Top 10 Legal Mistakes Made When Starting a New Business

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Prior to 2008, around 627,000 new employer small businesses began operations in the US and these small businesses have generated 64% of net new jobs created over the last 15 years according to the US Small Business Administration.  Unfortunately, the number of small businesses that closed or filed bankruptcy beginning in 2008 exceeded the number of new businesses that began that year. 

Some of these business owners fail because they make the costly mistake of not having a professional help advise and guide them. As managing partner of the Law Offices of Kirk Halpin & Associates, I have more than 14 years experience in helping small business owners with general business, contract, employment, real estate, and other legal needs.

The following is a list of the top 10 legal mistakes that business owners frequently make when they do not have professional assistance:

  1. Not having a written partnership agreement and a written buy-sell agreement
  2. Not understanding applicable local, state or federal regulations
  3. Not complying with state & federal securities laws when raising funds from investors
  4. Disclosing proprietary company information without a signed non-disclosure agreement
  5. Hiring new employees without checking restrictions in their current or past employment agreements
  6. Not having written employment agreements with new employees
  7. Ignoring intellectual property rights
  8. Copying contracts from the internet or using standard contracts from competitors
  9. Signing a lease without an escape clause or addressing the “what if” scenario
  10. Failing to Hire the Right Professionals

1. Not Having a Written Partnership Agreement and Written Buy-Sell Agreement

To the extent that the business has more than one owner, then the business should have a written partnership agreement.  The partnership agreement is also called an operating agreement for a limited liability company or a shareholder’s or stockholder’s agreement (collectively, the “Agreement”) for a corporation.  The Agreement governs the relations of the partners/members/shareholders (the “Owners”) between or among each other and memorializes rights, responsibilities and authority and also determines how profits and losses are shared.

The most important item to clearly define is how many Owners are required to sign documents or approve actions of the company.  Can one Owner obtain a company loan without approval from anyone else?  Can one Owner sign a contract to purchase a new phone system or new computer system without approval from anyone else?  Can one Owner hire employees (including other family members) and set salaries without approval from anyone else?

Typically, the Agreement will provide one Owner authority to take certain actions on behalf of the company, or obligate the company up to a certain dollar amount.  Any action beyond that authority will require prior approval of additional Owners.

To the extent that the business has more than one Owner, then the business also should have a written buy-sell agreement to the extent one is not already incorporated into the Agreement.  This document governs what happens if one or more of the Owners need to get divorced from the business.  Frequently, two or three friends form a company around an idea or product and never contemplate what would happen if there is a dispute between the friends and they can no longer work together.   There are many different methods of resolving this dispute, however one of the more popular is known as the “push-pull provision”.  Under this concept, the first party provides a price to the second party and the second party has the option of either selling his/her ownership at that price or buying the interest from the first party at the same price.  To the extent that there is not a tremendous disparity in wealth, then this provision helps assure that the offer made by the first party is fair and reasonable.

2. Not Understanding Applicable Local, State or Federal Regulations

There are frequently multiple layers of regulations that may impact the operations of the business at the city or municipality level, as well as the state level and sometimes the federal level as well.  A business owner needs to understand these regulations and know which govern, especially when the local regulations are different than the state and federal regulations.

For example, Howard County, Maryland requires that a taxicab company to have a valid taxicab certificate from the Department of Inspections Licenses & Permits which may be obtained after completing an application and having the taxicab inspected and certifying that the vehicle complies with the other applicable requirements.  Once the taxicab is certified, then the person that intends to drive the vehicle also needs a valid taxicab driver’s license issued by the County as well as a valid driver’s license issued by the State of Maryland. 

As Howard County has no official municipalities within its borders there is no need to check business regulations for any of the cities or towns within this County.  However, in Anne Arundel County, Maryland, the City of Annapolis as well as Anne Arundel County both have various overlapping regulations without even considering any applicable state regulations.  For example, the City of Annapolis regulates alcoholic beverages, massage parlors, pawnbrokers, sidewalk cafes, solicitors, taxicabs, towing companies and valet parking among numerous other categories of businesses.  Anne Arundel County also regulates food service facilities, hucksters, pawnbrokers, roadside vendors, taxicabs and towing companies among numerous other categories of businesses. 

Not only is it necessary to understand what license or permits are required where the business will be located as well as other places it will be doing business, but the business owner needs to understand any additional provisions or restrictions with regard to employment law issues (i.e. is it legal to not hire someone because of their sexual preference?) and contract law provisions (i.e. does the business need to provide customers with a 3-day right of rescission after signing a contract and what standard notices or disclosures are legally required to be included in the contract?) in such municipality, county, state as well as federal laws governing these issues.

3. Not Complying with State & Federal Securities Laws When Raising Funds

Many entrepreneurs start businesses with money from friends and family.  However, a number of entrepreneurs seek to raise money by using the internet, advertisements in local newspapers and other forms of “general solicitation”.  The Securities & Exchange Commission (“SEC”) as well as many states regulate activities related to raising monies or selling securities. 

Some activities in this regard, based upon the amount of funds that are planned to be raised, the net worth and sophistication of the potential investors, the states where the potential investors may reside, the level of active involvement of the investors in the organization, among many other factors, may require registering with the SEC before beginning to solicit investors.  Some activities in this regard also require registering with the applicable state securities administration before beginning to solicit investors, while other activities require either pre-registration with the applicable state securities administration or a notice filing afterwards.  And finally, some activities in this regard are completely exempt from any registration with the SEC and the applicable state securities administration. 

Failure to register the investment offering with the applicable governmental agency in advance may result in criminal penalties as well as having to return all monies invested.

4. Disclosing Proprietary Company Information Without a Non-Disclosure Agreement

To the extent that a business owner has developed a proprietary system for doing something differently or better than the competition, or to the extent that a business has a list of customers or clients, this information can and should be protected.  Frequently, business owners are looking to raise funds from prospective investors or may be contemplating the sale of the business to a prospective buyer, and do not require the investor or buyer to sign a confidentiality or non-disclosure agreement.

Recently, a client that had developed a niche business in a subset of government contracting decided to sell his business.  Most of the value of the business was the result of several contracts that originated from one of his employees.  A prospective buyer began asking many questions without being required to sign a non-disclosure or confidentiality agreement, quickly learning about this key employee.  Rather than buying the business, the prospective buyer subsequently decided to hire the key employee.

5. Hiring New Employees without Checking Restrictions in Their Current or Past Employment Agreements

Frequently, companies restrict or limit certain categories of employees (i.e. people in sales, marketing or business development, relationship managers, or mid-level or above executives) from working for their competitors through a restrictive covenant in their employment agreements.  It is important to ask to see a copy of a prospective employee’s employment agreement as it relates to restrictive covenants because there is potential liability for the new employer.  The new employer could possibly be sued for wrongful or tortious interference with contractual or business relationships.  

6. Not Having Written Employment Agreements with New Employees

As illustrated in the example in #4 above, not only is it crucial to have a confidentiality or non-disclosure agreement signed by prospective investors or buyers, but it is also important to have employees sign written employment agreements that contain confidentiality provisions, non-compete provisions and any necessary restrictive covenants. 

At a bare minimum, the employer should have an agreement with the new employee whereby the employee agrees to protect confidential information of the employer and not disclose it outside of the company.  To the extent that the employee is going to be in the sales, marketing or business development area, then the employer may want to restrict the employee from going to a competitor in the same industry within a certain geographic territory of the employer within a certain timeframe following the end of employment with the company. 

Another recent client lost more than half of his business when the national sales manager left the company to start his own company in the same industry, and ended up taking a number of the clients along with several regional sales representatives with him.  The client would be in a much stronger position to take action against the national sales manager if there was a written employment agreement between the employer and employee that would have prevented or restricted these actions by the former employee.

7. Ignoring Intellectual Property Rights

A business frequently develops various intellectual property rights that are able to be protected through copyrights, trademarks, service marks, and patents.  In order to prevent a competitor from stealing the idea, concept, product, mark, feel or methodology of the business, it is best to explore registering these intellectual property rights as soon as possible. 

Any retail or service business that plans on expanding beyond a single location should explore registering the name of its business along with any logo and tagline.  Any business that does something in a different or unique manner that creates a competitive edge for this business should explore obtaining a patent on the method.

8. Copying Contracts from the Internet or Using Standard Contracts

As referenced in mistake #2 above, many cities, counties and states regulate various industries and have certain provisions that are legally required to be contained within contracts or agreements with customers.  A flooring company had taken a template contract from one of its competitors and began using it, however the competitor’s contract did not comply with local laws and needed to be updated.  A new health club purchased its standard membership contract from the internet, however it did not comply with applicable state laws.

9. Signing a Lease Without an Escape Clause or Addressing the "What if" Scenario

After starting a business, many clients will begin looking for office or retail space and will not negotiate an escape clause provision in the lease.  If required, some landlords will agree to provide tenants with an automatic ability to terminate the lease if certain changes occur in the industry or in the tenant’s business. 

For example, a clothing consignment shop should include a provision that if closing consignment becomes illegal, then the lease can be terminated by the tenant.  Or, if a government contracting tenant loses its contract, there should be a provision in the lease that provides the tenant with the option to terminate its lease.  Or, if the U.S. Congress passes health reform legislation that puts health care brokers out of business, there should be a provision in the lease that also provides a tenant with the ability to terminate its lease.

In addition, the tenant should explore various “what if” scenarios and determine how they could impact the business and the lease.   For example, if the tenant is a retail business such as a card shop, bookstore, candy shop or clothing store, should there be a restriction that prevents the landlord from leasing another store in the same retail strip to a competing business?  What would happen to the first bookstore if the landlord allowed a second bookstore to open in the same shopping center?

10. Failing to Hire the Right Professionals

A business owner that hires knowledgeable legal, accounting and tax advisors who are used to working with early stage businesses can help prevent all of the mistakes identified in this article along with many others.   A business owner should hire and consult with these advisors in the early stages of its formation. Compliance with applicable laws and regulations can be relatively inexpensive if experienced professionals are brought on board initially.  The cost to fix these mistakes later, however, is frequently extremely expensive.

 

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