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Last 12 months, greater than 5 million recent firms were created in the United States. While this may occasionally be great news for innovation and the U.S. economy, startup founders face a unique set of legal challenges that might hinder their success.
Some common problems include:
- Starting a business while still employed elsewhere
- Offering shares to investors at different prices
- I do not understand capital letters
- Improper use of form documents
- Poorly documented accounts
- Not paying employees or treating everyone as contractors
Imagine the following scenario: Jack and Jill were employed at BigTechCo, but Jack left a few months ago. He contacted Jill and asked her to leave BigTechCo and start a recent company, HillCo (Jack may have violated his non-solicitation agreement with BigTechCo by asking Jill to leave).
Jill says no, but agrees to work with Jack on HillCo, which can run a competitive business to BigTechCo: a SaaS product. Because Jill is still employed by BigTechCo, BigTechCo will likely own any mental property rights that she purports to acquire for HillCo while still employed by BigTechCo.
Additionally, Jill is likely to be in violation of the conflict of interest policy and her duty of loyalty to BigTechCo.
Jack and Jill verbally agree to a 60/40 equity split (Jill/Jack), but never document it.
Jack and Jill copy and paste BigTechCo’s terms of service and privacy policy onto the HillCo website. BigTechCo has privacy and security protections that HillCo does not, and as a result, HillCo is ultimately sued in a class motion lawsuit by site visitors.
Jack leaves six months to work with Jill. Jack claims to own 50% of the company, but Jill claims to own 40% of the shares, only a part of which should have been acquired. However, there is no equity documentation or vesting agreement.
Moreover, Jack claims that he never signed any contract with HillCo. He concluded that he was free to use any IP address he created; that it is not sure by any confidentiality provisions in favor of HillCo; and that HillCo is not authorized to use the mental property it creates.
Jill decides to disband the entity because fighting Jack for it is too expensive and burdensome.
Starting a business while still employed elsewhere
First, there could also be a conflict of interest with Jill’s employer and/or there could also be confusion as to who owns the mental property she created for HillCo while still employed elsewhere. To avoid this issue entirely, Jill should have first consulted her worker handbook or other moonlighting/conflict policy to see what approval she might have needed from BigTechCo.
Reviewing her employment contract would enable Jill to see what mental property her employer would own and which she created during her employment.
Typically, she could be secure if she created an IP address outside of business hours; whether it didn’t use the employer’s facilities, equipment or confidential information in creating the mental property; and if the mental property is not related to its employer’s current or anticipated business or research and development activities.
Offering shares to investors at different prices
Some founders try to attract early investors by issuing common stock at different prices. This can create tax and other problems for the company because the stock can’t be issued for $1 a share to an investor and then issued to an worker for free.
The best way to overcome this is to use convertible securities (i.e. SAFE, convertible bonds), which avoid tax problems and are easy and low cost to implement.
I do not understand capital letters
Founders sometimes don’t understand how they will likely be diluted as more shares or convertible securities are issued.
To avoid this, Jack could use a cap table management platform where he would see how he was diluted across various instruments. He could also conduct due diligence on the relevant documents to be signed when issuing securities.
Finally, Jack could create a model cap table for his next price round to see how he could be diluted by convertible securities.
Improper use of form documents
While business owners are at all times focused on the bottom line, founders sometimes find ways to cut costs, including saving money by using online forms (e.g., copying terms of service or privacy policies). However, without understanding the documents, there could also be contracts that can not be implemented. For example, in the case of a privacy policy, they may very well be sued for misrepresenting their privacy stack.
To avoid this, it is clever for founders to invest in basic forms. A good startup lawyer can prepare common forms and explain how they may be used in the future. This may prevent problems from occurring later.
Poorly documented accounts
While drafting contracts may be tedious, it is a essential precaution. For example, hiring co-founders and advisors without a formal contract may result in disputes over terms; no IP address assigned; failure to provide individuals with an obligation of confidentiality; and in fact it didn’t issue equity to the people to whom it was promised.
To avoid this, founders should hunt down and complete inexpensive advisory agreement, consulting agreement or stock purchase agreement templates as early in the relationship as possible.
Not paying employees or treating everyone as contractors
At the starting of a company’s existence, there are normally insufficient funds to pay early employees. As such, founders often hire everyone as contractors. However, this practice may violate state and federal law and may even result in personal liability for the founders.
To prevent this from happening, founders ought to be clever and hire people they’ll pay. They can then review applicable wage law and who qualifies as a contractor.
Please note that signing a consulting contract does not mean that the person signing it is the contractor. Both state and federal law have standards that supersede any findings.
Founders should understand the risks of not paying people. They must also go a step further and implement a separation agreement, even if the worker was considered a contractor.
The most significant thing
Starting a business takes work. It also requires due diligence to prevent avoidable legal issues as the company matures and founders hire co-founders, employees and advisors.