Six Common Legal Errors that Entrepreneurs Can Avoid
by Amyli McDaniel, Attorney At Law

If you’re an entrepreneur, you’re naturally creative, resourceful and flexible. However, these qualities, while valuable, cannot help you if your business gets into one of the more common legal problems facing startups.

The good news is that by knowing the common pitfalls, you can avoid them and keep your business thriving and moving forward, without encountering these easily preventable legal problems:

MISTAKE #1
The first common mistake is not forming an LLC (limited liability company) or corporation for your business or forming one too late. Many mistakenly think you should wait until you have a positive cash flow before creating a limited liability company. This results in your business being operated as a sole proprietorship or partnership until that point, and these structure place everything you own personally at risk.

The fact is you should form an asset protection entity such as a limited liability company right away, as soon as you start operating your business. There are several reasons for this, but two are particularly important.

First of all, by creating a separate entity for your business, whether limited liability company or corporation, you separate your personal finances from your business finances. This means your personal assets can’t be seized to pay business debts and liabilities, and your personal credit record will not reflect your business credit, and vice versa.

Secondly, if you wait until your business is a going concern before creating a legal entity for the business, the IRS may levy heavy taxes on you and any other business owners at that time. In order to avoid unintended and potentially significant tax consequences, it is better to establish a limited liability company early and issue ownership interests immediately.

MISTAKE #2
Many business owners will create a legal entity for their business but then they fail to actually issue ownership interests in the business to themselves and other partners. When you delay issuing ownership interests at the outset, you open the door to problems. Why would you do this?

The primary problem here, when you have multiple business owners, is that everyone agrees and settles on the ownership details and responsibilities, but then they do not actually issue the ownership interests (limited liability company membership units or corporate stock) at that time. Perhaps they just agree and consider that enough, perhaps they don’t get to it, or perhaps they forget.

If you have not issued ownership interests in your limited liability company or corporation, and you need to do business with a third party, the other party may be reluctant or even refuse to work with your business without proof of proper ownership. This could cause delays or obstacles when it comes to borrowing needed capital, taking on strategic partners or signing important contracts with vendors.

There are other possible consequences, as well. The main problem, other than third parties looking for ownership documentation, is that memories can differ, and a gentleman’s agreement can be misunderstood. You can find yourself and your company in a position where the owners later have disagreements on what the actual ownership percentages are. This can ruin your relationships and take your business down. It is far better to issue ownership interests in your limited liability company at the outset based on the agreements of all involved. This will prevent confusion and make it easier for you and the other owners to conduct business.

MISTAKE #3
Mistake number three also involves ownership interests, but in this case, the mistake is giving outright ownership interests to service partners, rather than vesting those interests. What does this mean, exactly?

If you’re like many business owners, you may take on partners who do not directly contribute, financially, to the business. They may provide a service or do other things for the company that move you toward your goals, but they don’t put money in to become a partner. Or, they put some money in, but you agree to issue a relatively larger amount of ownership in exchange for the services they are providing.

The common mistake with service partners is giving them outright ownership interest in the limited liability company up front. If they do not meet their obligation, you cannot take the ownership interest back by force. Ownership rights can only be rescinded with the owner’s permission, which you may not be able to get.

You can avoid this common and troubling problem by vesting the ownership interest. This means that the service partner will have to meet certain requirements to receive an ownership interest. If the partner does not meet their obligation, they forfeit their ownership rights in your limited liability company.

This is the best way to protect yourself and the other partners from an unscrupulous, or simply unreliable, service partner.

MISTAKE #4
The fourth common mistake entrepreneurs make is allowing contractors to keep ownership rights of intellectual property. This mistake, of course, is inadvertent, but it is crucial that you make sure ownership rights of all your property belong to you.

As an entrepreneur, you may contract a great deal of your business, including web design, contact, and possibly product development, such as software or other intellectual property. Using contractors is great for your business. You can reduce your overhead and help conserve your funds and grow your business quite well with outsourcers.

However, copyright law generally gives the creator ownership of all work. This means you must get the contractor to assign rights or sign a work-for-hire agreement giving you all rights to the final product upon payment for the work. This is very easy, and most contractors are used to assigning rights. However, if you’re working with overseas contractors, make sure that you obtain all the necessary international rights to the work.

MISTAKE #5
The fifth mistake most entrepreneurs make, that can seriously hurt your business, is not getting a signature on a nondisclosure agreement when sharing confidential information with third parties.

You should have a signed nondisclosure agreement before you show anyone business plans, information on marketing, branding or pricing, anything relating to business methods and processes, or intellectual property. In fact, you can actually lose the right to patent your own innovations if you show them to someone without the proper protection from a nondisclosure agreement.

If you truly need or want to show information to someone who is not willing to sign a nondisclosure agreement, you should put a confidentiality notice on all written documents you share. This will serve two purposes. It will show other parties that the material is confidential and it may also give you trade secret protection in state court.

Sharing confidential information unwisely can cost you your business, so be very cautious. Work only with people and companies you trust and do your best to get a nondisclosure agreement whenever possible.

MISTAKE #6
The sixth, and possibly most damaging, mistake people make when they start and operate a business, is not hiring a lawyer who specializes in business. Hiring a general practitioner lawyer sounds cheaper at first, because their billable rate is usually lower.

However, a lawyer without the experience and knowledge to protect your business can cost you heavily. While a general lawyer may have a lower billable rate, you will likely end up paying more in legal fees for the lawyer’s time. They lack the expertise and charge by the lawyer so you will pay for their research and time to learn the applicable business law. More importantly, you may not be as well protected as by a lawyer who specializes in business law and has seen and dealt with the common traps that befall business owners.

All of these common mistakes can happen to you, but none of them have to. You can avoid these and other business legal issues for your business by hiring a competent and experienced business lawyer and understanding what you should do to protect your business.

ABOUT THE AUTHOR:
Amyli McDaniel is a practicing business attorney with 15 years of experience helping entrepreneurs to start and grow their businesses. Visit her at The LLC Expert.