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Common Legal Errors Startups Need to Avoid

According to statistics collected by startup publication Failory, 9 out of 10 startups fail, with 10% of them failing in the first year alone. When it comes to launching or managing a startup, even the slightest errors can put the company at risk.

Unfortunately, there are still several common legal mistakes that some startup founders make. While most of these errors may look harmless on paper, they could lead to costly lawsuits and drive away potential investors.

In this article, we’ll go over some of the common legal mistakes that startups make and how you can avoid them.

Company Name Has Legal Issues And Conflicts

When choosing or finalizing your company’s name, it’s essential to conduct thorough research to find issues like trademark infringement.

A company name is generally protected as a trademark under federal and state law. Using an existing name or something confusingly similar is courting legal trouble and may prevent you from doing business.

When choosing a company name, consider doing these steps to avoid naming conflicts:

  1. Do some Google research to check if other companies have the same name or a similar one. Prioritize checking for names in the same industry your company will be working in to prevent potential trademark infringements.
  2. You can get in touch with the US Patent and Trademark Office or use their website to search for existing trademark registrations that might be carrying your proposed company name.
  3. If you believe that your company name is worth the investment, consider hiring a naming firm. A naming firm can help plan, design, and even recommend the right name for your company or brand. They often handle most of the legal concerns associated with choosing a company as well. The average cost for their services ranges from $5,000 to $50,000.

Neglecting Tax-Related Concerns and Issues

Startup founders need to make sure their company stays compliant with federal and state regulations. Neglecting any tax-related concerns or issues can lead to violations, lawsuits, and other costly penalties that can put your company at risk.

Here are some tax-related concerns that startups often have issues with:

  • Qualified Small Business Stock (QSBS): One important reason startups need to structure their business as a C corporation is the opportunity to take advantage of the QSBS. This allows investors, founders, and even early employees to write off the proceeds from selling their shares by almost 100%. The tax savings can be significant, but some startups are not eligible for QSBS because they never started as a C corporation.
  • Section 83 (b) elections: It’s possible to mitigate future tax obligations by having founders and employees file an ‘83 (b) elections’ with the Internal Revenue Service. This allows the IRS to know the purchase price, date, and volume of shares purchased by a shareholder. Suppose the founders decide to sell the company in the future. In that case, the tax authorities can use the information on the form to tax the company as long-term capital gains, which can be significantly lower if taxed as income.

Ignoring Insurance

three people discussing about insurance

Business insurance should be considered a requirement for any company, including startups. Businesses are required by law to have at least workers’ compensation insurance or an employers’ liability insurance since employers are ultimately responsible for their employees’ safety.

Having the right insurance can also protect your company from a wide variety of situations like litigation costs and compensations bills. There are specific kinds of insurance for certain types of businesses. For example, gun-related businesses have gun shop liability insurance, and companies publishing online content have media liability insurance.

While most types of business insurance aren’t required, having some of them can help protect your business and assets. Having the right insurance can also help you secure investments since most investors prefer companies that actively mitigate risks.

Corporate Documentation Are Not Properly Maintained

Proper maintenance of corporate and HR documentation is an essential responsibility that many startups fail to do, which leads to inefficient document processing. According to global market intelligence firm IDC, 75.9% of companies experienced significant business risks and compliance issues because of broken document processes.

Improper maintenance of records can also lead to several red flags when your startup is going through investor audits and reviews. The following is a list of documents that startups need to maintain.

  • Records of all contracts that the company signed
  • Shareholder minutes and resolutions
  • Records of all intellectual property assignment agreements
  • Stock and option award agreements like stock plans, proof of payments, 83 (b) election forms, executed purchase and option agreements, etc.
  • Employment agreements, offer letters, job applications, and resumes
  • Personnel files such as official warnings, employee termination notices, and severance agreements
  • Employee compensation, benefits plans, and bonus history
  • Records of completed Form I-9 for each employee to confirm they are legally eligible to work in the US

Any company that cannot address or avoid any of these legal issues from the start runs the risk of failure. In the hyper-competitive world of startups, building a legally sound and financially stable foundation is vital to success.

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