Ten Common Legal Mistakes of Early-Stage Companies

By Rob Fogler and Lee Reichert

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The overriding emphasis for technology startups, particularly those seeking financing, has been on generating revenue and profits. Early-stage companies, however, can incur significant liability and expense unless they avoid the following common legal mistakes.

• Choosing an improper legal entity — Founders may choose to operate their business as a limited liability company or a limited partnership for the tax advantages or flexibility they provide, but these entities can cause problems for later investors. If founders instead choose to operate their business as a corporation, they must select the state in which to incorporate. Though Delaware and Colorado are the leading candidates for Colorado-based companies, each has its own benefits and drawbacks.
• Failing to follow corporate formalities — A company that does not follow proper corporate formalities, such as holding director and shareholder meetings or properly documenting and maintaining minutes for such meetings, inadvertently may create personal liability for its shareholders or directors. Moreover, a company that fails to maintain proper corporate records may lose credibility with a potential investor performing due diligence.
• Misunderstanding fiduciary duties — Stockholders, directors and officers of a company have different fiduciary obligations to the company and other stockholders. These obligations can become especially confusing if one person wears one or more hats — sometimes as a stockholder, director and/or an officer of the corporation. Without proper legal counseling, a company can find itself in the middle of stockholder disputes or even lawsuits over breaches of applicable duties.
• Misunderstanding the pitfalls of financing options — Each type of financing of a company, whether a line of credit from a bank, seed financing from friends and family, angel financing or venture capital, has its own disadvantages and potential pitfalls.
  • Companies that do not understand the restrictions and timing issues associated with each type of financing may become unable to carry out their business as planned. Attorneys who understand current market terms and conditions can assist in the financing process.
• Issuing stock in violation of securities laws — Federal and state securities laws prohibit early-stage companies from issuing stock to investors, founders or employees unless there is an exemption from the registration requirements for such issuances. If a company violates these laws, it may incur substantial liability, which in the worst cases can prevent a company from going public or create personal liability for its officers and directors.
• Issuing stock without regard for tax consequences — There are many ways to allow founders and key employees to participate in the financial success and upside of a company. Businesses that issue stock or stock options to founders and employees without considering the tax consequences can create significant tax liability for these persons.
• Mishandling employment issues — Companies that are not careful when documenting relationships with employees and independent contractors accidentally may change their status from an at-will employee to one with special rights upon termination, or from an independent contractor to an employee for whom the company must provide benefits and withhold taxes.
  • In addition, employee obligations such as noncompetition, nonsolicitation, confidentiality and intellectual property obligations should be properly negotiated and documented at the time of hiring to ensure enforceability.
• Failing to anticipate stockholder disputes — In a closely held company, stockholder disputes about the business, philosophy or strategy of the company often can lead to corporate deadlock. Stockholders may want to provide that in certain circumstances, one stockholder may buy out the other. These provisions are difficult to negotiate and document properly, and as a result, parties always should consult lawyers with regard to these provisions.
• Failing to protect intellectual property — Any company that owns, or hopes to own, significant intellectual property should take the proper legal steps to protect and establish good title to it. To protect certain items, such as trade names and inventions, the company may wish to file for trademark or patent protection.
  • Entering into legally enforceable confidentiality or licensing agreements may protect other intellectual property. Companies also should take proper steps to ensure that work-for-hire entities created by others remain the property of the company.
• Failing to hire the right professionals — A company that hires knowledgeable legal, accounting and tax advisors who are used to working with early-stage companies can avoid all of the above mistakes. A company should hire and consult with those advisors in the early stages of its formation. Compliance with applicable laws can be relatively inexpensive if experienced professionals are brought on board at the right time. But the cost to fix these mistakes is not.

— Rob Fogler and Lee Reichert are partners in the corporate department of law firm Kamlet Shepherd & Reichert LLP in Denver. They can be reached at, respectively, rfogler@ksrlaw.com and lreichert@ksrlaw.com.

This article originally appeared in the July, 2002 edition of FrontRange Tech Biz and is reprinted with permission.