Many founders get overwhelmed by the multitude of legal issues facing their startups. These issues include formation, IP acquisition and protection, privacy and data security, labor and employment, securities laws compliance, executive compensation, social media, and supplier and customer relationships.
This checklist details the key legal issues that commonly arise in startup business and tips for how to handle them.
CORPORATE FORMATION: CHOOSING THE TYPE OF LEGAL ENTITY
• Evaluate the benefits and drawbacks of the possible legal entity structures. The following considerations should be weighed: future growth plans, capital raising goals and projections, tax considerations, and the desired type of governance structure.
• Consider that the legal entity type will vary with the industry and geographic location of the business. Do not assume your business will be a certain structure because you have other businesses operating under a particular structure or your peers operate their business a certain way.
• Consider that limited liability companies (LLCs) and limited partnerships can be problematic for startup businesses that want to issue equity compensation or plan to get venture capital funding (in which case it is typically preferable to structure the business as a C-corporation).
• Consider that you may inadvertently be exposing the founders to personal liability by operating as either a sole proprietor or general partnership. If you haven’t registered your business with your State, you are probably exposing the founders to personal liability.
• Ensure that all business activities are conducted through the legal entity, once formed, and not by an individual founder or other third party.
CLEAR AND PROTECT THE BUSINESS BRAND PRIOR TO CREATING VALUE
• Ensure you can obtain the right to your desired business and brand name(s), logos, and domain names. This should happen before you begin creating value in such names, phrases, or images so you do not infringe on another business’ IP rights.
• Plan for growth and success by filing proactively for rights protection in the US and foreign jurisdictions where the company reasonably expects to do business in the future. Startup companies should: (i) make a list of jurisdictions where the company plans to operate and decide where the company can afford to file, (ii) take advantage of intent-to-use US trademark registration, which allows the company to register a trademark before actually using it if the company has a genuine intent to use the mark in connection with the goods or services listed in the company’s trademark application; and, (iii) keep in mind that the world generally works on a first to file basis. It is common practice in some areas of the world for third parties to register the trademarks of growing companies to extort cash from those companies by selling the rights to these registered trademarks back to them.
DOCUMENT EACH FOUNDERS’ ROLES AND RESPONSIBILITIES
• Memorialize the understanding among founders as to each founder’s role and the expectations for each founder. Do not rely on handshake deals. Having a common understanding of expectations creates certainty.
• Set out in writing each founder’s role and responsibilities, including day-to-day operations of the business.
• Create a ledger or cap table detailing the ownership percentages of each founder and investor.
• Determine how key business decisions will be made and if these decisions will require a simple majority vote or whether certain actions will require the unanimous vote of the founders.
• Determine who can act on behalf of the company and whether there are limitations as to what each person is allowed to do (e.g., dollar thresholds).
• Determine how disputes will be resolved if the founders and decision-makers cannot agree on a company action.
• Address the possibility of a founder’s exit from the business, including whether: (i) the departing founder’s stock is subject to time-based vesting, (ii) there is any limit on the departing founder’s right to continue to hold an equity stock in the business, (iii) the departing founder has any voting rights on business decisions, and (iv) any restrictive covenants govern the departing founder’s conduct after leaving the business (e.g., non-compete, non-solicitation, etc.).
DEVELOP AN INTELLECTUAL PROPERTY STRATEGY
• Take into consideration the company’s growth and expansion strategy when creating, acquiring, and protecting the company intellectual property.
• All IP that has been contributed by the company’s founders, advisors, employees, and other third parties need to be assigned or licensed to the company.
• Determine the appropriate kind of IP protection for technology developed by the company, taking into account: (i) the likelihood of obtaining that protection, (ii) the time and costs required to obtain the protection, and (iii) the protection’s length and strength.
- Protect the company’s IP in early-stage business activities. For example: (i) safeguard confidential business information and trade secrets by using confidentiality and nondisclosure agreements, (ii) register copyrights and use copyright notices, (iii) clear and register trademarks and use appropriate notices, (iv) secure rights protections for any company proprietary software, and (v) take steps to protect the company’s valuable data and databases.
• If your company utilizes social media, develop a policy for its use and ensure employees are properly educated in complying with such a policy. For example, the policy should cover issues such as who owns works created by them and whether and how they may share those works outside of the company.
COMPLY WITH SECURITIES LAWS WHEN RAISING CAPITAL
• If your company is offering equity in exchange for money or services, be aware that state and federal securities laws apply to such offering.
• Take appropriate actions to avoid facing potential regulatory action, incurring an obligation to offer investors a right of rescission, or harming the economics of a future investment in, or sale of, the company.
• Proceed with caution if issuing securities to non-accredited investors, even close friends and family.
COMPLY WITH LABOR AND EMPLOYMENT LAWS
• Federal wage and hour laws are complex and need to be recognized from the outset. For each employee, consider the following: (i) classifying employees as exempt or nonexempt from the federal minimum wage and overtime laws under the Fair Labor Standards Act (FLSA), (ii) compensating all non-exempt employees with payment for minimum wage and overtime, (iii) ensuring all exempt employees perform the job functions necessary to qualify for an exemption under the FLSA and are paid the minimum threshold on a salary basis, and (iv) complying with any state or local wage laws that may be more generous to employees than the FLSA.
• If the company hires unpaid interns or independent contractors, ensure that they are properly classified and the company maintains procedures to ensure the status of these workers is not jeopardized.
• Be aware of state and local laws that govern the employment relationship. For example, some jurisdictions require employers to provide paid sick leave or other benefits, and send certain wage payment notices to all new employees, for example stating their rates and dates of pay.
• Plan for payroll and benefits administration.
• Ensure that employees are classified as “at-will” in such employee’s offer letter or employment agreement. An exception to this might be employment relationships with senior executives who may have rights to severance or other post-employment benefits.
• Ensure that founders and owners understand that they may be personally liable for unpaid wages, even if the business fails.
DEVELOP A COMPENSATION PLAN FOR FOUNDERS AND KEY EMPLOYEES
• Conduct research as to industry standards for salary averages for the job descriptions needed at your company.
• Decide whether to use some form of equity (for example, options, restricted stock, or stock appreciation rights) to compensate employees when developing a compensation strategy.
• Understand the legal implications, tax consequences, and accounting treatment of granting each type of equity award, including any vesting requirements. Consider how much equity should be designated for employees and the consequences of an equity plan for future investors.
Institute a Policy for Social Media, Data Collection, and Other Online and Mobile Activities
• Secure the company’s rights in its website and other online assets.
• Pay close attention to privacy and data security laws governing the collection, use, security, transfer, and disposal of the personal information of employees and customers that is collected and maintained by or for the company.
• Ensure employees are educated and trained not to mention future capital raising activities on social media. This could be a major securities law violation.
• Consider the variety of legal issues surrounding early-stage e-commerce (for example, interstate commerce, business and tax payment mechanisms, privacy, sales tax, and data security).
PROPERLY DOCUMENT CUSTOMER, SUPPLIER, EMPLOYEE, AND OTHER KEY THIRD-PARTY RELATIONSHIPS
• Create written contracts with customers, suppliers, employees, and independent contractors.
• Do not assume that the company has to accept all of the terms proposed in contracts with more established companies. Understand how vendors and customers can allocate the risk of non-performance to the counterparty in a transaction through indemnification, exclusive remedies, limitations on liability, and warranty provisions. For more information on risk allocation in commercial transactions.
• Create and use key form agreements for core business activities early in the company’s life cycle.
• Ensure agreements are in place with employees regarding the ownership of the company’s IP and the protection of the company’s confidential and proprietary information.
• Develop a trade secret protection program to ensure that employees cannot steal valuable and proprietary information of the company if they leave the company.
• Consider whether each employee will be bound by restrictive covenants, such as non-competes and non-solicitation agreements. At a minimum, if an employee leaves the company, they should be bound by an agreement not to solicit company employees to come with them, and they should be barred from trying to solicit customers of the company to leave the company in favor of the departing employee’s new company.