Chris Sloan
Small businesses, particularly in the early stages and during periods of high growth, face a number of common legal concerns. With some planning and good advice from experienced counsel, these issues can be easily addressed. If ignored, some of these issues can quickly turn into problems that are often more expensive and difficult to resolve later. Here are some of the most common legal mistakes, and how to avoid them:
No Vesting Restrictions on Founders
Each founder of a small business typically has the expectation that the other founders will actively work to build and grow the company. Sometimes, though, a founder leaves the company. It could happen for a variety of reasons; some good (a great job opportunity), some bad (the founders no longer get along), some tragic (a founder dies),
What happens to the departing founder’s equity? Absent a specific agreement, the answer is nothing! Legally, that founder keeps all of their equity, which can also create problems and concerns for future investors and employees. Some companies have failed because of problems caused by this issue.
To avoid this problem, co-founders should enter into reciprocal vesting agreements that cause their equity to vest over time. If a founder leaves, they keep what is vested and forfeit the rest. This is very similar to the vesting restriction that startups often impose on stock options or restricted stock issued to employees as incentives, and creates a strong incentive for the founders to stick with the company. More importantly, it creates an alignment of interests and expectations among the founders and a pre-agreed mechanism for handling a founder who leaves.
Choosing the Wrong Entity
Should you be an LLC or a corporation? In what state should the company be formed? These are all important questions that can have lasting consequences. Broadly speaking, if a company is “VC or bust,” it is best to be a C-corporation formed in Delaware. Most venture capital funds will not invest in LLCs, and Delaware has the most respected and widely-known body of corporate law in the U.S. So, a Delaware corporation establishes a familiar and highly-investable corporate structure for potential investors.
However, if venture funding is not a likely growth strategy, start as an LLC in the state in which the business is located. It is almost always possible to convert later to a corporation if the need arises. It is also usually much easier to convert from an LLC into a corporation than the other way around.
Not Protecting IP
One of the most common mistakes high-growth companies make is failing to take steps early enough to protect intellectual property. When dealing with something potentially patentable, waiting can be costly, especially with the recent changes to patent law. The key is to have a plan and decide what the company needs to protect and when to do it. Put another way, if the company fails to decide, the decision might be made for it.
The “work made for hire” doctrine under copyright law is often misunderstood. People usually assume that when they pay for work product such as software, they will own it. However, that is usually not the case, except for work that is done by an employee who is acting within the scope of their employment. Most of the time, absent an express, written assignment of copyrights, the outside developer will own the work product, even in spite of what both parties may have intended all along. So, get an assignment, and get it in writing.
Poor Contract Practices
Get your deals in writing. Make sure that if something is important to the business, it is written into the agreement. Always read carefully and apply the “law of common sense.”
Lastly, keep your agreements simple! When a businessperson reads a contract that is written clearly and concisely, there is a greater chance of getting that contract signed without extensive legal review. Consult a business lawyer to determine exactly which provisions really add value, streamline the rest, and you may be surprised at how much more effective it will be.
Chris Sloan, shareholder and co-chair of Baker Donelson’s Emerging Companies Group; csloan@bakerdonelson.com
