Four Legal Mistakes Small Business Owners Make When Starting Out

In the rush of starting a business, many owners overlook or give short shrift to the critical issues listed below, which can affect the viability of their business or worse, (in the case of unsecured IP) scuttle it before there is a chance to flourish. With a little bit of planning and foresight, small business owners just starting out can avoid these four pitfalls and thus lay a solid foundation for future success.

1. Forming the Wrong Type of Entity (or Not Forming One at All)

All prospective small business owners face the important question of what type of business formation to choose for their companies. Some unfortunately choose to initially “punt” on this question, which can expose their personal assets such as houses and bank accounts to liability for their business debts or judgments in lawsuits against the business.

The answer as to which type of entity is right for a business depends on a variety of factors. If the business has no intention of going public and wishes to remain closely held, then LLCs, S-corporations, or for those in California, close corporations, may be appropriate types of entities. Sole proprietors may consider a single-member LLC or an S-corporation as their best choice, while those with an intent on going public might rely on the classic C-corporation or an LLC taking a corporate election.

2. Failing to Adhere to Formalities Required to Maintain Limited Liability Status

Some business owners may actually make the right choice when forming a business, but later fail to adhere to the formalities required to maintain limited liability status, which is the very reason to form a separate entity in the first place. This failure can lead to a plaintiff in a lawsuit “piercing the veil” of the LLC or corporation and then going after the members’ or shareholders’ personal assets.

The most common reasons for vulnerability of limited liability status are (1) commingling personal assets (particularly money) with the entity’s, and (2) undercapitalization of the business (i.e., not keeping enough money to pay for the business’s liabilities). In the case of corporations, limited liability status can be jeopardized by failing to adhere to statutory requirements like holding regular meetings or maintaining appropriate quorums at meetings when making decisions.

3. Failing to Consider Buy-Outs, Withdrawals, or Forced Exits

In the glow of starting a business, owners sometimes can’t conceive of the possibility that something could go wrong between partners, but unfortunately many times they do. That is why business owners need to have an orderly written plan for the possibility of one or more owners leaving, and in particular how those departing will be compensated for their interests in the company. Shareholder agreements, buy-sell agreements, or buy-sell provisions in an LLC operating agreement are the most common vehicles for plotting orderly exits.

4. Failure to Adequately Protect Intellectual Property

In many cases intellectual property such as a valuable invention, a catchy name or slogan, or a trade secret can be the lifeblood of a new business. However, any advantages these assets may give a business can be lost by not adequately protecting them from the start. From the beginning, companies should make co-owners and employees sign non-disclosure agreements regarding IP. Similarly, founders or early company employees should execute written assignments to the company for any IP they created that is being used in the business. Finally, registration of any patents, trademarks, or copyrights should be initiated as early as possible in order to preserve the valuable remedies for infringement that can be lost by failure to register or by registering too late.