Doug Ramler of Gray Plant Mooty walks us through legal requirements that new businesses often overlook
Starting a new company is hard work, and even the best-laid business plans go awry with alarming frequency. We’re in no mood to recount any of the depressing statistics that suggest most businesses fail during the first few years of life.
Most budding entrepreneurs, particularly first-timers, assume that translating an innovative idea into a scalable, profitable enterprise is the toughest, most time- and attention-consuming aspect of startup management. But running an early-stage company is about more than inspiring a talented team to realize a disruptive vision.
“There are many legal considerations involved in starting a business,” says Doug Ramler, a Gray Plant Mooty attorney who oversees the firm’s technology group. “For individuals who haven’t previously started a company, it’s common to overlook some.”
Ramler’s group helps technology companies at every stage of the business lifecycle — “we work with early stage startups, $100 million companies, and everyone in between,” he says — keep these considerations straight, setting a strong legal foundation for (hopefully) many successful years.
Ramler recently identified 10 common startup mistakes for budding business owners:
- Not Setting Up a Legal Entity. “You don’t have to incorporate a legal business entity,” says Ramler, “but it’s a very cost-effective way to protect your personal assets from business creditors.” If you do form an LLC, he adds, the key is to maintain strict separation: Don’t commingle personal and business finances or use personal property for business use. Without strict separation, your creditors may have legal standing to “pierce the corporate veil” and seize personal assets to settle bad business debts.
- Not Properly Allocating and Restricting Equity. If you’re compensating employees with equity, particularly early in the game, it’s important to have awkward conversations (and put in writing) what that equity is for. In other words, why is Person A entitled to 20% of your company from day one? Ramler recommends restricting equity until certain goals or obligations are met, such as three years of service to the company. This prevents early employees from “disappearing” and taking a significant chunk of the firm’s equity with them.
- Failure to Consider Tax Issues. Every transaction has some sort of tax implication, says Ramler. The IRS doesn’t have the resources to scrutinize every single dealing, “but it can be very painful when they do,” he adds. When in doubt, consult an attorney or tax professional.
- Failure to Comply with Securities Law. Recently, Ramler’s team worked with a larger client involved in a $25 million transaction. As the transaction progressed, it became apparent that the firm hadn’t followed applicable securities law, nearly scuttling the whole deal. “It’s actually not that hard to follow securities law,” he says, “but it can be catastrophic when you don’t.” One of the most common errors: failure to retain a third party to confirm that only accredited investors participate in fundraising rounds.
- No Written Assignment of Intellectual Property. Intellectual property producers have broad ownership rights to their work. If you hire an employee or retain a contractor to create intellectual property for your company — i.e., build a software platform — you need to have a written agreement assigning said property from the individual or entity to your firm. Otherwise, that person or entity essentially has a lien on the IP, creating massive headaches down the line.
- Failure to Protect Intellectual Property. Once assigned, IP must be protected with a patent, trademark, or other appropriate instrument. Ramler isn’t a patent lawyer himself, but he’s well-connected in the field and routinely points startups to attorneys capable of conducting thorough patent and trademark searches.
- Failure to Use Written Agreements. Intellectual property isn’t the only matter that demands written, legally enforceable agreements. “Verbal understandings are great until something goes wrong and you have to figure out what was actually said or agreed to,” says Ramler. “That can be a nightmare.” And written contracts are far less likely to produce legal action: “98% of potential disputes go away with written agreements,” he adds.
- Not Identifying, or Misclassifying, Employees and Contractors. Thanks to high-profile lawsuits against Uber and other “sharing economy” companies, labor classification is a hot issue these days. “It’s so easy to say to a worker, ‘You’re hired as an independent contractor; look for your 1099 in the mail next year,’” says Ramler, “but if that worker works exclusively for you and you set the terms of his or her employment, that may not be the appropriate course of action.” According to Ramler, the IRS has nearly two dozen regulations covering the employee-contractor issue. Entrepreneurs need to understand them — or work with an attorney who does.
- Not Working with an Experienced Startup Attorney. A bit of self-serving advice, to be sure, but sensible nonetheless. According to Ramler, entrepreneurs resist working with startup attorneys mainly due to the expense — downloading incorporation documents from LegalZoom or working with a lawyer relative tends to be cheaper than retaining someone like Ramler. But going the cut-rate route increases the risk of a costly, possibly fatal oversight down the road. “Starting a business is about much more than filing incorporation documents,” says Ramler. “Working with an attorney who has practical experience can save a lot of financial pain and stress down the road.”