Covering All the Bases: How to Set the Legal Framework for Your New Business
It's what ensures that your service or product is protected, that you're not operating illegally, and that you don't lose out if things change among your staff.
By nature, founders are big-picture people; we love envisioning new ways of doing things. The problem, though, is that sometimes we try to paint the bigger picture before we set up the mechanics of actually running a company. The legal side of setting up a business is often seen as a time-consuming chore, brushed under the carpet until it’s a screaming necessity. But to enable your business to run freely, this has to be prioritized before you even consider bringing on clients, hiring staff, or eventually pitching to investors.
The legal framework of a business is what ensures that your service or product is protected, that you're not operating illegally, and that you don't lose out if things change in your team. A prime example of not doing this right is the Winklevoss twins, who famously failed to legally document the early stages of their social media platform, allowing Mark Zuckerberg to launch Facebook using part of the code he had written for them.
Despite being easily avoided, legal challenges are one of the top reasons why startups fail. Founders who don't identify their legal needs from the start could end up realizing there's a fundamental problem with their business late in the journey.
To ensure you’re covered in the eyes of the law, take the following steps to set up your legal framework, as explained by the experts.
Define your intellectual property ASAP.
This is the first, and arguably most important legal step to take with your company. If you don't develop a comprehensive intellectual property strategy early on (even before you start building anything tangible), someone else could claim your ideas, patents, or trademarks, and be granted ownership. For instance, a former employee could leave your startup and begin their own company using your core ideas, or a loose-tongued executive boasting about your algorithm at a conference could see a competitor quickly patent it before you. Remember, it's a first come, first served battle for intellectual property rights.
Not only this, but if your product isn't protected, you could be accused of patent or copyright infringement by other companies—perhaps competitors with similar business models, or former employers claiming you stole an idea from them.
The person responsible for defining intellectual property depends on how your company is structured. Normally, the CEO, CTO, or product lead takes the reins, but it can be beneficial to have other team members contributing to the discussion to get a different perspective on what parts of your business should be classed as intellectual property. For example, in the digital age, more companies are choosing to protect data such as financial information, materials in the cloud, user profiles, and device information.
Start with trademarks and patents by registering with the US Patent and Trademark Office. A trademark filing costs around $400, depending on the scope of goods and services your using the mark with. Patents are several thousand dollars. This might be a big expense for early-stage ventures, but it's a fraction of the price you have to pay if you do not file and you are later accused of infringement.
Jim Gatto, open source team leader at Sheppard Mullin, says that "patenting is not strictly a one-time event; founders need to get advice early on from a lawyer to understand what exactly is protectable, and if there are any deadlines they have to meet. This process needs to be repeated as products evolve and new features are added."
Draft a solid co-founder and equity agreement.
If you're starting a company with another person, you absolutely have to have a co-founder agreement. Often, founders begin their journey with a strong relationship, but find that the connection deteriorates as times get tough. Legally stating ownership and responsibilities, and what happens if things turn sour, can help ensure you're financially protected under any circumstance—and can save you a lot of awkward conversations.
A co-founder agreement should specify who owns what percentage of the business and how equity is divided. There is no firm rule about how to split equity—this should be a judgement call based on what each co-founder brings to the table. It's worth contacting an accountant beforehand to assess the value of existing company assets, and factor these into the agreement. Likewise, the agreement should have non-disclosure clauses that prevent founders from using information from the company to work for, or start, a rival business. Gatto also says “it is also important for all founders to agree in writing to assign all intellectual property to the company. Without this, if one founder leaves, the company may not own all of the intellectual property created by that founder.”
Alan Gongora, managing partner at Langon Law Group LLC, adds that "a co-founder agreement is the constitution for your startup. It's what you'll refer back to for roles, ownership, and salaries—all of which are legally binding; and if someone leaves, it's what will outline what they're entitled to."
A co-founder agreement can be drafted among you and your co-founders, however, it should be reviewed by a lawyer and once confirmed, a copy sent to all parties involved.
Know the legal obligations as you grow.
No matter how early you are in your company's lifecycle, preparing to scale should factor into your legal framework. Every business is looking to grow, and the quicker you know the legal requirements, the faster and more efficiently you can do so.
If your startup plans to have an international team or consumer base, you need to be clear on: whether or not you have to register a formal entity in foreign countries, if your company can be owned by foreign partners, and what tax obligations there are for selling outside of the U.S. Not only are these points necessary to avoid large fines, they will also help you identify what your margins are.
Gongora advises that "rather than starting in another country, try different formats that give you more flexibility." For example, startups are turning to offshoring models—where a portion of their team is located abroad—to lower operational costs and harness local insights about potential foreign markets to disrupt. Tools like Remote support offshoring models by acting as the employer of record, meaning you don't have to set up an international entity to scale overseas.
Offshoring has its advantages, but it definitely requires working through an agency, or having a distribution agreement with offshoring companies and employees. Similar to a co-founder agreement, this document should define who is involved, the amount of money being exchanged, and protections for company data. Again, you'll need to confirm with a lawyer that you're compliant with both local laws and U.S. laws when offshoring.
Although speaking with an attorney upfront will always be more valuable because it's tailored to your company, if you’re on a low budget you can do your own research using online resources. Gatto recommends browsing blogs from top legal firms, or signing up to mobile alerts from regulatory and judicial bodies in your industry (for example, the Food & Drug Administration) to keep on top of new rules, or lawsuits that are relevant to the places you're targeting.
However, spending a little time with an attorney up-front can be an invaluable investment. In a short time, a good attorney can provide advice on a comprehensive IP strategy and identify any regulatory issues that may be relevant to your business. Often, with cutting edge businesses, there are lurking regulatory issues which may not be apparent.
Do your due diligence before funding.
Having a great idea is not enough to attract solid investment. Investors are always going to do due diligence and check that you own and have protected your IP, have robust contracts and agreements, and are compliant in all the regulatory areas you plan to operate in. If you're not, you'll be viewed as too high risk to fund. Gatto recommends thinking of it like selling a house: "you need to do a complete home inspection and fix any problems before you put it on the market. No-one will buy the house if there are cracks and holes that could pose big problems down the line."
For example, if your product uses open-source software, you should make sure that none of the open source licenses pose legal issues. Gatto says that "some open-source licenses require that if you use that open source in your software, you must make the source code of your software available to others." If an investor discovers this during diligence, it may be a show stopper. Scan your code before diligence to eliminate any problematic open source.
Before you seek funding, meet with a lawyer to devise a clear checklist of the legal actions you need to take beforehand. Note that the checklist will vary depending on the type of funding you're hoping to get—for instance, crowdfunding will require a different legal framework to private funding from angel investors.
Not having a legal framework could cause your company to stall just as it begins gaining momentum. By dealing with these processes from the start, you and your business will be sailing smoothly into the more exciting phases of your journey, without being fearful of avoidable pitfalls.
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