Startup clients have often asked me what they should be watching out for, as if I have been embedded with their company for months and can readily identify gaps in their legal protection.
As external counsel tasked with working on discrete projects, rarely is it ever the case that I can immediately start listing out what the client has neglected to get done prior to my involvement. Some due diligence is necessary for that.
So, to answer that question I have so many of my own questions to ask and plenty of rocks to turn over. Because every company goes about everything in their own way, I might find a major gap in corporate governance at one startup and a major gap in intellectual property protection at another.
While I may not be able to answer that question here for every startup, I can at least provide a useful check-list. Every founder should go through this analysis in order to identify gaps; those areas where they may have failed, either partially or entirely, in securing necessary legal protections. Here are ten:
1. select the right corporate form
The moment founders are spending any considerable amount of time developing a product or service, purchasing domain names, building a marketing plan and/or seeking funding (at any level), they should set up a separate legal entity. I could go into a lengthy monologue as to why this is important, but it would take up valuable space and I would lose the reader’s attention.
Just as importantly, founders should not belabor the issue.
I can usually predict which startup will fail. It will be the one that spends more than an hour trying to decide between an LLC or a C-Corp. Successful founders are decisive, and recognize that they will have to make thousands of decisions their first year in operation.
Deliberating on this issue too long may in fact reveal a hesitancy by the founders to take a chance on this new endeavor. For those indecisive founders out there, my suggestion is that they keep their day jobs and practice feigning interest when a co-worker in the staff kitchenette gets into how excited she is over the wide assortment of flavored coffees offered by Keurig®. Comfort, boredom and stability are not part of startup life.
2. conduct official business through the legal entity
A major reason to set up a separate legal entity is to give life to an entity that is separate from its founders. However, this purpose is defeated if the founders continue to conduct official business as if they are doing so as individuals.
When signing contracts, founders should sign in their official capacity, not their personal capacity. Founders should likewise avoid personally guaranteeing any obligations of the company, unless the deal is vital to their existence and it’s the only way to get the deal done. Even so, before doing so they should seek a written obligation to be indemnified by the company.
When acquiring assets for the company (e.g. trademarks or domain names), this should be done under the name of the legal entity — not the names of the founders. It can be both costly and burdensome to transfer the ownership of assets from founders to the legal entity, and could in fact trigger a tax obligation if any of the assets have appreciated in value while under the legal ownership of any of the founders.
Just as important, prospective investors do not like seeing casual respect given to the legal entity. If they choose to invest, they want to see all the assets neatly sitting in one basket.
3. register trademarks
I am convinced that the only reason some startups wait so long to register their trademarks is because attorneys are scary, as in ‘scary-expensive’. So instead the founders keep kicking that can down the road, perhaps thinking that if the business is not viable they will have saved a few hundred dollars on what would by then be a useless trademark certificate.
Not all trademarks are alike, and some pose greater challenges than others. However, a good distinctive trademark should not be expensive to register, and indeed some founders have done it themselves without the assistance of an attorney. For founders who are do-it-yourselfers, it can cost as little as $225 in filing fees to register a trademark in one class of goods or services and it can all be done online.
Also, headaches can be avoided by choosing a trademark that is distinctive (i.e. not confusingly similar to an existing trademark). This improves the chances of coasting through the trademark examination process and avoiding the need to involve an attorney to get past legal challenges by the United States Patent & Trademark Office or any opposing third parties.
As an attorney, I certainly do not recommend filing for trademarks without the input of an attorney. An improperly prepared application can cause months in delays and result in the need to involve an attorney, at an hourly rate, to make the necessary repairs. The alternative is to abandon the improperly prepared application, but that results in a loss of the filing fees and the priority date of the application.
4. comply with regulations
I am going to safely assume that most founders reading this are only interested in direct to consumer sales over the Internet — at least initially.
While there are savings associated with skipping the brick & mortar route, launching a website that is accessible on a national scale opens the door to a multitude of federal and state regulations. California alone has several regulations that will apply to your website, and some of the strictest, whether you are selling goods or services. Comply with California and you’re close to 100% compliant everywhere else.
There is also increased scrutiny on marketing done through social media channels. It’s not rocket science remaining compliant, so spending a few hundred dollars on some basic legal advice and perhaps also the creation of a social media marketing policy will serve a startup well.
What is the return policy? How long is the product or service warranted? Are full refunds granted, including shipping charges? If a dispute arises, can a customer take part in a class action against the company? Is there a limitation on damages?
“There is gold in that there database.” That database of customers the startup is building could prove to be the startup’s greatest asset someday. But what good is it if the startup has not secured permission from its customers over the use of their data beyond the specific transactions?
7. work with a good tax person
Founders should work with a good tax person; perhaps one recommended by their attorney. By “tax person,” I do not mean a tax attorney. A tax attorney is only necessary when the company is in trouble with the IRS or some state’s department of revenue. So please do not confuse the two.
By “tax person”, I mean a CPA or even a sophisticated tax preparer; someone who understands business operations and how they may trigger tax reporting and payment obligations.
This is someone who will advise the startup whether to choose an LLC versus a C-Corp, and whether S-Corp status makes sense (and when it will no longer make sense). It should also be someone with whom the startup checks in regularly, and not just whenever tax reporting is due. In fact, every major transaction or initiative should involve input from a good tax person, who can advise how best to structure a deal in order to minimize tax obligations and likewise remain compliant with taxing authorities.
8. organize your contracts and corporate documents
I have often asked clients for a copy of a contract, or perhaps even just their operating agreement. What I have received in return has often been a bit jaw-dropping. For example: contracts without a counter-signature; contracts with no signatures; contracts without vital exhibits; signed vendor-drafted proposals standing in as contracts; missing contract amendments; and my favorite one of all, no contract at all. If a dispute should ever arise, think of how awkward it will be to ask the adversary for a copy of the contract. I have had to do this, and it’s not easy.
Founders should learn this now and take it with them to their deathbeds: A contract is worth less than the paper it’s written on if the party wishing to enforce it cannot locate a countersigned copy. Delay deal-signing celebrations until after a fully executed copy of each contract, complete with exhibits, has been received and archived by the startup. Every subsequent mutually executed amendment should also be filed and cross-referenced with its respective contract.
9. involve a generalist attorney
The vast majority of attorneys specialize in one area of law, and they make their money providing very specific advice in that one area. These attorneys are valuable, when a startup has that “one” complex problem.
But what of the startup that needs more generalized and ongoing legal advice, crossing over and into a variety of legal areas? That is when I suggest finding an attorney who has spent a major part of his or her career in-house and tasked with dealing with everything that came his or her way. Aside from being capable of dealing with the vast majority of legal issues that could land on the doorstep of the startup, these former in-house legal practitioners take considerably more practical approaches to solving legal problems. In-house attorneys rarely had the time or the luxury to over-complicate legal matters. This may be because not billing by the hour has a marvelous way of teaching attorneys how to be both efficient and practical.
Founders are therefore advised to look into the backgrounds of all candidates being vetted to handle the startup’s legal work. Those candidates should have a track record of both, providing legal advice and having hands-on experience, and in areas as varied as intellectual property, corporate law, real estate, commercial contracts, and regulatory compliance, to name a few. The attorney should also understand the realities that startups face, namely that there is no reward without having to stomach some risk.
When a letter arrives at the startup, perhaps making a legal allegation, the founders will know to whom it should immediately go for legal attention. This generalist can either handle the matter or identify the specialist attorney who might be better suited.
The founders have by now involved a tax person and an attorney. However, there is still one more individual needed to complete the team of professionals who will be charged with protecting the startup.
Any startup engaged in the sale of goods or services places itself at risk of litigation. In fact, even the startup’s own employees, freelancers or vendors can be a source of liability. For this reason, founders should identify an insurance broker who can assess the risks faced by the startup and assemble a menu of insurance plans that offer varying levels of coverage.
During my time spent as an in-house attorney, I had to file many claims with my client’s insurers. If my clients had not carried insurance, these matters could have cost my clients thousands of dollars in legal fees and the payment of damages. This is all to say that a good insurance broker will direct the startup to the right policies to cover the risks that the startup cannot carry alone. Carrying the right policies, in the right amounts, is also something prospective investors want to see during their due diligence.
The checklist above is certainly not exhaustive and perhaps not relevant to every startup, but it should give founders some idea of what they should be doing to protect their company and whom to involve. Looking at the company from the perspective of a prospective investor is also useful. If you were about to invest $250,000 in a company, what questions might you ask?
As the startup grows and becomes more complicated, the list will also grow and get increasingly complicated and detailed. The time may even come when the startup will have a C-level suite of professionals responsible for protecting the company, including an in-house attorney capable of quickly identifying and covering gaps in legal protections.
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Fabio R. Silva, Esq.
Disclaimer: The above is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.
©2017 Fabio R. Silva. All Rights Reserved.