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Legal insights for the startup journey

The entrepreneurial journey is exciting, but for many, it can also be difficult to navigate. While completing their checklist for launch, founders may also encounter legal issues along the way.

Some of those issues include establishing a new business while employed by another; offering investors shares at differing price points; misunderstanding capitalization; misuse of form documents; forming relationships without proper documentation; and withholding employee compensation or classifying all new hires as contractors.

Establishing a new business while employed by another

While it’s exciting to go solo and launch a new business, it’s important to keep in mind that any IP you create for your new business while working for someone else may belong to your employer. Therefore, before branching out on your own, review any agreements you have with your employer to provide clarity on what consent you may need regarding IP and ownership. 

Typically, if you create the IP outside of work hours; if you don’t use employer facilities, equipment, or confidential information; and if the IP is unrelated to your employer’s current or anticipated R&D activities, you should be safe from any legal issues.

Offering investors shares at differing price points at the same time

As a new business owner, you’ll want to ensure that you avoid tax issues relating to shares. As such, it’s best practice that when you bring on early investors, investors brought on at the same time are all offered the same price for shares. 

To avoid tax issues, implement convertible securities, like SAFEs or convertible notes. It’s cost-effective and can help minimize adverse tax issues. That being said, it’s important to know what you are signing when you issue these types of securities.

Misunderstanding capitalization

Founders sometimes underestimate the extent of their dilution when they issue more shares or convertible securities, which can lead to unexpected dilution.

Using a cap table management platform can show you how you’re diluted and can help prevent legal issues down the line. Further, it’s important to take the time to understand the documents when you issue securities. Finally, creating a model cap table for your next priced round can project how you may be diluted by convertible securities.

Misusing form documents

While it may be tempting to download or copy online forms for your new business, take caution. It’s critical to understand the contents of these documents, as you may unknowingly agree to something you ultimately cannot deliver. For example, with a privacy policy, you could face a lawsuit over misrepresenting your privacy stack.

To avoid this, spend a little money on basic forms. Take it a step further and consult with a startup attorney who can draft forms for you and explain their proper use.

Forming relationships without proper documentation

As a new business owner, you have a lot on your plate. Documenting everything can be tedious and time-consuming. So you decide to bring on a co-founder without a formal agreement in place.

This approach can lead to myriad legal issues, including disputes over terms; failure to get your IP assigned; failure to ensure confidentiality; and withholding equity from those to whom it was promised.

However, proper documentation can mean iron-clad agreements for stock purchases, or with advisors and consultants. Implement them as early as possible in the relationship.

Withholding employee compensation or classifying all new hires as contractors

It’s not unusual for new startup hires to not receive a salary; instead, founders consider new hires as contractors. However, this may violate both state and federal law and may even expose founders to personal liability.

That’s why founders must be prudent in their hiring practices. First, they should brush up on the laws around wages and what constitutes being a contractor. When they’re not paying salaries, founders also should research the associated risks. Finally, when someone who hasn’t received pay is terminated – regardless of whether or not they were a contractor – implement a separation agreement. 

The bottom line

Getting a new business off the ground takes determination and a high level of due diligence. However, founders can set themselves up for success by taking the time to understand the myriad issues they may encounter along the way; it can help them avoid legal issues as the business matures.

David Siegel is a partner at Grellas Shah, a full-service boutique law firm.

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