Every startup is unique and different with individual circumstances and needs and there are avoidable mistakes that all startups should consider that can lead to legal complications. Complications which can jeopardize the long-term success of a business and future rounds of financing.
People like to give advice and share their opinion, but wise men seek counsel from someone who has been there and done that! AIN’s goal is to use our years of experience and all we’ve learned to help you.
Here are the 5 quagmires to avoid at all costs!
FAILURE TO DOCUMENT A FOUNDER AGREEMENT AT THE BEGINNING.
This oversight can lead to the so-called “skeletons in the closet”. Early co-founders sometimes drop out of the picture due to disagreements and you might forget about them, but they don’t forget about the verbal agreements you two made. Later when your venture is closing on financing or even going public, that forgotten early partner surfaces demanding shares, warrants or even money.
This problem can be avoided by incorporating immediately and issuing shares to the founders, which are recorded in the minutes of the corporation. Everything you discuss should be documented. There’s a great tool we use titled “Elements To The Perfect Agreement”. This text helps to identify and document expectations between partners. We also recommend and use Laughlin & Associates for all our “Corporate Compliance” . They help make sure Corporate records include minutes and proper documentation that meet legal requirements for everything done on behalf of the corporation.
INCORPORATE & ISSUE FOUNDERS SHARES IMMEDIATELY.
Many startups delay incorporation until the first formal round of financing, which is too late. At this point your entity may already have several million in valuation, so the IRS can tax your shares as income at that value immediately. This is called “phantom income” and is to be avoided at all costs. If you don’t, you might have to pay taxes on stock that has no liquidity and or real cash value.
The solution again is to incorporate early, when founders’ shares clearly have trivial value. Also, file an “83(b) election” with the IRS within 30 days of the agreement. Then you will only have pay tax on the increased value of your shares when they are sold.
DISCLOSING PATENTABLE INVENTIONS BEFORE THE PATENT APPLICATION IS FILED.
Entrepreneurs often put off the hassle and the cost of filing a patent until their first funding. Sometimes they share their invention with the public, the might even launch and start selling their product before filing a patent application. Eventually, they realize that not filing a patent has them looking like a novice, which investors will likely shy away from.
There is no excuse for not filing at least a provisional patent early. This will hold your place in the patent line for a year. The costs and time for this provisional filing are generally less than a full patent would be. Trade secrets need to be documented, and reasonable steps taken to keep them secret. Business plans and other documents should always be labeled as confidential.
MAKING SURE YOU ARE LEGALLY COMPLIANT BEFORE ACCEPTING MONEY FROM INVESTORS.
Laws can be very complicated. Many times, federal laws don’t necessarily line up with state laws, which make it difficult for the novice entrepreneur to understand what applies to them. With the new crowdfunding laws, things are changing dramatically state by state and on a federal level. Bottom line, make sure to get legal counsel when raising capital to ensure you comply with both state and federal laws.
Overall, the biggest legal mistake that a startup can make is to assume that legal problems can be resolved later. Finding a lawyer early is easy, we use and recommend James E. Burk at the law firm of Burk & Reedy. In reality, it will cost you much less to get it right the first time, when the stakes are still low, compared to the heartache and cost of correcting something later.
ALLOCATE FULL TIME TO RAISING YOUR CAPITAL AND DON’T STOP UNTIL THE JOB IS DONE!
We see hundreds of deals every month. Way too many entrepreneurs start the process of raising capital, get a portion in the door, then start to focus on the business without finishing the financing round. They end up in a situation of never having enough money to actually implement the business plan as outlined and then end up raising money for months and even years. I am guilty of this myself, which is why I don’t want you to do down that road.
I think it is great advice to get your plan for funding together and go at it full bore nonstop until the money you need is raised. Don’t let off of the throttle one bit after you get the first few checks in the door. Work at it full time until completely funded before you executing your plan.