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It’s a Trap! Nine Legal Quagmires for Entrepreneurs to Avoid

Legal Traps and Mistakes

When JJ Abrams’ production company Bad Robot recently confirmed that filming for Star Wars Episode VII is officially underway, it got me thinking about the similarities between the wars fought in a galaxy far, far away, and the battles fought every day by the entrepreneurs in this solar system.

Entrepreneurship, with all its risks and unknowns, can often feel like Luke Skywalker’s treacherous mission to destroy the Death Star in Star Wars IV. Experts continue to debate whether entrepreneurship can be taught, or whether it’s something more like the Force: a natural phenomenon that someone is either attuned to or not. Putting aside whether you have enough midi-chlorians to start a successful business, everyone will have to dodge legal traps and obstacles along the way.

Most of the legal problems new entrepreneurs get themselves into are not the product of fraud or neglect, but rather ignorance. Here are nine examples, and tips (from a non-attorney) for avoiding them:

Forgetting to establish a founder’s agreement with all co-founders. By documenting who the co-founders of the business are, their rights and responsibilities, and the relationship they are entering into, you protect yourself from a former partner, or even employees and acquaintances, demanding compensation they aren’t entitled to. This can take the form of an operating agreement (for an LLC), corporate by-laws (for a corporation), or a partnership agreement (for a partnership). Among other things, every founder’s agreement should:

  • Describe what the business does.
  • Prescribe how and when the business will be terminated.
  • Include methods for resolving disagreements among founders.
  • Quantify what each partner brings into the business.
  • Account for how the business will handle accounting.
  • Establish how to distribute business assets when the agreement is terminated.

Failing to keep the company’s website “up to code.” Remember that pop-up window? The one where you quickly clicked “Accept” to sign away all your rights and download the newest version of iTunes already? Well, if your website sells anything at all, it also needs one of those agreements, and they are important. Terms of Service, Terms of Use, Terms & Conditions, and the Privacy Policy in 8 point font at the bottom of your website all help limit your company’s liability if the relationship between you and your customer goes sour. Take appropriate steps to safeguard user information collected through your website – for example, comply with PCI security standards if you collect credit card information, or HIPAA requirements if you collect health information. And don’t infringe on others’ intellectual property – remember to cite sources, give proper attribution, or obtain explicit permission or even a license before using others’ materials on your website.

Waiting too long to incorporate your business. The tax owed on your founders’ stock depends on it! If you file an 83(b) election with the IRS right after incorporation, you’ll owe a trivial amount of tax at the time shares are issued, and if you wait at least a year before selling, you’ll only pay the long term capital gain. Alternatively, if you delay incorporation until after you’ve raised a seed round, your business may have a substantial valuation making you liable for ordinary income tax on the value of the shares at that time. Ouch. Better to sidestep such an expensive and easily avoidable mistake.

Being too busy or too careless or too cheap to file a provisional patent application and protect secrets. A provisional patent application will hold your place in the patent line for up to a year, giving you time to prepare and file a non-provisional application. In the meantime, be careful about what information you disclose to the public online, in slide decks, or even at lunch with friends. Casual disclosures of your company’s secret sauce to the wrong people can undermine your ability to protect your intellectual property. Be cautious when speaking to anyone outside of the company about anything that could be considered a trade secret. Use non-disclosure agreements when appropriate, but be aware that some parties, including most investors and bankers, will never sign them.

Allowing online social networks to turn into a liability instead of a marketing tool. This normally goes without saying, but due to the recent glut of social media gaffes by major corporations, perhaps it bears repeating: always be aware that your posts are both public and permanent! Creating a company-wide social media policy is a great first step to ensuring that your tweet isn’t the next to go viral…in a bad way. Remember to be positive and transparent when responding to criticism of your business online because disappointed customers appreciate genuine engagement, and potential customers will be watching.

Non-compete negligence. Many business ideas start off as a side project while you remain a full-time employee at another company. However, if your new business has any similarity to the company you currently work for, your employer may have cause to take legal action. Before you go too far, carefully consider whether you are a party to any written, verbal, or implied non-disclosure or non-compete agreements from any current or former employers. Have every new hire do the same. If you are currently employed, be open and honest with your boss about any new ventures you are working on. Either your boss will be fine with what you’re doing, or it might segue into a nice opportunity to ask for a raise… As for former employers, do the same and you could end up with your first investor, or at the very least you’ll have an email documenting their response.

Leaving yourself exposed. Step one is to make sure you set up an appropriate legal entity (usually an LLC or corporation) as soon as you decide to go into business. And follow your attorney’s and accountant’s advice about recordkeeping and other practices so you don’t lose the protections provided by the legal entity. Next, not having enough or the right types of insurance could bankrupt your business, and possibly you and your family. Buy coverage for specific liabilities relevant to your business and industry. Run a store, restaurant, or manage a large staff? You’ll need defalcation insurance to protect yourself from employee theft. Network with friends and colleagues to find a trustworthy insurance agent that can evaluate your situation and sell you the appropriate coverage.

Promises, Ponzis, and Crowdfunding. Crowdfunding websites are multiplying like crazy and seeing huge growth in the amount of money they’re raising. Kickstarter alone has raised about one billion dollars for over 63,000 projects to date. More and more people are using these websites, and where there is money, there will be scammers and fraud. A good rule of thumb is to not over promise and under deliver (or break state and federal securities laws, obviously). Also make sure to at least consult with a good attorney before the stakes get too high. Even if you’re just collecting seed money from willing friends and family members, it’s never a good idea to take money without full disclosures and proper documentation. Carefully read the Terms and Conditions of any site you are considering to host a crowdfunding campaign. Make a habit of regularly communicating with your backers, and be transparent and honest if you stumble.

Hiring unpaid interns. Make sure your internship program complies with state and federal guidelines. Even if the intern wants to work for free, the government can decide that the intern should be paid, and force you to cough up back pay, back taxes, and penalties. To be safe, you should only hire paid interns from the start, or nix the internship program altogether since you’ll always get the best results from true employees. There is a wealth of advice online for how to recruit the best candidates for your startup or small business. You should also consider the expertise of independent contractors instead of “part-time for college credit” help.

Do you have any stories you’d like to share about a legal trap your business fell into? Post in the comments section below. Your story could keep another small business from falling to the Dark Side…by which I mean going out-of-business.

Needless to say, I am neither an attorney nor Yoda. This article only represents general information, and is not intended to provide legal advice. You should hire a qualified attorney to advise you on all legal matters.


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Author(s) (other articles by )
Original Publication DateJune 12, 2014
Related categoriesLegal, Lessons Learned

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