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7 Legal Mistakes to Avoid When Starting a Business

January 31 2021

 

Have you ever been in love? What about your first love--are you guys still together?

 

Most people have had that “first love” when they just know it’s going to work out. Everything is perfect! Butterflies, puppies, and rainbows.

But things happen. People change. You find out that things weren’t as they seemed.

It’s not just love either. It’s an old business idea that didn’t work out. An old friendship that fell apart. A deal that fell through.

All these things are just like your business. You knew everything would work out with (insert any business relationship, partner, contractor, investor, banker, landlord, etc.) because you were a fair person and so were they.

But all too often things don’t pan out as you planned.

That’s where these 7 Legal Mistakes come in. These are the critical legal mistakes that most business owners don’t predict. Or they don’t think about them. Or they think about them but don’t address them because “they’ll never be a problem.”

But these mistakes are so common that if you don’t address them in the beginning of your business, the consequences will be tragic down the road.

This being said, it's not all bad news. The upside is that you can usually DIY prevent all these mistakes.

 

Mistake #1: Relying on Google

First let me throw in a caveat--Google is FANTASTIC for researching the legal issues you know to look for. There are thousands of resources, contract templates, and generally great articles out there. And best of all, it’s free!

But relying solely on Google is the one of the biggest mistakes entrepreneurs make.

Here’s why: you probably “know” about 20% of the legal issues that might impact your company. If you want to start a company, you’ll search “start a company” and if you want to hire someone, you might search for “contractor template.”

But for both of those topics, 80% of the problems that occur result from issues you wouldn’t have known to search for.

So, if you’re starting a company, you might be told to make sure you have an operating agreement, but what if you aren’t aware of all the issues that need to be addressed in that agreement? Or why they’re important?

Or what if you don’t know that you need to do a trademark search to make sure your company name isn’t already used by someone else? You might be told to make sure no other company in your state uses the same name as you, but that doesn’t mean a company in another state hasn’t already registered the name.

So, despite all the advantages Google brings, a sole reliance on search results too often causes early stage companies and the dreams that come with starting those companies to be ruined.

  

Mistake #2: Not Protecting Your Confidential Information

 

The sexy thing to say here is, “You just have an idea, and any investor or prospective buyer would balk if you told them they had to sign an NDA before you shared it with them. You’d get laughed out of the room!”


But that’s a huge oversimplification. While not all information or ideas are confidential confidential, there's a good chance that your company is getting some advatage because some of it is. And if you share confidential information (think: a customer list) with someone without getting their consent to keep it confidential, then you just lost all the value of what you shared.

In other words, if you shared that customer list with a possible buyer without an NDA, it’s no longer a trade secret, which makes it worth nothing.

 

EXAMPLE

Imagine you hired a contractor, virtual assistant, or employee to manage your social media accounts for your online business. He didn’t sign any contract and had access to all your confidential info in your main Google Drive.

The contractor falls off the map and you find out months later he got an offer to work with a competitor who created a new product similar to yours. You know the contractor took all your confidential information and gave it to your competitor. And even worse—they also took your customer list, so the competing business is suddenly stealing your best customers.

What would you say if you found out you had no recourse? You could say they stole trade secrets, but if your “confidential information” wasn’t protected, the information is no longer a trade secret and the information was never confidential in the first place. Even the customer list—that’s almost always a trade secret. That is, unless you didn’t keep it confidential, and it loses its value.

 

Mistake #3: Not Assigning your IP

 

Imagine that you and your co-founder create a product that automates the automation of sales. You had the idea,but your co-founder wrote all the code. After you develop the product, you form an LLC.

When you formed the LLC, you didn’t have any IP assignment contract indicating that the code your co-founder wrote was assigned (think of “assigned” as being an ownership transfer) from him to the company.

A year later, you and your co-founder get in a dispute and he leaves the company, starts a new company, and profits substantially using the exact same code your company was using. He later sues you for stealing his technology.


The crazy part is that he can do that. At no point in time did the company actually own the IP your co-founder created. This is why you need to either assign all relevant IP to your company or license it.

 

Mistake #4: Hiring a Contractor Without A Written Contract

 

Let’s build on that last mistake. So you hired your friend from college to create your logo. He’s your friend so you didn’t think you needed any written contract. Your company and goodwill take off and two years later, a competitor emerges with a logo nearly identical to yours.

You try to sue for trademark infringement, but you’ll probably lose because without a written contract, your friend (the logo designer) owns the IP and you merely have a license to use it.

 

Without a written agreement with your contractors, you’ll run into a host of other problems, the biggest being unfulfilled expectations. Let’s say you hired a contractor to “build your website.” What specifically does he build? Do you get veto power if it doesn’t meet your expectations? Does the “website” include the blog you wanted or other landing pages?

A written contract with precise terms could have cleared all that up. In this example, a work-made-for-hire provision and IP assignment provision along with clear terms about expected deliverables could have prevented these problems.

 

Mistake #5: Making The Wrong Decisions (Or Not Making Any!) When You Start Your Business


When you start your company, there’s a bunch of legal tasks you need to complete.

Some are commonly known. For example, most people know to set up an entity. And that they have a choice between LLC, Corporation, and Nonprofit Corporation. A lot of people also know you form your entity in one specific state--and that Delaware is very popular!

But other tasks often get put on hold and are never completed. Do you have an operating agreement or bylaws for your company? Did you know that even as a single-member LLC, you should still have an operating agreement?

So what kind of problems does either putting these tasks on hold or making the wrong choice cause?

Let’s start with setting up your entity. Did you think you needed to form in Delaware? Have you ever actually wondered why that is? While Delaware is great for certain companies, often setting up in your home state makes the most sense. This is because you avoid having to pay fees for two states--your home state and Delaware.


And what about the entity you picked?

For most companies, LLC’s are best. For startups, Corporations are often better.

Quite simply, it’s because startups aren’t usually making money in the beginning so they don’t have to worry about the dreaded “double tax.” And startups are better and more simple when you want to pay equity as compensation to fellow founders or employees. Investors like corporations better as well for a lot of reasons we discuss here.

Finally, what about the tasks that are put on hold or never completed? Like not having an operating agreement or bylaws or not having a good version of those organizational documents? Or not conducting a trademark search?

See examples for what could happen if you don’t have an operating agreement here. This applies especially if you have partners. 

If you don’t do a trademark search, you could eventually lose all your goodwill when you find out a year into your business that another company had your name trademarked and forces you to change your logo and business name.


Honestly, there’s a lot of things that should be addressed at the beginning of your company, so we put together an actionable checklist for single-member LLCs to help cover them in more detail.


 

EXAMPLE

Imagine this scenario: you and your co-founder form an LLC, and you both agree that everything will be “fair” and you’ll split everything 50/50. When you formed, you were both devoting full-time work to the LLC. But a few months later, your co-founder starts a second business that arguably competes with yours and only works part-time for your LLC. He then sells half his interest to someone you’ve never met. Then, a few weeks later, you find out he took out a $10,000 loan on behalf of the company. You want to kick him out of the LLC, but you can’t unless you have a contract provision that allows that.

 

A properly drafted operating agreement could’ve prevented all of this by including:

  • An expulsion provision;
  • A provision restricting transfer of interests;
  • A provision indicating how much contract authority each member has, if any;
  • A provision outlining the required amount of work each member must to commit to the company.
     

 

Mistake 6: Failing to do all the Common Legal Tasks After You Form

There are 3 important issues you should take care of after you start your business, and many people ignore at least some parts of each.


You need to do the proper corporate formalities.


Why? For one, you can lose your “corporate veil” which means you’re more exposed to liability. Also, it’s great to keep track of things like votes on big decisions so your co-founder can’t come back later and say he never agreed to some decision that caused the company to lose a lot of money.

Also, there’s other formalities like filing annual reports that, if you fail to do them, you could be administratively dissolved (this has endless problems associated with it, so don’t mess with it).


You need to get the right licenses and permits.

Generally speaking, there’s federal, state, and local (think city and municipality) licenses and permits. Not a lot of people realize just how much red tape they see it. 

The best example I’ve seen of this is if you create some type of product. Do you know about the CPSC? You need to know about them.


And for things like local licenses, did you know that sometimes you need a business license even when operating out of your home on a website? Whether you need one or not can sometimes be completely arbitrary, so there’s no rule of thumb. You just need to figure out if you need one (hint: contacting your city hall often is the easiest way to figure this out).

What happens if you don’t do this? It depends. Sometimes it might be something as small as a $50 fine. Other times, the government will shut down your business. So, it’s not worth taking any chances on.

 

You need to pay the right taxes.


Everyone knows about income tax. But what about sales tax? Or FICA (Social Security and Medicare)? FUTA (Federal Unemployment Tax)? Have you talked to an accountant or CPA to find out what’s necessary?


Are you paying quarterly taxes, a requirement for businesses? Many pepole aren’t used to that if they came from a background as an employee.


Here’s a great checklist for what you should do after you’ve formed if you’re an LLC.

Mistake 7: Waiting Until It’s Too Late

 

This is truly the biggest mistake entrepreneurs make. The problem with “waiting until it’s too late” to resolve legal issues is that once it’s too late, no one wants to sign a contract. You can’t go back in time and get the person you’re in a dispute with to agree to XYZ. It never works that way.


If you were married and your soon-to-be ex-spouse wanted a divorce that would entitle her to 50 percent of all assets, do you think she’s going to sign a contract after the fact that says she’s only entitled to 10 percent if she initiates the divorce?

 

Of course not. But she might’ve signed it before you were married.

 

If you’re an early stage company and you run into one of these types of legal mistakes, for many of them, it’s going to destroy your business (if you’re a mature company, chances are you’ve hired a lawyer to help you avoid these problems).


If you suddenly own no IP or have to rebrand your entire company, that’s probably going to be the death knell. Or if you suddenly have to defend litigation from a co-owner or former employee, you most likely don’t have the resources to do that.


So what does this all mean?


I wrote this because I wanted to raise awareness about specific legal problems so many entrepreneurs are making. And to point out the consequences of failing to address those problems.


But it’s not designed to just freak you out. Instead, it’s to say, “hey, you’re probably overlooking some stuff, and you can solve most of these problems on your own.”


Don’t think you need to hire some high-priced lawyer to resolve this. You just need to know what the problems are, then you’ll know what to look for on Google.

 

In other words, you need to know what you don’t know, and then resolve it now rather than later so you can keep crushing it with your business and not get taken out by something silly like what we discussed here.

(NOTE: Learn about 62 other common avoidable mistakes you could be making so you can solve them on your own with your free Complete Legal Guide to Running Your Company).

Chris Daming, J.D., LL.M.

Written by Chris Daming, J.D., LL.M.

Chris is the founder and CEO of LegalGPS. Previously, he served in the Army (82nd Airborne), then went to law school and got his J.D. and LL.M. He practiced law and ran the Startup Legal law firm before founding LegalGPS.

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