There are lots of good articles out there about how to succeed. Here are a few pointers on how to mess up your company from a legal perspective.
- Pick a name without checking it out. You may not be the first one to think of your name. Do some Googling. Go to the search function on the US Patent Office website and search the trademark database. Check with an IP lawyer about running a “knock out” search to try to identify any conflicts. You do not want to invest heavily in a particular name only to get a nasty letter from a trademark owner demanding that you “cease and desist” using that name. Here’s a bonus tip: go ahead and file an “intent to use” application. The filing fee is $350 but you could spend 10 times that amount or more if you fail to establish your rights early on.
- Have a vague understanding between cofounders. Some founders go with a handshake. After all, you were roommates in college and everything! But clarity is good for everyone. Work with your lawyer to document the ownership amounts and expectations for each co-founder.
- Give a bunch of equity to someone who later leaves. Everyone joins a startup with the best of intentions. But it does not always work out. Sometimes one founder stays and the other leaves. For everyone’s protection, put in place some vesting or other mechanism to get some or all of the equity back from someone who leaves.
- Get creative with the equity. Founders are creative people, otherwise they might have ended up as lawyers and accountants. Creativity is good, but not when it comes to the equity structure of your company. Unusual one of a kind equity incentives or contracts often have unexpected consequences. If it is too off the wall, you may have created a complicated problem that a future investor will insist get fixed before they will invest money.
- Fail to protect your Intellectual Property. Skipping steps like having a short invention assignment agreement for all your founders, friends and others involved can lead to fights about who owns an idea or software: the individual who created it or the company? Save yourself some trouble and have everyone sign a one paragraph invention assignment agreement.
- Do-it-yourself incorporation. One startup thought they had formed an LLC because they all signed some LLC articles of formation. But they never filed any documents with the state where they lived, so they never succeeded in forming an LLC. Even if funds are tight, find a lawyer to help you get that entity formed properly.
- What securities laws? The USA and every state have laws you must comply with to validly issue equity. What happens if you do not comply? For starters, an investor in an invalid offering gets a “rescission right” to unwind the transaction and get their money back. The government can also impose fines and penalties. One bad offering can disqualify you from using legally compliant methods in the future. One of the biggest mistakes? Announcing that you’re looking for investors on your website or otherwise generally soliciting the public for money. While general public solicitation is now allowed in limited circumstances, you may greatly limit your ability to raise funds from certain sources (like your nana in Minnesota!).
- Don’t pay any attention to taxes. Corporations and LLCs are taxed differently. Choose wisely. If you pay people, you need to know whether they are an employee or independent contractor and whether any taxes need to be withheld or paid. Here is an easy one to miss: the IRS 83(b) election. Say you issue stock to a founder that vests over time. When that stock vests, the value of the stock will be taxable income to that person based on the value at that time. So if the value goes way up, the taxable income goes way up. Filing an IRS 83(b) election allows you to take all that value into income on the front end, when values are low. You will want to have your lawyer or accountant help you with the technicalities of filing an IRS 83(b) election.
Starting a company is hard enough. Don’t make it harder by falling into these common traps.