Startups face a number of hurdles ranging from marketing to financial to legal issues. However, legal issues can kill a startup just as it is getting started. Some legal mistakes are worse than others, and they vary in severity, as well. Here are the 4 biggest legal mistakes startups commit. We’ll explain why they’re major mistakes you don’t want to make in your business and how to avoid making them yourself.
You need to put everything down in writing from the very start. Start with a founder’s agreement. What are the roles and responsibilities of each founder? How much equity does each person get, or will they be paid a salary? How will decisions be made? How will you handle someone’s departure?
You also need to draft formal contracts with contractors and suppliers as well as have written employment contracts with every new hire. Do not rely on verbal agreements or emails. You don’t want to end up in court because someone promised a new hire a 5% stake in the business if they agreed to a lower pay rate.
Another mistake is not having written employment policies and procedures. Create an employee handbook that outlines company policies, and have an attorney review it to make sure it complies with labor laws.
There are many labor laws to follow when you hire your first employee. Your employment agreement should list someone’s job title, pay rate, and job responsibilities. Other companies have been penalized for not paying people overtime by wrongly classifying them as salaried rather than hourly employees. The government has forced companies to repay wages going back as far as three years. You can also create unnecessary liability if you impose unfair obligations on job candidates like overly restrictive covenants.
Only ask them to commit to legitimate restrictions based on their position, the needs of the company, and state law. On the other hand, your business will suffer if you don’t require everyone from founders to workers to sign non-disclosure agreements.
When you hire employees, you’re obligated to collect payroll taxes. You must then send the money to the government. Corporate officers who withhold taxes could be held personally liable for uncollected income taxes.
You can run into trouble if you incorrectly classify someone to try to avoid this hassle. For example, many startups have classified people as contractors rather than employees to try to avoid the payroll obligations that come with employees. Craft job descriptions that justify classifying someone as a contractor rather than an employee and understand your obligations when you have to begin processing payroll taxes.
It is very easy for a small business owner to start the business as a sole proprietorship, while it is common for small groups to form a partnership. This is a serious mistake because it leaves the business owners exposed.
Instead, set up your small business as a corporation or limited liability company. Corporations and LLCs are independent legal entities. If they go bankrupt or are sued for several million dollars, the owners are shielded from the liability. An S-corporation can serve as a tax-through entity that passes profits to the owners similar to how it would in a partnership, without the money being double-taxed. A C-corporation is the default choice for venture capital backed startups.
Legal mistakes can lead to lawsuits and loss of intellectual property that kill a small business. That is why you need to know what the worst mistakes you could make are and then ensure that you don’t make them yourself.