avoiding common mistakes
Starting a business can be intimidating. Choosing a location, hiring staff and building a customer base are among many pieces of the puzzle that must be assembled in order to build a strong business. In the midst of all that activity, important elements of legal planning can be overlooked, sometimes with consequences that are not easily remedied.
Here are ten common mistakes made by new business owners, with some thoughts on how to avoid them:
1. Making Risky Personal Guarantees Your personal guarantees to banks, landlords, and others may expose you to a much greater downside than you anticipate. While your equity investment is at risk, your total risk may be much greater. Make sure your personal guarantees are limited where possible. Also, see that your co-investors assume their fair share of risk to avoid being solely financially responsible.
2. Assuming Unlimited Liability Operating your business as a sole proprietorship or general partnership, without a liability shield, is a common mistake. By forming and operating a business through a corporation or limited liability company, your liability will in most instances be limited to the amount you invest plus amounts you personally guarantee. Without a liability shield, you will be personally liable for all business obligations.
3. Not Planning for Taxes Most new businesses generate losses during start-up, but those losses can have tax value. To utilize tax losses while enjoying limited liability, many businesses organize as either an LLC or an S corporation. The tax code contains an elaborate set of rules addressing the taxation of S corporations and placing restrictions on their capital structure. Since LLCs are not subject to the same restrictions, there is a growing trend for new businesses to organize as LLCs. Organizing as an S corporation or LLC has the additional benefit of facilitating the eventual sale of the business with only one level of tax.
4. Not Safeguarding Equity Successful owners safeguard their equity. Choose your co-owners carefully. If a co-owner doesn’t work out, changing the arrangement can lead to substantial legal fees and costs at a time when the business cannot easily afford it. If possible, enter into a buy-sell agreement with your co-owners. While many owners issue equity to key employees for sound business reasons, sometimes the employee’s contribution is less significant than anticipated or the relationship sours. Carefully drawn stock option agreements and other arrangements can link equity ownership to performance, securing your value in return for parting with equity.
5. Losing Control Protect both your upside and downside by maintaining control of the business. For either a corporation or LLC, the owners elect a board and the board elects the officers. As an owner, electing a majority of the board is your key to control. Use a shareholder control agreement or member control agreement to ensure you retain control.
6. Inadvertently Violating Securities Laws Many new business owners mistakenly believe that securities laws only apply to companies that are traded on the National Stock Exchanges. Shares of stock in a corporation and membership interests in an LLC are considered securities under state and federal laws. It is illegal to sell securities in a transaction that is not exempt from registration under the securities laws. It is also illegal to misrepresent or omit material facts. Violations may create a variety of difficulties for the owner and the company, particularly if you bring in outside investors.
7. Signing Leases without Understanding the Consequences Most start-up businesses lease instead of purchase their business premises. Your prospective landlord will submit a one-sided "standard" lease for you to sign. This document is negotiable! You need to negotiate as much flexibility as possible to enable you to respond to future business developments. For example, a short term lease with options to extend is more flexible than a long-term lease; the landlord’s consent will also be needed for alternations, assignment, subletting and in many other circumstances; the landlord will be able to arbitrarily withhold its consent unless the lease requires the landlord to be reasonable. Watch what is billed to the tenant under the common area expense provisions so that you don’t end up reimbursing the landlord for costs you think the landlord should bear. Last, but not least, try to avoid or limit any personal guaranty of the lease. If you own property that you are leasing, beware of offering a right of first refusal to your tenant. A right of first refusal requires that in the event you receive an offer that you are willing to accept for a purchase of the property, you must first submit this offer to the tenant, who has the right to match the offer. Only if the tenant refuses or declines to match the offer can you proceed with the sale. It’s very difficult getting a third party to commit to a signed purchase and sale agreement when they run the risk of being outbid by the holder of the right of first refusal.
8. Failing to Protect Intellectual Property Intellectual property (patents, trademarks, confidential information, know-how) is often vital to success and building value. Conduct appropriate searches to avoid violating the rights of others. Be sure that your employees are not violating non-compete agreements with prior employers or improperly using a prior employer’s customer list or other confidential information. Protect your own trademarks by registration and valuable innovations by patenting. Protect your own confidential information by obtaining non-compete and confidentiality agreements from all your key employees and sales people before they start work.
9. Misunderstandings when Hiring Employees Mistakes made or misunderstandings from a casual hiring processes can result in aggravation, legal fees and costs a year or two later. Document your employment arrangements at least in a brief letter so people know what has and has not been promised. Be sure all employees are that "at will." Retain discretion over bonuses and structure them to promote retention.
10. Failing to Select Competent and Dedicated Advisors There is a great deal to keep track of once you have a business to run. A team of loyal and competent advisors (e.g., accountant, lawyer and insurance agent) can help by saving you time and enabling you to focus on the areas vital to business success. While director liability concerns means you are unlikely to find people willing to sit on your board and advise you just for the honor, if carefully chosen, your outside professionals can function as a board of advisors and provide ideas and guidance on many topics.
