Turning an idea into a successful business isn’t easy, but you can keep your journey on track by avoiding these top five legal pitfalls.
Pitfall No. 5: Not conducting a timely trademark search.
The name and branding behind an idea can be as important as the idea itself. However, using a name before thoroughly confirming its availability can have fatal consequences.
A trademark is any word, name, logo or design, or any combination, that identifies goods or services of one source and distinguishes them from others. Registering a trademark will help prevent others from trying to use the same, or confusingly similar, name as you. More importantly, registering a trademark allows you to use a name without the worry of infringing on someone else’s rights.¬
A trademark application requires that you are already using your product or service in commerce or intend to in the foreseeable future. You may file an “intent-to-use” application that reserves your trademark until you are ready, so long as you file evidence of use in commerce within six months, subject to certain extension periods.
Because serial entrepreneurs generally move fast, they often fall victim to this fact pattern: You have the perfect idea, the right business plan and the right team to push the product into the market. The excitement begins and you build out a webpage, search engine optimization (SEO) and manufacture and package the product or service for sale. The product or service gains traction, and once you start to realize profit, you receive a letter demanding you stop using the name because you are infringing on the trademark rights of a senior user. After investing sweat equity and money into your company, you are left with no choice but to completely rebrand and start over.
To avoid this pitfall, consult with an attorney early in the startup process. A trademark attorney can assist in conducting a thorough trademark search and a successful application thereafter.
Pitfall No. 4: Not organizing the company properly.
Most startups begin with an idea among small groups of like-minded individuals or friends; therefore, most startups do not make clear the deal between cofounders nor anticipate cofounder conflict. However, not having an operating agreement to govern the company’s internal operations can be fatal when friendly turns to fire.
An operating agreement is a legal document that outlines the company’s ownership, management and structure. In other words, an operating agreement is a company’s playbook for dispute resolution and governs the functional and financial decisions of the company, its members and the business.
Here are some important terms an operating agreement should address:
- How will the equity be split among the members, and how are profits and losses distributed?
- How will major decisions and day-to-day management of the company be made, and by whom?
- How will members be admitted or removed, and can the members sell or transfer their interests?
- Will the members or managers be subject to a non-compete clause during or after their time with the company?
- How is the company taxed?
- Who is liable for what?
- What happens if the company is sold?
Many startups fail because the founders cannot resolve disputes amicably.
To avoid fatal disputes over management and finances in the future, agree on the terms of an operating agreement at the outset.
Pitfall No. 3: Not keeping business and personal funds separate.
Because early-stage startups are short on cash and/or self-funded, many founders have trouble keeping personal and business bank accounts separate. However, commingling of funds can have severe consequences for both the founders and the company itself.
For startups, commingling of funds often means the founders treat their personal and business funds as one. For example, the founders may make withdrawals from the business account to pay personal expenses or deposit personal money to pay for business expenses. This is bad business from a tax perspective, but also from a legal perspective.
Most startups are formed as LLCs or corporations to protect the founders from the company’s debts and lawsuits. However, if the founders commingle funds, they may lose this liability protection through what is known as “piercing the corporate veil.” If the corporate veil is pierced because the founders treated the company’s money as their own, their personal assets may be reached to satisfy debts of the company.
To avoid this common mistake, it is important to keep separate business and personal bank accounts and identify what transactions are personal versus business. If not, you jeopardize the protection an LLC or corporation provides to reduce your personal liability risks.
Pitfall No. 2: Not using tailored contracts.
The internet makes everything easier, including the ability to find forms of contracts online. While this might save time and money short-term, it also exposes many startups to risks down the road.
Many startups do not know what type of contract they need. Using an online form can result in omitting a key contract provision, or even including a fatal provision. Contracts should be tailored to the specific needs of your business, the parties to the contract and the transaction. Online contracts won’t explain the transaction, account for terms important to the transaction, set clear obligations of the parties or address dispute resolution.
Unfortunately, most startups do not realize the risk of online contracts until it is too late. Online contracts often result in disputes or lawsuits that could have been easily avoided if the company set aside time and money at the outset to properly draft their agreements.
It is important to understand that individual words in contracts have severe consequences, and the decision to save a few hundred dollars at the outset may cost you thousands of dollars if the contract is litigated.
To avoid these legal risks, hire a professional to draft your startup’s formation and operating contracts.
Pitfall No. 1: Not complying with securities laws.
Early-stage startups often raise capital from investors, friends and families without considering state and federal securities laws. If you are raising money from investors, you are likely going to be issuing securities and subject to these laws.
Securities laws operate to protect investors and prevent fraud. While the legal requirements of securities laws are complicated, both federal and state law require a company selling a security to register that security with the SEC or the state, unless an exemption to registration is available. Most exemptions require the company to undertake certain actions or refrain from certain other actions, as well as impose significant limitations on how you can sell and who you can sell to. As such, relevant securities laws require certain disclosure, filing and form compliances, but also prohibit you from making certain statements when raising money.
The company and its founders may be subject to various types of liabilities for not complying with state and federal securities laws, including civil or criminal lawsuits. In addition, the company and its founders may be required to return to investors their investment plus interest if the investment goes bad.
To avoid this fatal consequence, it is essential your startup and its founders have a thorough understanding of the laws and retain a securities law attorney before raising capital or using capital raised to operate the company.
Many serial entrepreneurs and startups make mistakes by moving too fast, often without knowing it. Whether you are in the idea stage or a fully operational business, your future self will thank you for slowing down. Consider consulting an attorney so you, too, can avoid these pitfalls.