As aspiring entrepreneurs, we often focus on the exciting aspects of starting a business, such as developing innovative ideas and securing funding. However, it’s crucial not to overlook the legal aspects that can make or break a venture. Harvard Business School associate professor Connie Bagley shares her insights on the top ten legal mistakes that entrepreneurs commonly make, providing valuable advice for those navigating the complex world of business law.
Mistake #10: Failing to incorporate early enough
One common pitfall arises when a partner involved in starting a venture later drops out, only to return when the company achieves financing or prepares for an IPO. This partner may demand equity, often overestimating their contribution. Incorporating early and issuing shares to the founders, subject to vesting, can help eliminate this problem. Additionally, founders should be required to assign all relevant inventions and works related to the business to the corporation as partial consideration for their shares. Incorporating early also prevents potential tax issues related to inexpensive stock issuance later on.
Mistake #9: Issuing founder shares without vesting
Vesting protects the founding team members who drive the venture forward. It ensures that shares only fully belong to team members who remain productive and committed. If team members leave before vesting, their shares can be retrieved and given to replacements.
Mistake #8: Hiring a lawyer without experience in dealing with entrepreneurs and venture capitalists
The choice of legal counsel can influence how venture capitalists perceive an entrepreneur’s judgment. It’s important to hire a lawyer who understands the nuances of working with entrepreneurs and investors. A lawyer with experience in the field can focus on the right aspects of the deal, negotiate effectively, and close the deal promptly.
Mistake #7: Failing to make a timely Section 83(b) election
By following advice from Mistake #9, shares are issued subject to vesting. If the stock is acquired under a substantial risk of forfeiture, the IRS does not consider the purchase complete until the risk disappears. When the stock vests, the risk evaporates, and the IRS calculates the difference between the price paid initially and the fair market value at that later date, taxing it as ordinary income. However, making an 83(b) election allows the tax computation to be based on the value at the time the shares are issued, often resulting in lower taxes.
Mistake #6: Negotiating venture capital financing based solely on valuation
While valuation is important, there are other critical factors to consider when selecting a venture capitalist and negotiating funding. Reputation, industry contacts, and the ability to support entrepreneurs during challenging times are essential considerations. The highest valuation may not always come from the most reputable sources of equity.
Mistake #5: Waiting to consider international intellectual property protection
When it comes to patents and trademarks, one must act promptly, as regulations vary across countries. Selling or publicizing an invention before filing a patent application can render it unpatentable in certain countries. Similarly, trademarks developed in the United States may infringe upon existing trademarks in other markets. Entrepreneurs must make informed choices about the markets they target and allocate resources to protect their intellectual property early on.
Mistake #4: Disclosing inventions without a nondisclosure agreement or before filing a patent application
If patent protection is not available, maintaining inventions as trade secrets becomes crucial. Entrepreneurs must take reasonable steps to keep trade secrets confidential from competitors. While getting potential venture capitalists to sign nondisclosure agreements is ideal, it may not always be possible. However, explicit confidentiality statements in business plans can provide some legal protection.
Mistake #3: Starting a business while employed by a potential competitor or hiring employees without checking their agreements with current employers
Operating a competing business while employed by another company, particularly as a key employee, is generally prohibited by law. Entrepreneurs should approach their current employers, either resigning or disclosing their plans and exploring potential investment opportunities. Even after leaving the employer, employees should not use or disclose trade secrets from their previous job. It’s also important to be aware of non-compete agreements and assignments of inventions that employees may have signed with their current employers.
Mistake #2: Promising more in the business plan than can be delivered and failing to comply with state and federal securities laws
Integrity is key when it comes to business plans. Entrepreneurs must make honest appraisals and clearly outline their assumptions. Promising more than what can be realistically achieved amounts to fraud and can lead to legal consequences. Additionally, entrepreneurs must ensure compliance with federal and state securities laws when selling stocks or other securities. Ignorance of the law is not an excuse, and violations can have severe repercussions.
Mistake #1: Thinking legal problems can be solved later
One of the most critical mistakes entrepreneurs make is assuming that legal issues can be addressed at a later stage of the business. Neglecting legal considerations early on can lead to significant complications down the line. Hiring a competent lawyer from the start can save time, effort, and money in the long run. Experienced legal counsel can guide entrepreneurs, ensuring they navigate legal challenges effectively and minimize risks.
Remember, understanding and addressing the legal aspects of entrepreneurship are crucial for long-term success. Being mindful of these common legal mistakes can help entrepreneurs build a solid foundation for their ventures.
FAQs
Q: What are the top ten legal mistakes made by entrepreneurs?
A: The top ten legal mistakes made by entrepreneurs include: failing to incorporate early enough, issuing founder shares without vesting, hiring a lawyer without experience in dealing with entrepreneurs and venture capitalists, failing to make a timely Section 83(b) election, negotiating venture capital financing solely based on valuation, waiting to consider international intellectual property protection, disclosing inventions without a nondisclosure agreement or before filing a patent application, starting a business while employed by a potential competitor or hiring employees without checking their agreements with current employers, promising more in the business plan than can be delivered, and thinking any legal problems can be solved later.
Conclusion
Navigating the legal landscape is an essential part of entrepreneurship. By avoiding these common legal mistakes and seeking expert guidance, entrepreneurs can protect their interests, minimize risks, and ensure a solid foundation for their ventures. Remember, proactive legal measures are far more cost-effective than trying to fix issues later on. So, prioritize legal considerations and set yourself up for success.