3 Mistakes Every Entrepreneur Should Avoid

Legal principles to keep in mind when starting a business 

When you start a business, you have to make a lot of decisions from what your unique selling proposition is to how you are going to make money. Of all these decisions, how you are going to legally structure and operate your company is among the most important. Betty Wong, co-founder of Stage2Startups, talked to Phil Crowley, Managing Partner of Crowley Law, LLC, about some of the common legal mistakes entrepreneurs can make when they are forming their startup. While Phil can’t provide legal advice unless you are his client, he did speak to us about some of the legal principles involved that every business founder should keep in mind. Here are three common mistakes he sees entrepreneurs make.

Mistake 1: Fail to Form a Legal Entity to Financially Protect Yourself

“When I think about forming companies, I think about the spaghetti western, “The Good, The Bad and the Ugly,” says Phil. According to Phil, the “bad” approach is to open and run a business as a solo entrepreneur without forming any legal entity to limit your personal liability. In this scenario, business founders are taking a big risk because all the business’ liabilities can be attached to any and all of your personal assets, including your home and banking and savings accounts. 

But, according to Phil, there is something even worse (the ugly) than this and that is when two or more people begin a business without a written agreement setting out the parameters of working together. Under the law, this type of relationship is considered a partnership where the actions and liabilities of any one of the participants within the scope of the partnership are the liabilities of all the other participants. In this scenario for example,  if a partner rents space for the company and then doesn’t pay the landlord, the landlord can selectively come after your personal assets for the rent. It is then up to you to get the money from your partner. That’s why it is important to have a limited liability entity of some sort so that your potential loss is limited to the assets you put into the business and your personal assets are protected. 

But, if you think you are going to move to the stage where you are going to try and get angel investors or venture capital involved,  then it is good to consider forming a corporation where it is very clear that the only liability of the shareholder is what they have invested in the corporation. Many serious investors prefer to invest in a corporation because they know their personal assets will be shielded. 

Mistake 2: Fail to Establish Partner Or Operating Agreements

A partnership agreement is a legal agreement between two or more partners which spells out the authority, scope of responsibilities, liabilities and requirements for paying into the partnership among the various partners. An operating agreement is a document that sets out the parameters under which a limited liability company will operate. Both of these agreements cover issues such as the authority to sign contracts, how much debt each founder can incur for the business without the agreement of the others, and whether the partners or members (in the case of a limited liability company) can be called on to invest more themselves (a “capital call”). 

“Where I see entrepreneurs put themselves at risk is when they don’t make the upfront investment to delineate the responsibilities of all the parties,” says Phil.  “I recommend founders document as much as possible their relationship with their co-founders and be as explicit as possible because it is much easier to work out any potential disagreements at the beginning when the co-founders are friends rather than try to work it out when they are at loggerheads.”

It is also Important to have a lawyer involved in developing these agreements because it is unlikely that you can anticipate all the problems that can come up while running a business together. A lawyer who specializes in helping founders set up businesses will have a broader range of experience and help you think through a whole series of potential issues that you may not have considered.

Our moderator, Betty Wong, emphasized the importance of doing this upfront work based on her personal experience. “In my previous company, I ended up disagreeing with my partner and it resulted in the dissolution of our company,” said Betty. “It is a long and difficult process to delineate upfront what each partner should be doing, but it is so important to put in the work to prevent putting the business at risk down the line.”

Mistake 3: Fail to Have Written Agreements with Third Parties

Another area of risk for entrepreneurs is when they bring in third parties to do work for the company.  “Whenever you engage a third party to do work for your company, it is important to have a written agreement in place that says any intellectual property that is created belongs to the business and that the work is a ‘work for hire’,” says Phil. 

Without an agreement, you may end up with an incomplete right to use something that was created for your company. Without complete rights, you may be required to use the original vendor when you want to make changes to the work; if you try to use someone else, you risk the original vendor asserting his rights and you will need to pay him to switch vendors.  

In addition, third party agreements are important when you are seeking investors. Sophisticated investors will want to review your written agreements with outside vendors to ensure all the work and ideas they created, and for which you paid, really belong to the company. The worst case scenario is having a number of independent contractors that have created value for the company without proper agreements. This can cause investors to back off until you have rectified the situation which can prove to be very expensive. 

Whether you remain a solo entrepreneur, bring on partners or investors or eventually sell your company, it is important to have the right legal framework in place before you start out.  Taking the time upfront to put the right legal agreements in place will prevent a lot of headaches in the future.  For more insights from Phil, go to Crowleylawllc.com.

Copyright 2022: Emelie Smith Calbick and Betty Wong