The Top Five Legal Mistakes for Startup Companies to Avoid

The Top Five Legal Mistakes for Startup Companies to Avoid

By Patrick Perrin and Miles King 

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Most people know that starting a new company is a big endeavor, but few appreciate the legal pitfalls that can sink a startup before its products or services ever reach the marketplace. Entrepreneurs are typically moving very quickly to develop and launch products and services, raise capital and meet real and imagined deadlines. It will be legal counsel’s job to identify and help entrepreneurs avoid these five common startup mistakes.

(1)  Failure to Secure Clear Intellectual Property Ownership

Intellectual property (“IP”) is often a new company’s single most valuable asset.  Unfortunately, proper screening and protection of IP rights is often overlooked during the startup phase. Existing IP ownership might be claimed by a founder’s or employee’s former employer under a prior employment or other agreement. A seemingly novel company or product name or invention might already be a federally registered trademark or patent of another company.  Failure to conduct trademark clearance searches, to properly review the ownership of existing IP, or to register new IP can be costly mistakes that can result in loss of the assets that a company needs to thrive or even survive. 

(2)   Neglecting to Obtain Employee/Independent Contractor Assignments of IP

While securing rights to initial IP is an important first step, a company must also secure rights to newly developed IP and improvements. Many new companies hire independent contractors to provide various development services and sometimes fail to have these contractors sign IP assignments for their works, instead assuming that “because they paid for it they own it.”  Without proper IP assignment agreements, a company might be startled to find out that its cutting edge website, eye catching logo, innovative software or other technology is actually still owned by the contractor who created it. A similar risk exists where company employees do not execute assignment of inventions agreements. If an employee comes up with an invention outside of his or her normal working hours or job description, there could be a dispute as to ownership, even if the invention is related to the company’s business.  This problem frequently becomes apparent when an employee decides to leave the company and start or join a competing business.

(3)   Not Honoring Prior Confidentiality and Non-Disclosure Agreements

New companies often understand the need for their employees to sign confidentiality and non-disclosure agreements (“NDAs”) to preserve their competitive advantage in the marketplace.  It is equally important to perform adequate diligence concerning their employees’ NDAs with prior employers.  As with the IP ownership issue discussed above, adequate due diligence and inquiry is the name of the game here, and the cost of losing could be serious legal liability for misappropriation or violation of another company’s trade secrets, copyrights, patents or confidential information.

(4)  Overlooking the Importance of Founder Written Agreements and Organizational Documents

The allure of simplicity and blind trust in the early days can come back to haunt a company.  Properly drafted operating agreements, partnership agreements or other applicable organizational documents are critical for memorializing company ownership and funding and to understand company management and owner rights.  In the absence of clear written agreements, disputes are more likely to arise. Taking the time up front to prepare organizational documents that clearly outline ownership and management rights and responsibilities will go a long way towards preventing founders and investors from becoming adversaries whose disputes may result in the failure of the business.

(5)  Misunderstanding the Tax Implications of Stock and Option Grants: 83(b) Elections

Proper tax planning is important to both the startup and its employees when implementing any type of equity incentive plan. Restricted stock grants, subject to vesting at a later date, are a great way to provide non-monetary compensation and incentives for founders and employees. However, not appreciating the importance of making timely 83(b) elections can give rise to hefty income tax liabilities that could otherwise have been avoided. Equity grants can be an important tool for compensating employees, but timing is everything when paying taxes on restricted stock, and once the 83(b) ship has sailed, it is gone forever.

New entrepreneurs tend to think that startup legal issues will never arise, or will simply resolve themselves once they do arise. Successful serial entrepreneurs and experienced legal counsel know better. It's much better to spend a little time and money up front to put the proper protections in place than to be hamstrung by costly litigation or tax bills later on. Such problems could cause a failure to launch for your startup client.