The 5 Most Expensive Legal Mistakes made by Startups

The early stages in the life of a startup are often overwhelming. And let’s be honest, dealing with the legal affairs of the business is probably the last thing founders want to dive into. Especially at a time when they are already struggling to keep their heads above water juggling the multitude of priorities making demands of their limited time and cash.

Unlike the exciting product launch, shiny new website, or cash in the bank from sales, getting legal protection in place for the business rarely leaves founders with any immediate, tangible proof of its value. The result is that many of them don’t seek out legal services at all in their first year, opting instead to pour their limited resources into finalising the product or service offering and making sales.

The truth is that legal mistakes in the early days of a startup’s life can ruin its chances of success in the long term, just as effectively as a poor product-market fit or failed sales and marketing strategy.

A secret that most successful business owners know is that good lawyers are cheap. Not because they offer bargain-basement prices, but because they more than make-up for the costs of their services in the value that they add to the businesses they serve.

Here are 5 of the most expensive legal mistakes we have seen start-ups make in their first year and our tips on what can be done to avoid them.

1. Wrong legal structure. Oops, no protection from insolvency.

Many new founders launch into their new venture without giving much thought to the legal structure of the business. By default, they end up operating as a sole trader or, if there are two or more founders, as a general partnership. These legal structures are easy to set up and inexpensive to run, with no formal filing requirements to contend with.

But they leave the founders open to a genuinely hair-raising risk: if the business runs into financial difficulty and cannot pay its debts or faces an expensive legal claim from a disgruntled customer, the personal assets of the founders will be up for grabs, including savings, cars and even the family home.

For most businesses, incorporating as a limited company is the legal structure of choice, the biggest benefit being limited liability protection for business owners. As a shareholder, unless they have acted fraudulently, founders have no legal obligation to pay more than the value of the shares they have in the company towards the company’s debts and can therefore protect themselves from the risk of financial ruin if the business goes south.

2. No founders agreement. Oops, no protection from co-founder conflict.

New founders often take on co-founders, if not from the very start, then later on in the life of the startup as the needs of the business grow. Being able to offer an equity share of the business in return for the dedication of a co-founder is a great way of getting a business going before you have the revenue to hire employees.

But what if the new co-founder fails to break a sweat for his or her “sweat equity”?

In the absence of an agreement setting out clearly where everyone stands and how any disputes are to be resolved, disagreements between co-founders over their respective roles and responsibilities or vision for the business can cripple a growing startup, at a time when acting fast and being able to adapt quickly to changes in the market are key.

A comprehensive founder agreement will ensure that the business can survive such disagreements. The agreement should cover issues such as share vesting arrangements to make sure co-founders are only rewarded with equity after showing a long-term commitment to the company’s success, the time commitment expected of each founder, the circumstances under which a founder can be fired as an employee, and the vision for the business.

3. Inadequate standard terms. Oops, no protection from trading risks.

The lifeblood of every business is its customers (and their cash), so landing that very first customer is a moment to be celebrated. But that joy can soon turn to tears if the company isn’t protected from the common risks of doing business, like late payments, scope creep eating into your margins, and financial caps on liability if things go wrong.

Every business should have its own, tailor-made standard contracts for customers which accurately reflect the way it does business. But in reality, many start-ups rely on generic templates or re-purpose contracts obtained from competitors which may not match up with their expectations or address important risks that they face.

I’ll let you in on a secret: poorly drafted or ill-suited contracts are not worth the paper they are written on.

Having your own standard terms will ensure that you’re able to provide the protection that your business needs and will enhance your reputation because customers will know what to expect from you.

4. Poor service agreements. Oops, no protection from rogue employees.

In their first year, many start-ups will utilise the skills of a range of individuals to build the business, including interns, freelancers, consultants, and employees. These individuals are often given access to the start-up’s confidential information, including customers and supplier details, product formulas, trade secrets, and anything else that gives the business a competitive advantage or could be damaging if it was released.

It is tempting to hire individuals on a handshake or a bare-bones service agreement, but this opens start-ups up to the risk of that confidential information being leaked which could spell the death of the business, especially in this fast-moving and highly competitive digital age.

To guard against this risk, everyone who works for the business must be required to enter into a comprehensive service agreement that includes confidentiality provisions to ensure that workers are contractually bound to keep any confidential information they learn about the business secret, even after they leave, and restrictive covenants to stop former employees from working for a competitor for a certain period of time or from poaching your customers.

5. Neglected intellectual property assets. Oops, no protection from competitors.

Many start-ups are aware of the importance of intellectual property (IP), recognising that IP is often a start-up’s most valuable asset. IP dictates the ownership of important assets, from the start-up’s name, down to the lines of code that make its product work.

Despite this, a common mistake made by early-stage start-ups is a failure to ensure that it has ownership over these assets, especially software code.

It is crucial that employees, consultants, and any agencies engaged by the start-up enter into an agreement which makes clear that ownership of intellectual property rights in the work product lies with the company and not with the service provider, or they could sell it to your competitors.

Similarly, startups can get into legal hot water if they fail to protect their brand name by registering it as a trademark. Before spending the time and resources on designing a website, having a logo made, and printing business cards make sure that your chosen name has not already been protected by a competitor.

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