As Chartered Accountants involved with startups, we have seen plenty of legal mistakes made by entrepreneurs and start-up companies. The following are some of the most common legal mistakes we have come across and the startups should make sure they do not commit the same.
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Not making a clear deal with your co-founders
You definitely have to agree with your co-founders early on what the deal is among you. Not doing so can cause enormous problems later. Splitting up mid way does favour neither to the founders nor to the company and has in many cases brought the down fall of the entire setup. Below mentioned are the key deal terms you need to address in some kind of written founder agreement:
- Shareholding pattern of the company?
- Is the percentage of ownership subject to continued participation in the business?
- What are the roles and responsibilities of the founders?
- How much time commitment to the business is expected of each founder?
- What are the salaries (if any) the founders are entitled to? How can that be changed and how it is to be decided?
- If one founder leaves, who does he sell his shares to? Does the company or other founders reserve a right to buy back that founder’s shares? If so at what valuation?
- What happens if one founder isn’t living up to expectations under the founder agreement? How is it resolved?
- How are key decisions and day-to-day decisions of the business to be made? (Majority vote, Unanimous vote, or certain decisions solely in the hands of the CEO?).
- What is the overall goal and vision for the business?
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Not starting the business as a corporation
One of the very first decisions that founders must make is in what legal form to operate the business, but founders often start a business without consulting a Chartered Accountant and, as a result, often incur higher irregularities and become subject to significant liabilities that could have been avoided if the business was started as a corporation.
The types of business forms that are available to a startup business are as follows:
Sole Proprietorships : A sole proprietorship requires no legal documentation, fees, or filings other than state and local business permits. But there are disadvantages in operating as a sole proprietorship: (1) it only has one owner and if additional capital is required from another investor, the form is not available and a partnership or other entity form is required and (2) a sole proprietorship provides no protection for the founder against creditors of the business (in other words, creditors can directly sue the founder), in contrast to corporations where, generally speaking, the creditors of the business cannot successfully sue the founders and other investors. We don’t recommend sole proprietorships.
General Partnerships : If there is more than one founder, a general partnership is often chosen as the legal form of business entity. Preferably, the founders will agree on a partnership agreement to “set the terms” among the founders. Each partner of a partnership is generally liable for the debts of the business and thus exposes the personal assets of each partner to the business’ creditors. We don’t recommend forming a general partnership.
Corporations and limited liability partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax, and accounting issues. However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLPs, and ease in raising capital in contrast to sole proprietorships and partnerships.
Sole proprietorships and partnerships can later convert to a LLP, or other legal entity but keep in mind that the conversion costs can be significant.
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Not coming up with a standard form contract in favor of your company
Almost every company should have a standard form contract when dealing with customers or clients. But, there really isn’t a “standard form contract,” as every contract can be tailored to be more favorable to one side or the other. The key is to start with your form of contract, and hope the other side doesn’t negotiate it much. Here are some key items to come up with your form of contract:
- Get sample contracts of what other people do in the industry. There is no need to re-invent a contract.
- Make sure you have an experienced counsel doing the drafting, one that already has good forms to start with.
- Make sure you make it look like a standard form pre-printed contract with typeface and font size.
- Make sure you have clearly spelled out pricing, when payment is due, and what penalties or interest is owed if payment isn’t made.
- Include a “force majeure” clause relieving you from breach if unforeseen events occur.
- Include a clause on how disputes will be resolved. Our preference is for confidential binding arbitration in front of one arbitrator.
- Include limitations on your liability if the product or service doesn’t meet expectations.
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Lack of employment documentation
Business startups often encounter problems when they do not maintain adequate employment documentation. Consequently, startups should have prepared a core group of employment documents to be signed by most, if not all, employees. A starting list of employment documents for a new company would typically include the following:
- Stock Option documents (if a corporation has been formed), including a Stock Incentive Plan, Notice of Stock Option Grant, and Option Agreement
- “At-Will” employment offer letters (signed by the company and the employee, acknowledging that the employee or employer could terminate employment “at-will”)
- Employee Handbook (setting forth company policies on vacation, conflicts of interest, internet usage, etc.)
- Benefit forms, for benefits available to employees and family members
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Not carefully considering intellectual property protection
If you have developed a unique product, technology, or service, you need to consider the appropriate steps to protect the intellectual property you have developed. Both the company’s founders and its investors have a stake in ensuring that the company protects its intellectual property and avoids infringing the intellectual property rights of third parties. Here are some of the common protective measures undertaken by start-ups:
Patents. Patents are the best protection you can get for a new product. A patent gives its inventor the right to prevent others from making, using, or selling the patented subjected matter described in words in the patent’s claims. The key issues in determining whether you can get a patent are: (1) Only the concrete embodiment of an idea, formula, and so on is patentable, (2) the invention must be new or novel, (3) the invention must not have been patented or described in a printed publication previously, and (4) the invention must have some useful purpose.
Copyrights. Copyrights cover original works of authorship, such as art, advertising copy, books, articles, music, movies, software, etc. A copyright gives the owner the exclusive right to make copies of the work and to prepare derivative works (such as sequels or revisions) based on the work.
Trademarks. A trademark right protects the symbolic value of a word, name, symbol, or device that the trademark owner used to identify or distinguish its good from those of others.
Confidentiality Agreements. These are also referred to as Non-Disclosure Agreements or NDAs. The purpose of the agreement is to allow the holder of confidential information (such as a product or business idea) to share it with a third party. But then the third party is obligated to keep the information confidential and not use it whatsoever, unless allowed by the holder of the information. There are usually standard exceptions to the confidentially obligations (such as if the information is already in the public domain).
Confidentiality and Assignment Agreement for Employees. Every employee should be required to sign such an agreement. It accomplishes several purposes. First, it obligates the employee to keep confidential the proprietary information of the business, both during employment and after employment. Second, it ensures any inventions, ideas, products, or services developed by the employee during the term of employment and related to the business belong to the company and not the employee.
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Not taking into account important tax issues
When starting a business, there are some key tax issues to consider. Here are some of the most common issues:
Sales Tax The company needs to collect sales tax on sales of its products, because failure to do so can have disastrous consequences. This issue is compounded if the company is selling in multiple states.
Tax Incentives Depending on the nature of the business, various tax incentives may be available, such as renewable energy tax credits and investment tax credits.
Service Tax The company needs to collect service tax on sales of its services, because failure to do so can have disastrous consequences.
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Coming up with a name for the company that has trademark issues, domain name problems, or other issues
When picking a company name, it’s important to do some research to help you avoid trademark infringement or domain name problems. You may be infringing someone’s trademark if your use of a mark is likely to cause confusion among customers as to the source of the goods or services. Make sure the name is distinctive and memorable. Don’t make the name so limiting that you will have to change it later on as the business changes or expands. Come up with five names you like, and test market it with prospective employees, partners, investors, and customers. Think about international implications of the name (you don’t want to have a name that turns out to be embarrassing or negative in another language). Avoid unusual spellings of the name. This is likely to cause problems or confusion down the road (though some companies like Google or Yahoo have been successful with unusual names, such success is often the exception rather than the rule).
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Not having a good Terms of Use Agreement and Privacy Policy for your website
Terms of Use Agreement sets forth the terms and conditions for people using your website. Your Privacy Policy is a legal statement on your website setting forth what you will do with the personal data collected from users and customers of the site, and how such data may be used, sold, or released to third parties.
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Not having the right legal counsel
In a misguided effort to save on expenses, start-up businesses do not make consultations with legal counsel. Founders should consider taking consultations from proper counsel who have experience in some, if not all, of the following legal areas:
- Companies Law
- Tax Regulations
- FEMA
- Excise, Customs Duty, VAT, CST and Service Tax Acts
- Contract law
- Employment law
- Intellectual property laws
- Real estate laws
Although it is not necessary that the counsel retained by the founder have experience in all of the foregoing areas because certain problems can be “farmed out” to different firms, it is often best that the founders retain a firm that can handle some, if not many, of the areas of expertise listed above so as to provide continuity between the founders and their counsel.
(Disclaimer: This is a guest post submitted on Techstory by the mentioned authors.All the contents and images in the article have been provided to Techstory by the authors of the article. Techstory is not responsible or liable for any content in this article.)
About The Author:
Aswin Kumaar P A, Managing Partner, P A A & Associates, Chartered Accountants leads the operations of the firm at Chennai. Being both an Electrical Engineer from PSG College of Technology and a Chartered Accountant he has far greater insights into tech and manufacturing startups. He works closely with startups in guiding them up to meet up with the requisite regulations and compliance. P A A & Associates has partners with immense experience in diverse fields such as Accounting, Auditing, Consultancy and Taxation of Corporates spanning over 6 decades. To contact the author drop a mail at [email protected]
