Top 10 Legal Mistakes Made by Startups

10. Use of Prior Employer’s Facilities

Many entrepreneurs are still employed by another company upon the beginning of their startups. They may spend some of their workday working on their startup at the soon-to-be-former employer’s facilities.

This is risky because this employer may in the future claim intellectual property rights over work that the entrepreneur created using the company’s facilities or on company time.

Employees usually are asked to assign all intellectual property rights to the employer over works created by the employee during the employment term. Such clauses a very common, especially with technology companies. An entrepreneur may risk losing intellectual property rights over his or her work due to an assignment contract that was previously signed with the employer.

Even without an assignment, a company may use a patented invention free from a claim of patent infringement if the invention was created by its employee within the scope of their employment, using the company’s equipment, or invented at the company’s expense. Similarly, under the “work for hire” doctrine (17 U.S.C. § 101), certain works created by an employee within the scope of employment are the property of the employer.

It should be noted, however, that California Labor Code § 2870: An employee is not required to assign any inventions for which no property of the Company was used, that were developed entirely on the employee’s own time, and that do not relate to the business, research, or development of the Company, or do not result from any work performed for the Company.
Start-ups get into trouble with former employees when they develop IP using use employer facilities or on employer time.

A well-advised entrepreneur will take care not to create rights in his former employer.

9. Failure to Comply with Securities Laws

State and federal securities laws regulate the offering and sale of securities. The Securities Act of 1933 regulates the issuance and sale of securities and requires companies to file detailed statements with the Securities and Exchange Commission (“SEC”). Common exemptions for start-ups include the Private Offering Exemption under SEC Regulation D, and the safe harbor promulgated under Section 4(2) of the Securities Act of 1933.

The Securities Exchange Act of 1934 regulates the public trading of company stocks, mainly regarding the illegality of insider trading. State securities law also requires documentation of investments.

Under California Corporate Securities Law of 1968 (“California Blue Sky Laws”), all securities offered or sold must be either qualified with the Commissioner of Corporations or exempted from registration by a specific Rule of the Commissioner or specific law. The failure to comply with securities laws may result in heavy fines, including disgorgement of profits, and criminal prosecution.

Often a start-up will take money from early investors without any attempted compliance with securities laws. Sometimes the transaction can be cleansed, sometimes not. The consequences of this mistake are severe, and a company should never sell securities (i.e. take money) without legal counsel.

8. 409A Violations

Code section 409A was enacted as part of the American Jobs Creation Act of 2004 in response to abusive compensation practices (such as involved in the Enron scandal). The section applies to nonqualified deferred compensation plans (compensation that employees earn in one year and that is deferred for payment in a future year) such as severance plans, and employment agreements. Section 409A contains very specific rules regarding the following:

  • The timing of deferral elections
  • Timing of distributions
  • Funding

The penalties for violation of these rules is severe, and include the following:

  • Immediate tax payment on deferrals for current and prior years
  • Interest at IRS underpayment rate plus 1% from original deferral date
  • Additional 20% tax on deferred amount

California tax rules mirror the federal rules, so the costs of non-compliance add up quickly.

The most common 409A mistake is with respect to the pricing of stock options. The strike price of stock options must be fair market value. In the case of private company stock, fair market value is determined “by the reasonable application of a reasonable valuation method.” This usually means a professional valuation.

Of course, those cost money and startup companies don’t often have a lot of money. As a result, they may cut corners on this item, making it one of the most common legal issues.

7. Infringing Another’s Trademarks

Technically, a trademark is a distinctive mark that identifies the source of a product or service and distinguishes it from other sources. A trademark can be a word, name, logo, or design. A person receives rights over a trademark simply by using it in the market and does not have to register his or her trademark in order to enjoy trademark protection. Some companies will commence business with a name or mark that is already uses.

After putting much money and effort into building their brand around that mark, they come to find out that they do not have sufficient rights, usually in the wake of a cease and desist letter from a lawyer.

Trademark due diligence is important, maybe not today, maybe not tomorrow, but soon, and for the rest of your life (thank you, Casa Blanca). The entrepreneur should conduct a search before settling on a trademark for the company to avoid using a trademark that is already owned by another.

At a minimum, a basic web search is necessary, and a full trademark search is advisable.

6. Failure to Obtain Invention Assignments

Similar to the contracts discussed in Tip #10, as a start-up entrepreneur acting as an employer, it is important to secure invention assignments from employees creating inventions for the company so that the company retains rights over those assets. Otherwise, an employee may be able to walk out the door with an invention that should have belonged to the company.

This issue often arises in an angel or venture capital financing, when the investors are unable to determine a clear chain of title to the startup’s intellectual property as part of their legal due diligence investigation. Also, there is some unfortunate language floating around in the free forms that you can download from the internet that state that the employee “agrees to assign.”

The language of the agreement should delineate that the assignor (employee) “hereby assigns” instead of “agrees to assign” so that the assignment is effective immediately. See Board of Trustees of the Leland Stanford Junior University v. Roche Molecular Systems,583 F.3d 832, (Fed. Cir. 2009) for a jarring example of the difference a few words can make.

5. Non-compliance with California Wage and Hour Laws

California wage and hour law are almost impossible to comply with, especially in a startup company environment. For example, how many startups are diligent about providing meal and rest break periods to hourly employees?

In addition, how many startups pay all of their people in cash? Typically, people are expected to work for equity at work hours that would make Kathie Lee Gifford cringe (oh, c’mon, it’s a joke!).

As of this writing, the federal minimum wage is $7.25 per hour, California is $8.00 per hour and San Francisco is $9.92 per hour.

Under California Labor Code § 510 an employee can work no more than eight hours in a workday or no more than 40 hours in a week unless he or she is paid overtime for the hours worked over the maximum amount.

Under § 512(a) a meal period of at least 30 minutes must be given to the employee if the employee works more than six hours in the workday. Damages for labor law violations are generally large (See Morgan v. Family Dollar Stores, 551 F.3d 1233 (11th Cir. 2008) (final judgment of about $35.5 million against Family Dollar Stores).

As painful as it is to hear, startups should pay minimum wage. Period. Except possibly to founder types, but even that is a fuzzy exception.

4. Lack of Tax Planning

Too few founders stop to figure out what type of entity the start-up should be (i.e., sole proprietorship, partnership, LLC, S-Corporation). Tax consequences vary. For example, whereas a C-Corporation is subject to double taxation, an LLC is not.

Unfortunately, the standard in Silicon Valley is to start with a C corporation rather than an LLC or S corporation. The usual reason is that the company is going to do a preferred stock round with a VC very soon anyway and will have to be a C corporation at that time. While that is sometimes true, it is not the real reason that startups are usually C corporations.

The real reason is that their lawyers are lazy. A C corporation is easy. It is cheap and requires very little thought, in a practice area where law firms where law firms do money for nothing and law for free (i.e. defer fees until financing) and do not have much appetite for a lot of planning. In fact, the choice of entity decision can be significant as a tax matter, and hard to fix when not properly thought through at the front end.

For example, the tax burden on the sale of assets by a C corporation can be in excess of 60% (42% at the corporate level and another 24% at the shareholder level). If that company were an LLC or S corporation, the income tax burden could be closer to 25%. It is a difference that is worth some planning.

3. Entrenched Management

In two words, “No Vesting.” When founders and employees are fully vested in their stock, the company has that fewer shares to use to attract and incentivize additional service providers. If the vested, or entrenched, employees leave and are not required to surrender some part of their shares, the company may be stressed to find the equity to attract their replacements. managers are able to use the company to further their own interests rather than the interests of shareholders.

It is a hard conversation to have with founders – that it is in their interests to invest there and everyone else’s shares – but a necessary one. Generally, if there are three founders, it is not unlikely that one of the three will find better things to do by the time the company goes out for funding.

If there are four founders, it is likely. With five or more, it is almost a certainty. The bottom line is that founders shares should vest.

2. Lack of Corporate Documentation

Startups don’t keep good corporate records. That is a fact of life that everyone understands and accepts and hopes they can correct when they get some money. Call it deferred legal maintenance.

However, proper corporate documentation is not that tough and can avoid many headaches later on. In addition, under state law, director and shareholder meetings are required, and the penalty for failing to follow formalities can be the loss of limited liability protection.

Good documentation is also important to avoid later disputes and can act as “paper trail,” resolving any disputes that may arise with directors, shareholders, the IRS, the SEC, and courts. They may also show that fair and necessary steps were taken in a transaction or decision and in legal disputes may prove almost dispositive.

The take away is to maintain accurate and updated corporate books and records, even if there are no other shareholders.

1. Not Having the Right Legal Counsel

No lawyer can make your company successful, but the wrong lawyer can certainly cause it to fail. Many people do not like consulting lawyers until a problem arises and many entrepreneurs mistakenly ignore the legal aspects of business altogether.

It is almost always cheaper to do things right the first time rather than fixing legal mistakes which can be expensive and timely. More importantly, some legal mistakes cannot be fixed.

Legal counsel can also help you know what to anticipate and understand applicable federal and state regulations such as tax law, securities law, corporate law, and intellectual property law. Having the right legal counsel for international business matters is even more important, but that is another article.

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