10 Mistakes in Starting a Business

It is extremely difficult to resist the temptation to start a business as quickly as possible without addressing all critical legal issues. This is because new business owners likely have a good idea, and just want to get started and begin selling their services or products as quickly as possible so that they can earn revenue. If there are legal issues down the road, they’ll address them later, when they’re more pressing.

The problem is that certain issues, if not addressed at the outset, can later shatter a business, no matter how good its product or services are. Failure to address the issues at the outset is a mistake, and there are some classic mistakes in starting a business that corporate lawyers see clients making again and again.

This article will identify some of those mistakes, so that business owners can be wary of them from the outset, and hopefully avoid making the same mistakes themselves.

1) Choose the wrong entity for your business

There is no such thing as a one-size-fits-all choice of entity solution. Whether you choose to be a sole proprietor, or incorporate your business as an LLC, corporation (C or S corporation) or become a partnership of some sort, you should try to consider as many possible scenarios about the future of your business. Here is a list of some of the questions you should ask yourself, in choosing your entity:

– Do you intend to run the business as your sole source of income?
– Do you intend to build the business so that you can sell it?
– Do you intend to build a multi-generational family business that you can pass on to your heirs?
– Do you intend to bring on new owners?  If so, who, when, and how many?
– How do you intend to pay yourself?
– Will you have a board of directors, or other advisors?
– Will you have employees?
– Do you have investors?
– Are there different types of investors?
– Do you expect to get angel funding?
– How long do you want to run the business?

Your answers to these questions, and others like them, will determine the best entity (if any) to choose. This list really can go on and on, depending on the type and complexity of the business. If you’re going into business with others, it’s practically impossible for you and your business partners to have the same answers and expectations, so it’s best to address these types of questions ahead of time, before the entity is selected and the company is incorporated. In general, if you want to learn more about choosing a corporate entity, see this article.

2) Incorporate in the wrong state

If you’re starting a relatively simple business that you intend to manage on your own, capitalize on your own, and do not anticipate having an active board of directors, then start by thinking of forming an entity in the state where your business is located.

You’ve probably heard that incorporating in Delaware or Nevada is a good idea, but if you just want to go it alone, then there’s much less of a reason to do so. You’d otherwise be subjecting yourself to the jurisdiction of the courts in those states, without getting much of the benefits of those states’ corporate laws.

If, however, you have big dreams and intend to bring in outside investors, venture capital or angel funding, you will likely want to incorporate in Delaware. Why? Because Delaware corporate law is extremely favorable to management, and investors often will not sit on your Board unless you have a Delaware corporation.

So, from a very general perspective, if small, think local, but if large, think Delaware.

3) Ignore your employment agreement(s)

If you’re building up your side business while employed by another company, make sure to review in detail all of your employment agreements, especially if you are in upper level management or the business you intend to pursue has any overlap with your current employment. Review in detail any confidentiality agreements you may have signed, non-disclosure agreements and any employee handbooks. The last thing you want is to build a successful business only to later find out that you have breached agreements at your former place of employment.

4) Choose the wrong cofounder

Starting a business with someone is like getting married: most individuals only see the bright side when going into the relationship. In starting a business, you will be entering into a binding contractual relationship with your cofounder (again, much like marriage). If you don’t discuss in detail each person’s objectives, values and strengths and weaknesses, you’re leaving open potentially huge pitfalls for down the road.

Consider some of these questions before you start a business with a cofounder:

– What are their long term objectives for the business? To sell it?  If so, when?  To pass it on to their family? To make it their life’s work?
– What complementary skills do they bring to the business?
– Do your personalities fit well together?
– How much money can they realistically contribute?
– How much time can they realistically contribute?
– Which of you will take on the marketing, and which will take care of the back end work?
– What personal obligations do they already have outside of the business?

The more questions like this that you ask, the closer you’ll get to success.

5) Split ownership 50/50

This is a classic mistake of new entrepreneurs who have not delved deep into some of the questions above, in number 4, as well as other critical questions. 50/50 ownership is the fall-back, easy solution that two business owners end up at when they fail to have detailed, extensive discussions about what they want to give to, and get out of, the business. Rarely is 50/50 the right solution to splitting up ownership of the company from the outset, because, more often than not, one person will be “work” (will do most of the work in the business) while the other will be “money” (will do less work, but will contribute more of the money).

Even if both are initially doing an equal amount of work, one may want to pursue working in the business for the longer term, while the other may want to take a step back and act in a more passive investor role. These outcomes should be addressed in the beginning so co-owners properly decide upon how to split up ownership.

6) Fail to consider buy sell agreements

Buy-sell agreements are exactly the type of agreements co-founders enter into after engaging in thorough discussions with each other about what each will contribute to the business, and what each expects to get out of the business. It is also helpful to have a clear buy-sell agreement whenever co-founders or partners consider buying or selling a business.

Buy-sell agreements set forth exactly what will happen to a business owner’s shares in the business if he or she retires, becomes disabled, passes away or wishes to sell his or her ownership interests. In essence, it is like insurance: if one of those events occur, then the business owners will be assured of a quick and seamless succession so that the business can continue on.

When there are many owners, buy-sell agreements can become more complex and costly, which often causes business owners to ignore them. However, if buy-sell agreements are not put in place at the outset, it becomes more complex to do so later on when the business is operating, the value of stock has changed, and business owners may not be in as an agreeable and cooperative working relationship.

7)  Fail to consider vesting schedules

What if you’re starting a company with others, and you’re not sure of their level of commitment, or you’re wary of how long they may decide to be involved in the business before leaving to pursue other ventures? You wouldn’t want to give them significant ownership positions in the company up front, only to see them leave soon thereafter, and walk away with that stock in hand. A solution to this common problem amongst cofounders is vesting schedules.

Vesting schedules allow stock ownership to vest over time, upon the occurrence of certain predetermined events, or upon a certain schedule. The schedules can be set forth in restricted stock purchase agreements, which could allow the company to repurchase any unvested shares at the time of the founder’s departure.

8) Fail to comply with securities laws

Securities laws are extremely complex, and must be complied with when there is an issuance any securities. The term “securities” is broadly defined, and encompasses not only stock, but also includes a long list of items that most entrepreneurs and business owners would never consider. For example, under Oregon state law (ORS 59.015), the term “securities” means the following:

“a note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in a pension plan or profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, variable annuity, certificate of deposit for a security, certificate of interest or participation in an oil, gas, or mining title or lease or in payments out of production under such title or lease, real estate paper sold by a broker-dealer, mortgage banker, mortgage broker or a person described in subsection (1)(b) of this section to persons other than persons enumerated in ORS 59.035 (4), or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of interest or participation in, temporary or interim certificates for, receipt for, guarantee of, or warrant or right to subscribe to or purchase any of the foregoing.”

In other words, a security, as defined under Oregon law, is, for all practical purposes, nearly anything you can think of as an investment. Securities laws require compliance with disclosure, filing and form requirements unless an exemption is met, and the failure to comply with those laws can lead to costly financial penalties.

For securities being offered to intrastate investors–that is, only to in state investors–then state securities laws need only be complied with. However, most securities offerings occur on an interstate basis–that is, to investors in more than one state–and therefore federal laws must also be complied with.

Oregon’s Division of Finance and Corporate Securities is the state agency that governs securities offerings in this state, and they maintain quite a helpful FAQ section on their web site, here, for those interested in learning more about Oregon securities laws.

9) Fail to account for (no pun intended) tax issues

Whatever the size of the business, there will be myriad tax issues. An accountant should be retained from the outset, and consulted with on a regular basis.

Most new business owners do not realize that they will have tax issues on the local, state and federal level, and that they will have to pay taxes on a quarterly basis. Moreover, they do not understand how their choice of entity will affect the taxes they will pay, and they miss some tax benefits that are available to them, but that are not readily apparent.

One such benefit is an 83(b) election. In short, an 83(b) election is a tool that accelerates the recognition of income for service providers (i.e., employees) who receive restricted property (often stock) as compensation. It is a very helpful benefit in closely held corporations that allows shareholders to avoid a large tax bill years down the line.

10) Being your own lawyer (or expert in everything, for that matter)

Don’t try to be your own lawyer.  You should focus on your business, and hire the best talent you can find to help you with all of the other tasks that are most important to the success of your company.  Three areas that are critical to every company’s success—no matter what field that company is in—are law, accounting and insurance.

Every company will need to comply with, and navigate through, the laws that apply to it; every company will have tax issues; and every company—if it has any possibility of success—will have insurance issues.  It doesn’t matter how good your idea is if you don’t have all of these three bases covered.  If you’re successful (which is the whole point, right?), you’ll inevitably run into complex issues in all three of these fields—and most of these issues you won’t be able to predict.

These days, the costs of starting up a company are extremely low, and there is a wealth of accessible information for entrepreneurs to attempt to do many tasks on their own—this includes legal tasks. Companies such as Legal Zoom offer entrepreneurs prepackaged legal forms at a low cost, giving the illusion that all legal issues are taken care of.

However, it is practically a rule of thumb that entrepreneurs cannot know all of the possible legal issues that might affect them, because each company is unique: each has its own intellectual property; its own owners, with their own specific backgrounds, timelines, objectives and goals; and its own assets, contracts, etc. Moreover, unpredictable events inevitably occur, and you’ll be less capable of protecting yourself from those unpredictable events if you do not have good legal advice from the outset.

Don’t get me wrong, you do not need overpriced legal advice from a non-expert in the field, but you do need legal advice, if you have any intention of being successful, especially in the long term.

Consider these examples (I’ve personally seen them):

– A company is started by a sole founder, who has no intention to bring on other founders.  He later becomes so overwhelmed by all of the work in running the company (and realizes that he does not have the expertise in all fields) that he desperately gives away majority ownership to others at a bargain price, losing control of the company.

– Three co-founders start a company together (an LLC), which is, by default, taxed as a partnership. There’s a falling out, and two decide to give none of the annual distributions to the third, year after year. The third has no recourse because, under default partnership tax law, he must pay taxes on 1/3 of the company’s income, regardless of whether he actually received any distributions from the company. He’s essentially locked in and frozen out of a company, and he must pay taxes on income he never actually receives.

As time goes by, cofounders change their minds, business opportunities arise that could not have been predicted at the outset, and sometimes events that appear wholly unrelated to the company’s existence (a co-founder’s divorce, for example) critically affect the company.  As a small business owner, you don’t want to be unprepared for these events. Even if you are, with a solid legal foundation in place from the outset, you’ll already have addressed them, allowing you to continue focusing on growing your company.

Bootstrapping a startup doesn’t mean you have to solve every issue on your own, and starting up lean doesn’t mean you should take on unnecessary risks. Some of the biggest risks your company will face will undoubtedly involve legal issues, and so you should protect yourself from the outset by working with a lawyer in the areas where issues are the most critical.