Let's just say it: entrepreneurs are scrappy. We're curious, resourceful, gritty, independent. We are good at figuring things out and thrive when we're navigating new situations.
Most of the time, this works out great! Sometimes, it doesn't.
One of the most common questions business owners ask is "When should I involve an attorney? What should I be looking out for?" Here are six common areas of your business where there are legal issues to navigate. When you encounter one of these areas, it should trigger a call to your attorney! Discussing these things with your business attorney first will help you avoid some common mistakes.
1. Choosing Your Business Entity Type
The first step when forming a business is to decide what type of entity is the best form for your business. This decision depends on your business goals, timeline, structure, liability, management, and tax considerations. Non-tax factors are usually the primary considerations because, in some instances, an entity can choose how it's treated for tax purposes.
Businesses are formed under state law and can be corporations, partnerships (which come in several flavors), and limited liability companies (which can also come in several flavors). The state law classification of a business is not always the same as the federal tax classification of a business. For tax purposes, a business is treated as a disregarded entity, C-corporation, S-corporation, or a partnership. The tax classification is important because the tax rules are quite different for each classification.
You should discuss your business goals and timeline with an attorney so you can select the ideal entity type from the start. Entity selection isn't one-size-fits-all, and it's important your attorney understands your future growth and capital-raising plans to avoid future changes to the entity type. Some entity types that are commonly recommended for other businesses may not be a good fit for your growing startup, so being aware of how your unique factors impacts your overall decision is important. A lawyer can help you choose the type of legal entity that best supports achieving your goals from legal, tax, and early-stage investment perspectives.
2. Business Governance Documents
Your choice of entity will determine what specific business governance documents you need; corporations will have bylaws, an LLC will have an operating agreement. These foundational governing documents formalize the relationship between the company founders and keep you from doing business based on an unwritten, informal understanding. Business owners should avoid acting through oral agreements -- even (especially!) with friends and family members. Good governing documents protect important relationships and the strengthen your business.
Your attorney can provide you with recommendations for what documents you need and what they should include. A comprehensive set of governing documents will set out each founder's role and responsibilities, including the day-to-day operations of the business. These documents will also memorialize each founder's ownership percentages, as well any loans made to the business. They will specify how you and your co-founders will make key decisions, for example, about capital raises and the sale of the business, and identify a mechanism for solving disputes between the founders (such as how to break a tie if two founders disagree).
This process requires a modest commitment of time and expense, but it will go a long way in identifying and resolving any fundamental differences between the founders at the outset. The company and its leadership will be stronger as a result.
3. Raising Capital and Issuing Equity
a. Raising Capital
When raising capital, it's essential that your business complies with federal and state securities laws, which apply to all offers and sales of securities, including to friends and family. If your company will be issuing securities (selling shares, issuing membership interests, convertible debt instruments, conducting a SAFE financing, etc.), you must have a valid exemption from federal and state registration. If no exemption applies, then you must register your offering with the SEC.
An attorney can help you identify a federal registration exemption and comply with state blue sky laws. If your company will issue securities to non-accredited investors, even close friends and family, you should proceed with extreme caution. Rule 506 of Regulation D, the most commonly relied on exemption from federal securities registration, is generally only practical in securities offerings made solely to accredited investors. Talk to an attorney before you begin raising money so you can take appropriate action. It's worth it to avoid regulatory action or harming the economics of a future investment in your company.
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b. Issuing Equity
Security laws also apply when issuing equity compensation, so talk to your attorney before you issue any shares or membership interests to non-founders. Many companies don't have the cash flow to pay the high salaries or match the benefits offered by established businesses. As a result, most new companies offer some form of equity compensation (for example, stock options, restricted stock, or a profits interest) to compensate, retain, and motivate their employees.
Consider how much equity your company should designate for employees, and then consider how that will impact your overall funding strategy. Your attorney can help you understand the legal implications, tax consequences, and accounting treatment of granting each type of equity award, including any vesting requirements.
4. Protect Your Intellectual Property
a. Clear Your IP
Before you invest any value in your brand name, logo, and domain name, be sure to clear the rights to them. Do this while your business is still in the conceptual stage to avoid spending time and money creating IP that may not be useful in the long run. Protecting the IP will secure the right to use those trade designations when and where you want to sell your products or services. And, registration will prevent other similar businesses from using your them.
b. Develop an IP Strategy
It is essential that founders develop and implement a comprehensive IP strategy to ensure that the company has (and retains!) essential IP rights. A comprehensive IP strategy should cover IP creation, acquisition, and protection. It should also factor in your anticipated growth and expansion. Startups must ensure that the core IP is owned by (or at least securely licensed to) the business. Work with your lawyer to determine the appropriate kind of IP protection for your company, taking into account how likely you are to obtain that protection, the time and costs required to obtain it, and the length and strength of that protection.
c. Protect Your IP Rights
Founders can plan for growth and success by filing proactively for rights protection in the U.S. and in foreign jurisdictions where your company reasonably expects to do business. Startups should make a list of all the countries where the company plans to operate, then decide where the company can afford to file. Consider taking advantage of intent-to-use U.S. trademark registration, which allows your company to register a trademark before actually using it, if the company has a genuine intent to use the mark in connection with the goods or services listed in the application.
It's also essential to protect your company's IP in early-stage business activities. There are many practical steps you can take to safeguard confidential business information and trade secrets. For example, ask your attorney about confidentiality and nondisclosure agreements, registering copyrights and using copyright notices, and clearing and registering trademarks and using appropriate notices.
Lastly, if you'll be using third-party content, it's a good idea to work with your attorney to create a process for adequately clearing that content and consider what rights must be obtained (including for social media and other non-commercial uses).
5. Paper Up Key Relationships
It's also important to properly document the key relationships for your company. Your attorney can prepare form agreements you can use for your core business activities early in the company's life-cycle. Don't rely on oral arrangements with customers, suppliers, and employees -- not even with friends and existing business contacts. And when you're negotiating contracts, don't assume that you have to accept all of the proposed terms. Your attorney can help you understand how contracts shift risk between the parties through indemnification, exclusive remedies, limitations on liability, and warranty provisions, and ensure you agree to the right contract terms.
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6. Hiring Employees
Companies must comply with state and federal wage and hour laws for all employees from the outset. All employees must first be properly classified as exempt or nonexempt from the federal minimum wage and overtime laws under the Fair Labor Standards Act. Nonexempt employees must be paid at least minimum wage and compensated for all overtime. For exempt employees, you must ensure that they perform the job functions necessary to qualify for the exemption.
If your employees work remotely, be aware that state and local laws govern the employment relationship, and there are many laws that may be more generous to employees than the federal laws. For example, some states or cities require employers to provide paid sick leave or other benefits, and many have a higher minimum wage than the federal wage.
It's also essential you properly classify independent contractors and unpaid interns. Failure to do so can lead to substantial liability in several areas, including overtime pay, taxes and penalties, and employee benefits. Pay college students or recent grads performing services for the company at least minimum wage and overtime unless they meet the strict qualifications for unpaid interns under the FLSA.
If hiring employees is on your horizon, then plan ahead for payroll and benefits administration. However, don't assume that using a professional employer organization (PEO) or temporary staffing agency insulates your startup from liability for employment law violations. Founders must understand that they may be personally liable for unpaid wages, even if the business fails.
Lumin Law can help you navigate these issues and ensure they are properly addressed in a way that furthers your business goals. If these topics are on your horizon, please reach out and connect.