How to Avoid Common Mistakes
Start-ups’ legal mistakes run the gamut. They can include not having written contracts, depending on poorly designed partner or investor agreements, or failing to realize how many different aspects of running a business are regulated by various government entities. It’s impossible to provide a comprehensive list, but here are some common areas where pitfalls tend to occur:
- Contracts. Reliance on verbal or handshake agreements is one of the most predictable sources of legal problems for startups. It’s human nature to believe that “your word is your bond” and business dealings should be based on trust. And it’s almost inevitable that squabbles will result from different interpretations of verbal agreements. If you want things to run smoothly, then execute clear, professionally written contracts with employers, vendors, and investors. Remember, contracts protect all parties to the agreement, so you shouldn’t feel reluctant to ask that all understandings be put in writing.
- Partnership agreements. Agreements with partners can be particularly complex and emotional. That’s partly because friendships and family relationships may be involved, and also because people tend to have different levels of commitment and motivation to see the enterprise succeed.
Typically, entrepreneurs come in different flavors. Some are innovators; others are administrators, engineers, or marketers. Suppose you are a committed, administrator-type CEO in business with a long-time friend who is a serial innovator. You would definitely want to have a vesting agreement in place that controls the ownership of company stock in the beginning years of the company. Typically, vesting agreements extend over four years and grant ownership of 25% of the stock at the end of each year of service.
Without a vesting agreement, your friend and partner might enthusiastically participate in the launch of your business—and then decide abruptly to move on to a new venture. If he or she had ownership of half of your company’s stock, you would be stuck trying to manage a start-up with only half of its capital and divided control. With a vesting agreement, your partner would be incented to stay on—or else lose the shares that had not yet vested.
- Securities. The all-important process of raising capital and issuing shares may easily lead to misinterpretation of Securities and Exchange Commission (SEC) regulations. In April 2012, Congress passed the Jumpstart Our Business Startups (JOBS) Act, which completely rewrote the rules, both for advertising direct investment opportunities in small businesses and for qualifying investors who are eligible to participate. The popular perception is that the JOBS act allows advertising and crowdfunding. In fact, the bill introduces distinctions between a half-dozen different investment scenarios, each with different requirements. And, as of October 2013, the regulations governing these new permitted scenarios had not been finalized.
Here’s what you can do right now: You can publicly advertise for “accredited” investors who meet the long-standing threshold of having a net worth of $1 million or more, or an annual salary in excess of $200,000 for individuals and $300,000 for married couples. You will have to comply with all the provisions of Regulation D, Rule 506, that govern disclosure and registration. Note that the SEC adopted these rules changes in July of 2013.
In the near future, whenever the rules for Title III of the JOBS Act are finalized, you will be able to pursue “Public Securities Crowd Investing.” This means that you will be able to raise up to $1 million—in small amounts from many individuals—through traditional stockbrokers or via a funding portal website. Under this scenario, you will be able to recruit investors who are not as wealthy as traditional accredited investors. However, advertising will be limited and there will be caps on amounts individuals or couples are permitted to invest. And investor education requirements will also be stipulated.
- Advertising. There are also regulations that govern advertising to your potential and existing clients. These are the purview of the Federal Trade Commission (FTC). The most common law that emerging businesses are in danger of violating is the CAN-SPAM Act of 2003. The bill’s acronym stands for “Controlling the Assault of Non-Solicited Pornography And Marketing.”
You could violate CAN-SPAM unintentionally by sending out an email blast that reaches someone who had requested to opt out of your mailing list. Also, if the FTC considered your subject line deceptive, or if you fail to provide a physical address, you could be in violation. Penalties are $16,000 per email, so the cost of non-compliance is potentially severe.
Fortunately, the rules are relatively straightforward and easy to implement. You just need to create a CAN-SPAM-compliant template for your email, and be sure to keep your list up-to-date by promptly deleting people who tell you that they want to opt out.
- Intellectual property (IP). Other sections of this site discussed the importance of protecting your IP. The obvious corollary is that it’s also important to respect the IP of other businesses. Most violations are unintentional.
One common scenario occurs in the tech industry. Say you have a great idea for an invention while you are working for a giant company in Silicon Valley. You decide to go out on your own and commercialize it. Not so fast! Do you really own the rights to your idea? Your former employer may not think so. It all depends on what kind of specific waivers you may or may not have signed when you first started that job. Do your research and hire an IP attorney to help you. It’s better to negotiate before the fact than to get sued later.
Another inadvertent mistake can occur when designing marketing materials. You may spot the perfect photograph on the Web and decide to use it to promote your business, not realizing that this would violate the photographer’s copyright. Fortunately, there are many resources for buying rights to photos and illustrations at a low cost. Just search for “stock images” and you’ll find a lot of resources on the Web. Some of these are “royalty free” collections that you can use however you see fit. Others are “rights managed,” which means you can only use them in specific ways or for a limited period of time.
- Fundraising. Here’s a legal issue that won’t send you to jail, but could cost you money—in the form of missing out on venture capital investments. Because VCs are in the driver’s seat, they can play by a different rulebook than less influential investors. So, if you’re going to need VC financing, you’d better organize your business as a Delaware corporation. Delaware is known to be corporation-friendly, and it has a large body of well-understood legal precedents. That’s an extra comfort factor for VCs. If you don’t need that kind of financing, then you have a much wider range of options for an appropriate business structure and location.