Key Takeaways: Tech startups typically have lean budgets and limited time to spare on legal matters. It’s a combination that too often leads to legal mistakes with potentially expensive consequences. These are 5 common legal mistakes most tech startups make:
- Relying on trust instead of legal agreements.
- Adopting the wrong entity structure.
- Misusing or sharing trade secrets and intellectual property.
- Failing to comply with labor laws.
- Ignoring (intentionally or unintentionally) privacy obligations.
CGL’s Guide To Avoiding Mistakes Most Tech Startups Make
Most founders have habits that make attorneys shudder. Unfortunately, they are par for the course, since startups have so many costs competing for their limited financial resources. But some mistakes are more common than others. And, when it comes to legal mistakes, the fallout can be expensive and damaging.
The mistakes we outline in this article are often made in the very early stages of a startup’s lifecycle. Founders tend to avoid seeking legal advice in the early stages – usually because of the anticipated costs. Instead, they rely on research and documents populated using free document templates, blogs or personal contacts. These templates work in some cases but often, they don’t. So, we’ll provide some guidance about when you should seek legal advice for your startup.
Five Mistakes Most Tech Startups Make About The Law and Compliance:-
Mistake 1: Relying on trust between founders instead of legal documents.
The legal documents you create for your startup shape your relationships with your co-founders, investors, and early employees. We see a lot of clients who are confused about the importance of founders’ agreements. The reality is, in a typical tech startup, the relationship between the founders should be documented in the company’s Certificate of Incorporation, bylaws, stock purchase agreements, and confidential information and invention assignment agreements. These documents should all be formalized early in your relationship and, crucially, when it is in a good place. Founders’ agreements can be developed later – at the financing stage.
In the very early stage, you will need to agree on and document:
- Company structure.
- Management interest, if the company is an LLC.
- Decision-making rights.
- Voting rights, including tiebreaker rules.
- Initial capital and contributions.
- Intellectual property (IP) ownership and assignment.
- Finance management, including whether one or more founders need to sign off on expenses.
- Whether founders will be reimbursed for expenses.
- Founder roles and responsibilities.
- Founder wages.
- Dispute resolution processes.
- Founder exit.
- Founder removal.
- Company dissolution, including winding up and distribution of any assets.
How tech startups on a budget can reduce the cost of formalizing these agreements?
We don’t advise using templates when developing these documents. Templates aren’t appropriate because the documents that govern your startup are based on the unique circumstances of your relationship with the other founder(s). Templates also often assume you are using a specific entity type or state of formation. Both entity and jurisdiction impact which laws apply to your business and your business documents should reflect this.
The simplest way to minimize your legal costs is to come to a high level agreement about all the major provisions in advance of meeting with your attorney. The list above is a good starting point. Coming to an agreement in advance limits the time your attorney will spend investigating, saving you a few billable hours. Bear in mind, the costs of not doing this correctly can be significant – even catastrophic – if a founder walks out with no agreements in place.
Mistake 2: Failing to choose the right corporate structure.
Choosing the right entity structure for your tech startup is one of the most critical decisions you will make in the early stage. The consequences of not selecting the appropriate structure include increased tax obligations and limited access to external investment opportunities. Changing from one entity structure to another is also an expensive and time-consuming endeavour, if it’s possible at all.
Let’s consider this situation:
You’ve noticed that a lot of tech startups register as C Corps in Delaware. This is the preferred entity for high-growth startups – a category most tech startups (at least hope to) fall into. Delaware is the preferred state for registration, as a result of its highly-developed corporate laws for C Corps. The corporate governance structure is attractive for angel and venture capital investments. It’s also relatively straightforward to offer employee equity, alongside the preferred stocks favored by investors.
When might this not be an appropriate vehicle?
A Delaware C Corp is not the ideal structure for every business. Here are three situations where companies may not want to elect this entity structure:
- Companies which are already generating revenue and can be self funded may not intend to take in third party investment. In this case an LLC may be a better choice.
- Companies which do not plan on having employees to whom they want to grant equity may also benefit from the LLC entity structure.
- C Corps also aren’t suited to some industries – like the cannabis industry, for example, which tend to be LLCs for federal income tax purposes.
Mistake 3: Not respecting trade secrets and intellectual property.
Misuse of any trade secrets or intellectual property (IP) can be catastrophic – and may result in your idea no longer being considered yours. Startups should not use the trade secrets and IP owned by a company that the founders worked for previously. At the same time, founders should be careful to retain ownership of the trade secrets and IP they develop with the start up and that they developed prior to the start up.
Misusing your previous employer’s trade secrets and IP
Your employment contract (with any employer outside of the start up) likely assigns the rights to any trade secrets or IP you generate during your employment to your employer. This means your ideas could belong to your employer, depending on the circumstances.
If you’re uncertain whether your idea belongs to you or your employer, it’s worth seeking early legal advice. The financial burden of developing an idea and bringing it to market to then have a former employer claim ownership is devastating not only emotionally but also financially.
If you’re certain the IP is yours, don’t use any of your former employer’s technology, tools, time, or trade secrets to develop your idea. This can be interpreted as you developing an idea ‘in the course of your employment,’ which may result in the rights to the idea being assigned to your employer.
Be careful to retain ownership of your own trade secrets and IP
Ownership of all trade secrets and IP should be immediately assigned to the startup. From there, all founders, freelancers, employees, candidates and anyone else with whom the information is shared would ideally sign either:
- a non-disclosure agreement (NDA), or
- confidential or proprietary information and invention assignment agreement (CIIAA), depending on their role at the startup.
We say ideally because, in reality, investors and sometimes even contractors aren’t going to want to sign an NDA early in the relationship – and asking can sometimes hurt your relationship with them. Moreover, you aren’t likely to have the resources to enforce the NDA if it is breached.
Instead, you should create a ‘sliding scale’ of information to share with venture capital investors (VCs). Work out how you can talk about your idea without going into significant technical detail about execution. Over time, you can share more about your idea and, once you’ve established a relationship, you can ask for your NDA.
Mistake 4: Not paying employees properly.
Startups may run into issues related to worker classification and claims for unpaid wages.
Most startups follow this route when establishing a labor force: first, startups rely on work by the founders – who may or may not still be employed by a third party employer. Then, freelancers perform contract work when it is not financially feasible to hire employees. Finally, non-founding employees are typically brought in once funding arrives.
You need to use caution when determining how to engage an individual to provide services to the company (e.g. whether as a contractor or an employee). They must be correctly classified and paid in line with their classification to minimize risk of claims for unpaid wages. And these risks exist at every stage.
Founders as Employees
Founders may be considered employees of the startup, which means they may need to receive minimum wage for their contributions.
However, startups often rely on the mentality that founders aren’t likely to make a claim against their company for not receiving minimum wage. This is true – if the relationship between the founders stays intact. (Potentially expensive) Issues can arise if a disgruntled founder leaves or is removed and they make a claim for minimum wage.
Another mechanism startups also rely on is paying founders in equity. The federal law exempts founders with 20% or more equity from the requirement to receive minimum wage. But some states don’t allow this – California included.
Legal issues aside, investors are also alert to warning signs that you haven’t been compliant. You may lose the interest of investors if you haven’t been paying your team correctly.
Contractors as Employees
California’s controversial AB5 and Proposition 22 threw a spotlight on the issues companies face when classifying workers as contractors. There’s an entire ecosystem of laws relating to the contractor vs employee definition outside of AB5 and Proposition 22 in California as well as in other states – and it’s something you need to consider.
At the federal level, you need to grapple with the definition of an employee vs a contractor under the Fair Labor Standards Act (FLSA) and the IRS classification standards.
At the time of writing, the FLSA relies on an assessment of the total activity or situation that controls. The US Supreme Court has outlined 7 factors relating to the relationship that should be considered when determining whether a worker is an employee or a contractor. In May 2021, this will change to a test that considers two core factors as being the most probative, namely the nature and degree of control over the work and the worker’s opportunity for profit or loss. There are other guiding factors that will be considered too. You can find the 2021 Final Rule here.
The IRS considers the degree of behavioral control and financial control the startup has over the contractor, as well as how each party perceives their relationship.
The different tests mean that it is possible to classify your workers differently under each. But you should consult an employment attorney if you’re not certain about your obligations.
You’ll also need to contemplate any state standards. California, Connecticut, Delaware, Illinois, Indiana, Massachusetts, Nebraska, Nevada, New Hampshire, New Jersey, Vermont, Washington, and West Virginia, for instance, have stricter contractor laws than the federal standard. The exact application differs in each state and the list above is not intended to be exhaustive. If you’re not absolutely certain about your obligations, you should contact a lawyer.
There are no exceptions for startups under federal and state labor laws and penalties for unpaid wages and misclassification of employees can be expensive. You must pay your employees, including founders, what they’re entitled to or risk being liable for unpaid wages. The only thing you can do is abide by all federal and local laws that apply. If you’re uncertain, spending a little money on legal guidance here is often less costly in the long run.
Tech startups lure early employees with the promise of equity today for a big payout down the line. There are plenty of business decisions you’ll need to make about how much each employee is given. But the contracts you create to reflect your agreement with each employee need to be crystal clear.
Startups may consider using the template form of option agreement, form of exercise agreement, and equity incentive plans available online – but only if you are very clear about how they work. If not, find the template then book in for a consultation with your attorney to check everything is in order.
Mistake 5: Privacy should be built into your tech startup from the beginning, not as an afterthought.
Privacy is an important business consideration, as well as a legal compliance issue. Data breaches can leave your reputation in tatters. They also mean you’ll need to consult a privacy attorney to ensure you comply with all reporting requirements and to mitigate any legal fallout.
We previously wrote The Essential Small Business Guide to Data Privacy. Read it to learn more about building your startup culture around privacy. You can find further privacy insights here.
If you only take one thing away from this article, we want it to be this: Fixing legal mistakes is significantly more expensive than being compliant from the outset. It’s worthwhile building a relationship with an attorney experienced with startups to avoid the mistakes most tech startups make. They will know how to manage legal spend so that your money goes as far as possible.
If you’re ever concerned about your compliance, reach out to an attorney as soon as you can. It will be money well spent.
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