Depending on the nature of your startup, many potential legal issues could arise – like regulation compliance, leadership structure, non-compete agreements – the list goes on. Here is an overview of the legal issues every entrepreneur should consider before startup formation:
Depending on the startup and its industry, there are often specific regulations that may apply to your business. These must be adequately addressed to avoid serious legal and financial consequences. For example, financial services are a heavily regulated industry, with stringent federal and state regulations that all financial entities must comply with. Any startup operating a website marketing to children will also face strict regulations relating to privacy and collection of personal information. Subscription box startups need to comply with regulations in several states relating to how they notify subscribers about the renewal of their subscriptions.
While compliance may seem costly and daunting, a startup’s costs for failing to comply with applicable regulations adequately may cost much, much more. Startups that ignore their compliance obligations face regulatory action from state and federal government agencies, as well as class-action lawsuits.
Another common legal issue for many startups, especially tech startups or any other business involving intellectual property (IP), is failing to adequately protect that IP by not ensuring that it’s owned by the startup. Under US intellectual property law, the person actually creating the IP owns it, unless that person explicitly states otherwise in writing. When founding the company any founder who developed pre-existing intellectual property should transfer that IP to the startup in exchange for his or her stock, and sign an IP assignment agreement.
In addition, the startup should also require any employees or contractors developing intellectual property to sign contracts acknowledging that intellectual property will belong to the business rather than the individual. Failing to take these steps at your company’s formation could potentially jeopardize the startup’s overall future, particularly if disagreements arise between owners and IP creators.
Successful startups that turn into thriving businesses often begin by carefully delineating and formalizing the founding team’s roles and responsibilities. These roles will drastically vary depending on what exactly your company will do.
One of the most common reasons that many startups fail is not having the right team in place. For instance, many startups may choose to delay hiring a chief financial officer, assuming that managing the startup’s finances can’t be that difficult, especially at the beginning. But the chief financial officer is also responsible for working with potential investors, as well as developing financial processes and reporting requirements as the startup continues to grow.
While not required, it’s often a good idea for the founders to put together a founders’ agreement that outlines the roles, time commitments, financial commitments, and other contributions each founder will make. This kind of agreement can be important for measuring accountability as the startup grows.
Raising Money from Investors
Of all the legal issues every entrepreneur should consider before startup formation, it is important to note that raising money from investors is engaging in a highly regulated area of law. Preferred stock, convertible notes, and SAFEs are all securities and therefore regulated by state and federal securities laws. Startups need to work with an attorney with experience in securities laws before talking to investors, to ensure that they talk only to the right investors, disclose information where necessary, and address other potential requirements. It’s important to put together a legal plan for raising money BEFORE actually starting to raise money, to avoid costly mistakes. There’s a tendency for some startups to just download free template documents like SAFEs, and then issue them to investors without ever talking to an attorney. This is dangerous, as issuing securities is not a DIY type of project. By not complying with these laws and regulations, the startup jeopardizes its existence, and the founders are at risk of civil and criminal penalties, including jail.
Entrepreneurs looking to launch their startup often leave their current job to launch their new endeavors. Unfortunately, many employment contracts include provisions that make it incredibly difficult for an employee to launch their own business. These agreements typically last for about a year after the employee leaves and apply if an employee attempts to launch a business in a similar industry, since it may target the same customer base while using similar technology and knowledge. These agreements are specifically designed to protect companies from losing intellectual property or enduring competition and solicitation from former employees. Failing to address these issues before you quit your job may make this process even more difficult. It’s important to review all your employment documents from your current job, before leaving to create a startup.
Beyond that, many companies reflexively include non-competes in their employment agreements. If the startup is located in California, these non-competes are simply illegal and unenforceable. In other states, the landscape is rapidly changing in ways that make it harder to impose non-compete obligations on employees. When using a non-compete, it’s increasingly important to identify what state law will apply, as well as to identify what employer interests need protection. Then the company needs to carefully tailor the non-compete to address those interests, without being overly broad in terms of the time period or geographical scope.