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Common Legal Mistakes Made By Tech Startups

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by Lisa W. Liu, senior partner at The Mitzel Group

If you’re a startup looking to raise money from venture capital firms, take note!

Avoiding these common legal pitfalls can potentially save you multiple six figures in legal fees and a lot of heartache in not getting the funding you want.

Organizational Structure.

Startup founders are often enticed by the limited liability company (“LLC”) format because of its simplicity, lack of formalities, and quite often, because they didn’t spend the money to hire experienced attorneys. Don’t get me wrong; LLCs are a great organizational structure for certain types of businesses, but if you’re looking to grow the business and quickly exit or raise venture capital, a Delaware corporation is the only way to go.

Let me tell you why:

  • Why Delaware? Delaware has well-established and predictable laws that tend to be business friendly. Over a million legal entities are incorporated in Delaware (including a majority of Fortune 500 companies). As a result, Delaware’s statutes often serve as a model for other states. This means the vast majority of attorneys and investors are familiar, and more importantly, comfortable with Delaware corporate law. Bottom line – VCs like Delaware and giving them something different will give them pause.
  • Why a corporation rather than an LLC? Engaging investors or issuing equity to employees increases the number of company owners. The corporation format can easily accommodate rapid owner growth because shareholders are bound by the charter documents, whereas for LLCs, all owners must be parties to the operating agreement. From a tax perspective, unless the LLC makes an “S” election, the entity is taxed as a partnership and must issue K-1s to all members, which reveals how much income the LLC has made and is more transparency than startups usually prefer to give.

Intellectual Property Ownership

Failing to obtain clear rights to intellectual property and failing to properly license technology protected by others are two common pitfalls for tech startups.

  • The COMPANY must own its IP assets, not the individual founders or inventors. If the founders or inventors own the IP, the value of the IP is vested in those individuals rather than in the company. If those individuals leave the company, the value leaves as well (and so, too, does investor interest). As such, all founders and inventors should assign any pre-inception inventions to the company, and all employees should sign agreements assigning any inventions conceived while on the job.
  • Rights to use patented or copyrighted materials must be obtained, otherwise, you risk legal liability for infringement. You should be wary of using open source components that might expose your inventions to public disclosure or public license obligations, as often is required when granted a source code license.

Employment Quagmires

Two often overlooked employment-related missteps involve incentive stock options (ISOs) and misclassifying employees as independent contractors.

  • Qualified stock options are given capital gains tax treatment, whereas non-qualified stock options are subject to earned income tax upon exercise because ISOs require the holder to keep the stock for a longer period of time. In order to be a qualified plan, it must meet several specific criteria regarding how the options are issued, approved by shareholders, held and priced. Not adopting a qualified plan could mean unhappy employees with very big tax bills.
  • Misclassifying employees as independent contractors. When starting out, it is very tempting to hire independent contractors for certain roles as a way to save money on benefits and taxes or keep flexible staffing levels. Unfortunately, improper classification can expose the company to significant back taxes, penalties, interest, expensive lawsuits and government audits. If you thought you could get away with it in past years, that is no longer the case. With the rise of new legislation in California (AB5), all states are now taking a closer look at worker classification.

Fundraising – Not having a well-planned fundraising strategy

While not necessarily a legal topic, there are advantages to including your legal advisor in your fundraising plans from the start.

  • Ideas alone will not get funding, even amazing ones. On the other hand, long-form business plans explained in excruciating detail won’t get read. Instead, develop a well-articulated pitch deck that clearly conveys the problem, the solution you are providing, your competitive advantage, the size of the addressable market, and the fabulous team helping to manifest the vision.
  • Research potential investors – what kind of companies they invest in, what their networks look like, and how they might help you beyond just the capital investment. The better you know the audience, the more productive ($) the pitch will be.

By beginning with the end in mind and obtaining advice from experienced counsel, your technology startup will be positioned for success from the start.

 

Lisa Liu

Lisa W. Liu is a senior partner at The Mitzel Group, where her practice focuses on business and immigration issues. As an entrepreneur and former investment banker, Lisa skillfully leverages finance expertise in conjunction with the law to position clients for growth and successful exit.