moreover, you are now going to have to deal with that individual for the life of the company unless you buy them out later on, often at a substantial price increase (and this assumes your startup documents were properly drafted up front to provide a buyback option…see pitfall No. 2, above!). Plus, give away too much and soon you’ll find that you are working for someone else’s company. Vigorously protect the ownership of your company, strategically giving away pieces only when absolutely necessary.
Michael S. Fauver, Partner
DISCLAIMER: This Advisor is one of a series of business, real estate, employment, estate planning and tax bulletins prepared by the attorneys at Fauver, Large, Archbald & Spray, LLP. This Advisor is not exhaustive, nor is it legal advice. You should discuss your particular situation with us or with your own attorney. Our legal representation is only undertaken through a written engagement letter and not by the distribution or use of this Advisor.