What are some common legal mistakes made by startups?

Takeaway: The biggest legal faux pas is failing to file an 83(b) election on time. This is usually annoying and expensive to fix. The second biggest is being too casual with having folks sign PIIAs and then realizing you don’t own all your IP. The biggest business mistakes made by startups are usually hiring the wrong people or scaling too fast.

Starting a new business can be a complex process, and it's important for startup founders to be aware of potential legal pitfalls. Here are some common legal mistakes made by startup founders and how to avoid them.

Failing to Incorporate at the Right Time

Many startup founders make the mistake of operating as a sole proprietorship or partnership instead of incorporating their business. This can put personal assets at risk and make it harder to raise capital or sell the business. Incorporating the business provides legal protection for the founders' personal assets, helps with fundraising, and makes it easier to ultimately transfer ownership of the company.

A similar mistake I sometimes see is a startup using a non-law firm service to incorporate and failing to properly appoint their board of directors. All corporate actions taken after that may not be properly approved, which can pose an issue down the road if it is not caught early. A similar situation happens with appointing the company’s officers though this is more easily remedied.

Failing to File 83(b) Elections

This is a big one that can be easy to forget. It is essential to timely file 83(b) elections for all stock the company issues that is subject to vesting. There is a strict 30 day deadline and failing to file on time results in some pretty unfortunate tax withholding on the company’s part and recognition of “phantom” income on the stockholder’s part. There is no perfect fix for this. I wish the IRS would get rid of the 83(b) election requirement for startups but here we are.

Not Having Proper Contracts

Another common legal mistake made by startup founders is failing to have proper contracts in place. This can include contracts with employees, vendors, customers, and investors. Without proper contracts, there is no legal protection for the business, and disputes can arise that are difficult to resolve.

Being Casual With Intellectual Property Ownership

Intellectual property (IP) is a valuable asset for many startups, but founders often overlook the importance of protecting it. Having every employee and consultant sign a proprietary information and inventions agreement before they start work (i.e., at the same time they sign their employment agreement) is essential. In addition, patents, trademarks, and copyrights can help protect the business from competitors and ensure that the founders have exclusive rights to their ideas and inventions.

Hiring the Wrong People

Startup founders must be careful when hiring employees or contractors. It is critical to make excellent early hires - this can make or break a company’s early days. Failing to conduct background checks, not having proper agreements in place, or misclassifying workers as independent contractors can also lead to legal issues and costly disputes.

Raising Capital Incorrectly

Raising capital is essential for many startups, but founders must be careful to follow the proper legal procedures. This includes complying with securities laws, issuing stock or other securities properly, and ensuring that all investors are accredited or qualified. The angel investors that often fund early-stage companies are not always sophisticated on these legal issues and startups should not rely on them to ensure the investment transactions are legally tight.

Failing to Comply with Regulations

Many industries are subject to specific regulations, and startup founders must be aware of these rules and regulations to avoid legal issues. This includes areas such as data privacy, healthcare, and finance. Your law firm likely has subject matter experts that can assist with these specific regulatory areas.

Conclusion

Startup founders can avoid legal mistakes by incorporating their business, having proper contracts in place, protecting their intellectual property, hiring the right people, raising capital correctly, and complying with regulations. By being proactive and working with experienced legal counsel, founders can protect their business and avoid costly legal disputes.