Starting a business can be fraught with potential legal issues that are often overlooked by first-time entrepreneurs. Many details that don’t seem pressing at the start can mean the difference between success and failure later on. But many common pitfalls can be avoided with the right planning and execution. Here are five mistakes small-business owners make -- and how to avoid them.
Mistake No. 1: Making handshake deals with clients and vendors.
Always put your business dealings in writing. Don't naively assume that everything will go according to plan. "This is often not the case, and when things go wrong, the entrepreneur and the client or vendor may have different ideas about what is supposed to happen," says Rachel Rodgers, principal attorney with Rachel Rodgers Law Office in Phoenix, Ariz.
How to avoid it: Keep a written for every relationship your business enters into to protect yourself from loss of time, money, and potential lawsuits.
Related: Helpful Legal Forms and Templates
Mistake No. 2: Choosing the wrong business structure.
Whether you choose sole proprietorship, S-Corp, or limited liability company (LLC), making a hasty choice can put your business at risk, and lead to painful tax bills at the end of the year. With a sole proprietorship you are not required to register your business with the state and it's often chosen by startups operating on a shoestring, but beware there's no wall between your business and personal assets. S-Corps and LLCs may cost more to set up and maintain but your business is kept legally separate from personal assets -- so it's less risky if your company goes under or is the target of a lawsuit.
How to avoid it: Rodgers recommends incorporation in most cases. Since it's a more complex structure, it shows customers, banks and investors that you're serious about being in business over the long haul. If you opt for the simpler route of sole proprietor, she suggests looking at business insurance to protect your personal assets in case your company is sued and loses. Of course, you'll want to consult with a lawyer or accountant to determine the best structure for your particular size and needs.
Mistake No. 3: Bringing on partners without a detailed agreement. Many entrepreneurs put this paperwork on the back burner in favor of "focusing on the business," but several problems can arise in the meantime. "One of the biggest boons to my startup practice has been the movie The Social Network, which revolves around the litigation surrounding the ownership of the ideas, code, et cetera, at the onset of Facebook," says Gregory Kratofil, an attorney and shareholder with the law firm Polsinelli Shughart in Kansas City, Missouri. No matter how much you like and trust your business partners, you need a legally binding agreement -- not just detailing operations and responsibilities, but also what happens if you have opposite views of where to take the company.
How to avoid it: Have the hard conversations now, when everybody's still in love, says lawyer William M. Moore, founder of the Moore Firm in San Diego, a law firm that serves entrepreneurs. That's when to put in writing important issues like who owns what shares, who has what power, as in the case of deciding a potential buyout.
Mistake No. 4: Establishing a 50-50 partnership. In theory, this sounds great, but ultimately when issues arise -- like whether to bring on new investors -- somebody has to be able to make an executive decision. If you deadlock on a major decision and nobody budges, the company is frozen in limbo unless one of you buys out the other. "It's very difficult for human beings to decide how to divide things up after there is something to divide up," Moore adds.
How to avoid it: Consider at least a 51-49 split instead, where one partner is at the helm with the power to make critical decisions in the event of a stalemate. "Remember, a business is not a democracy," Moore says.
Mistake No. 5: Filing a trademark without doing enough homework. If you think a quick Internet search or cursory look at the U.S. Patent and Trademark Office database is all you need before filing for a trademark, think again. You don't want to invest in a brand only to learn someone else came up with it first, says lawyer Frank A. Natoli, founder of New York-based law firm Natoli-Lapin LLC. For example, Natoli had a client who lost most of his $100,000 investment in branded inventory after another company with the same name shut him down.
How to avoid it: Do your research not only with the Patent and Trademark Office, but on the state level (each state has its own registry), in business directories like YellowPages.com, domain-name companies, and even the Canadian Intellectual Property Office.
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Comments:
Great post Lisa. I am a big fan of lists. Some other common founder mistakes that I used to see working as a SV startup attorney and now at UpCounsel are: 1. Neglecting to put vesting into founder stock purchase agreements or founder agreements 2. Forgetting to file 83(b) elections when vesting is put in place for a founder 3. Neglecting to assign past and future IP to the company Also for your trademark issues, we have used Markify in the past for name searches (both trademark and url searches) and a number of attorneys are starting to use it.
I am thankful to Lisa because, as a beginner of a small business venture, the article has assisted me by providing the quick and yet applicable solutions. This has enabled me to avoid what would have been big mistakes to my venture andpossiblly led to a likely withdraw from the investment. Thank you and God bless you.
Really Great Article! Loved it.
One of the most asked questions by our clients is if they should be an LLC, S CROP or Sole... I always explain that you must somehow protect yourself but you need to contact your accountant and based on your financial situation he would best be able to advise what is the best route for you! Jen V http://www.pure-ecommerce.com Rule Your Life...Own Your Own Business
thanks greatly , simple and to the point, i have also shared with colleages on our Face Book busines forum group
Excellent advice and very timely! More and more people are starting business now and with the economy struggling it can be really hard to get a business going and get it off the ground. This advice can help anyone be successful, especially tip #1 - NEVER make handshake deals - always get it in writing, especially when it is a friend or relative, but with all business transactions. It amazes me how many people will still work without an agreement or contract - that is a scary proposition for any new business owner.
Hi Dave, the better way to handle it is to provide in the operating agreement or shareholder agreement how deadlocks are to be resolved. We actually use a variety of methods from designating a thrid party to tossing a coin. All the best, Frank Natoli-Lapin, LLC LanternLegal.com
Hi Lisa It's really enlightening. I agree with you that proper planning regarding the legal aspect is a must for setting up a company. Thank you very much. Regards
VERY GOOD INFO. Ms Gerard. THANKS AND LOOKING FORWARD TO MORE HELPFUL BITS FROM YOU.
Sound advice! It's tough when going into business with a partner to decide who gets 51% and who gets the 49. Everyone wants to be the boss!
Good points. I also like the advice of Donald Trump, who said that the 3 things to avoid in life are lawsuits, taxes, and divorce. A little comical, but it seems true from all the experience of entrepreneurs and businessmen.
Those are some great points! We actually had 8 employment law experts give their say in what they think are the most overlooked legal issues before starting a business. http://runapptivo.apptivo.com/8-employment-law-tips-to-know-before-starting-a-business-4221.html
Sounds simple - but register with the IRS. You don't want them knocking on your door because you forgot they're going to want their cut too!
I would add one more mistake...that of not preparing and reviewing GAAP financial statements for a better reality check on the business.
Excellent points. Little else to say -- these mistakes are common and avoidable.
so true on the partnership...I have had good partners and terrible partners...if you do not outline what each person's roll is, it will get ugly.
Lisa, Great advice for new Entrepreneurs! You only have to make one of those mistakes when starting a business to know you will never be a repeat offender! I would also add to the advice regarding the importance putting in place a written agreement with your partners the following: make certain you include a methodology to calculate the future value and purchase price for your business. Don't just wave your hands by stating the company will be valued at "fair market value". If you do, this definition will likely be challenged by all parties. Be as specific as possible! All the best, Holly Magister, CPA, CFP www.ExitPromise.com
This is a must read for anyone interested in starting their own business.
The only ship that won't sail is a partnership... *Dave Ramsey
Number three--the one about no written agreement concerning partnerships? Yeah . . . still paying DEARLY for making that mistake. Even better than having a good partnership agreement? Having NO partner at all. Keep it small--keep it all.
It's also good business sense to have unlimited access to a nationwide network of law firms. Don't "guess" your way to success as a business owner; rather, get sound legal advice (and protect your assets) before making any decisions, have all contracts reviewed before you sign them so your rights are protected, and stay one step ahead of any legal crisis by using preventative measures every step along the way.
http://www.pplonlinetools.com/video.php?uid=qm0iksqcoqa444ak Here is a link to an interview with Tom Donahue with The United States Chamber of Commerce that I found interesting.
These are some great tips to some very common issues plaguing young entrepreneurs. However, I would never suggest downloading generic legal forms from the internet, as they are often not worth spit. I realize you have included a disclaimer on your links forms page, I'm just throwing in my opinion. :)
You should also lay out in your business contract where disputes will be settled. Otherwise, if you want to seek damages against another party you will have to travel to the state that they are in. This could end up being a very expensive and time consuming process (on top of the issues you're already dealing with). Rob MileHighBusinessPlans.com
I have talked to far too many entrepreneurs who have gotten burned by making handshake deals with clients and vendors. Other than a "free consultation" a contract should be in place for any client or vendor relationship before services begin. Although a standard contract that has been reviewed by a legal professional is the best way to go something as a simple document spelling out what each party agrees to can protect your business.
I like what Pink FLoyd did in 1972 when Roger Waters and David Gilmour couldn't agree on the style of the record. Gilmour wanted a more groovy sound and Waters wanted a simplified, dry sound. They had agreed before that in the event of a stalemate, they would bring in a person they both respected and trusted, producer Chris Thomas. My point is that you should have a worst case scenario plan in place, and a mutually selected mediator is the best way to avoid stalemates.
Probably a better way to deal with a 50-50 split in ownership is to build into the Bylaws or Operating Agreement a mechanism to deal with stalemates instead of assigning an arbitrary ownership number. Remember that what you own needs to be tied to your capital investment and should not be based on some arbitrary fixing of numbers. This is especially true if you have incorporated and can have an impact on your tax basis in your company. It is always worth your time to sit down with a professional to work through this process instead of pay the price later.