In this four-part series, writer Polly Brewster explores avoiding common legal mistakes.
Think your start-up is so small it doesn't need to form a corporation? Think again. Incorporation gives you limited liability. More clearly stated, it provides a shield for your personal assets outside of your company. The apartment you own? The car you drive to your shared office space? Until you have an Inc. or LLC. at the end of your company name, that can all be up for grabs if someone decides to sue you or an investor wants their money back.
"Imagine you have a contract in front of you. Ask yourself are you signing it in your personal capacity—with all of your personal assets, like your personal bank account, behind it—or is it more appropriately an obligation of a company?" says Erika J.S. Buell, a Senior Lecturing Fellow at Duke Law School and a former in-house corporate counsel for Revolution Money Inc., a startup payments company.
That said, incorporating can be complicated, but we've outlined 5 missteps you can avoid.
1. Skipping the founders' agreement. There's a reason Facebook's beginnings made it to the big screen: Zuck and Co. never drew up a founders' agreement. Unless you're also looking for movie-style drama, sit down with your partners and hash out exactly who gets what down the line. Before you even think about incorporation, outline an equity agreement and, if necessary, agree to non-compete contracts to guarantee that you're starting off with a clear vision.
These talks can be awkward, but they could keep your friendship intact. "It can be tragic," says Esther Barron, Director of the Entrepreneurship Law Center at Northwestern University Law School. "I've seen businesses fail and friendships fall apart because there was so much internal fighting they couldn't focus on moving forward."
2. Incorporating while working somewhere else. If you're still clocking in as someone's employee, then you need to think about how your boss might view your new venture. "There are several things to consider: Is this new business in competition with your current employer? Are you subject to an enforceable non-compete agreement?" explains Buell. In addition, you should make sure you didn't use any of your current employer's resources or confidential information to launch your start-up. "Especially with intellectual property-based businesses, an entrepreneur needs to think about whether or not her current employer could have any claim to the intellectual property that is expected to be the basis of this new business," Buell says.
3. Not acting like a corporation. Just filing the legal documents to become an Inc or LLC. is not enough. Getting the protection that comes with incorporating requires work. "There are certain formalities," Barron says. "Most states require annual reports and board and shareholder meetings with minutes for corporations. But it's worth it." In addition, you need to build a firewall between your personal assets and the company's. "Accounts, records, and assets should be kept completely separate from personal ones," Buell advises. "All contracts should be in the company's name with appropriate corporate designation and signed by persons acting on its behalf."
4. Skipping payroll taxes. Making ends meet at the start of a new venture can be tough and you might be tempted to give your bottom line a little relief by covering payroll taxes at the next pay period. Resist this temptation. "I see entrepreneurs do this from time to time," Alan Singleton, managing partner of Singleton Law Firm that specializes in start-ups. "But this is one area where the government won't respect your limited legal liability. They will go after the personal assets of any high-level employees that are associated with payroll." So, once you've incorporated, be smart and pay Uncle Sam his due whenever you cut paychecks.
5. Not researching corporate entities. There are a variety of corporate entities and it's a smart idea to hire a lawyer to discuss what works best for your business, even if you feel confident enough to file the paperwork on your own. "There are different tax structures depending on whether you're an LLC. or an S Corporation (to just name two types) and certain investors like different types. For example, venture capital firms like C corporations," Singleton says, for their more flexible terms for stockholders. Spending the money on a lawyer early on in a business can be tough, so make sure you get someone who has worked with entrepreneurs in your field. "You also don't need just ‘a lawyer' but one who is well versed in this area," Buell explains. "Remember that each business will be different and each state has its own corporate, LLC., and partnership law which can change often."