TOP TEN LEGAL MISTAKES SMALL BUSINESS

OWNERS MAKE AND HOW TO AVOID THEM

Our experience, as well as those of our clients, has left us sensitive to the numerous
legal mistakes small business owners make. We offer this in an effort to help you
avoid them.

Pre-Formation

1. Starting a business while employed by a potential competitor, or hiring

employees without first checking their agreement with the current employer and
their knowledge of trade secrets.

The law is clear that if someone is currently working for a company, particularly if he
or she is a key employee, they cannot operate a competing business. Even just
incorporating may spark a lawsuit from the current employer. Would-be
entrepreneurs should first go to their current employer and either resign, or tell them
what they’re doing and ask them if they’d be interested in investing. Amazingly, that
is often a very smooth way of ending that relationship. Under no circumstances
should they misrepresent the nature of the new business.

Even after leaving the current employer, one cannot use or disclose the company’s
trade secrets. Under the so-called Inevitable Disclosure Doctrine, if someone has been
exposed to trade secrets at their job and leaves to work for someone else, and if their
responsibilities in their new job are sufficiently similar, some courts will conclude
that it is inevitable that they will use the information they had from the earlier
position. They could face an injunction prohibiting them from working for the new
employer until a number of months go by and whatever trade secrets they had are
stale.

It also helps to know whether potential recruits are subject to covenants-not-to-

compete. States vary in terms of how enforceable they are, but one shouldn’t assume
they are not. One should also check to see what assignment of inventions might have
been signed. Personnel files should be reviewed and recruits should check theirs, to
be certain that a covenant-not-to-compete or an assignment of inventions wasn’t
tucked into a signed non-disclosure agreement.
2. Mistakes When Leasing Office Space

Next to payroll expenses, facilities and related expenses are generally the second
highest expenditure for a company. Some of the most commons mistakes that
companies make when leasing space are:

• Not using an experienced commercial real estate broker.

• Waiting too long to start the process.
• Leasing the wrong amount of space.
• Picking the wrong location.
• Not thinking about the future.
• Not measuring the space.
• Signing too long or too short of a lease.
• Not verifying a buildings systems and infrastructure.
• Not having your insurance carrier review the lease language.

Formation

3. Choosing the Wrong Ownership Structure: Choosing an ownership structure is

one of the most important decisions you’ll make for your new business. You must
consider your specific needs. The following factors can help in making your decision:

• What are the potential risks and liabilities of your business? (For instance,
building houses, making edible goods, fixing cars, and selling alcohol carry
inherent risks.)
• How willing are you to spend the money it takes to set up and maintain the
records for a separate business structure (such as an LLC or a Corporation)?
• What are your expected profits or losses in the first couple of years?
Unincorporated business structures let you deduct business losses from your other
income, but corporations do not.
• What are your plans for seeking investors? Sophisticated investors often
prefer the stock structure of a corporation.

4. Consider your potential liability: There is a summary of the amount of liability

you may face depending on how you structure your business.

• Sole proprietors – Because sole proprietors are personally liable for all
business debts, you could potentially lose everything you own if your business
debts are not paid.
• Partnerships – Because your partners can make commitments that bind the
entire business, your liability may be even greater than a sole proprietorship.
Make sure you can trust your partners to protect your interests.
 • Limited Liability Companies (LLC) – LLCs are often subject to annual taxes
or annual reporting fees. Amounts vary by state and do not depend on whether
or not you turn a profit.
• Corporations – Corporations are required to keep many different records,
including recording every major decision and holding annual formal meetings.
If you fail to do so and are sued, a judge can find that the corporation was a
sham (this if often called “piercing the corporate vail”). Investors can also sue
you if they think you’re not operating the business in their best interest.

For most people, starting a one person business, operating as a sole proprietor at the
outset makes sense. But, if your business is especially likely to be sued, is funded by
outside investors, or might be profitable right from the start, consider forming an LLC
instead. For most people starting a business with more than one owner, an LLC is
preferable to a partnership as you get limited liability but need to do less record
keeping than a corporation, and the same taxation as a partnership.

Post Formation

5. Mistakes After Incorporating and/or Creating an LLC: A company that does

not follow proper formalities may inadvertently create personal liability for its
shareholders or members. In addition, a company that fails to maintain proper records
may lose credibility with potential investors performing due diligence.

Some of the mistakes small businesses often encounter include:

• Failing to issue and record stock or member certificates. After forming a

corporation or LLC, shares or membership certificates are issued to the
owners. Without issuing the share/certificates, there is a potential of having
the corporation pierced in a lawsuit because the court will claim that the
company is just an alter ego of the individual.
• Failure to hold the meeting of the shareholders or directors in a corporation.
Every corporation when it is first formed needs to have an initial meeting with
the shareholders and directors in order to adopt the Article of Incorporation,
By-Laws and to issue the shares for the company. This initial meeting is also
an opportunity for members of an LLC to create an Operating Agreement that
is crafted for their particular needs.
• No resolutions or other documents are kept for the ongoing venture. Every
corporation needs to maintain corporate records and meeting minutes. A
corporation resolution is a written document that gives someone in the
company authorization to perform a specific action. For example, if the
business needs a loan, the resolution would be written and signed with the
director of the company giving authority to an individual to open the loan and
use it for business purposes. Similar documents should be kept in the LLC
format. Many partnership formations also fail to create necessary initial
documents, such as having a signed partnership agreement which includes a
 defined exit strategy that allows either party to walk away or buy each other
out, without destroying the business.

The On-going Concern

6. Failing to Clearly Document Partners Rights and Responsibilities

This mistake is usually made at formation by not having a properly crafted Operative
Agreement. The consequences of that early mistake are revealed as the business
begins to operate. Founding shareholders or partners (or members of an LLC) should
have an agreement that answers at least the following questions:

• How much time and effort is each person expected to contribute?

• How much capital each person contributes?
• What happens if the business needs more capital?
• What happens if one person leaves the business?
• What happens if one person dies?
• Will the stock or partnership interest be brought back from the estate of the
deceased or from the person leaving the business?

7. Unclear Expectations and Rules for Employees

It is important to set clear expectations and rules for your employees. Make sure they
acknowledge that they are At-will employees, which means they can quit or be
terminated at any time without exposing your business to liability. It is also important
to inform your employees that discrimination, sexual harassment and other illegal acts
will not be tolerated.

Human Resource Manuals, also known as employee handbooks, do not have to be in

writing, however, a policy manual is the clearest way of spelling out what is and is
not acceptable. A manual is not the only legal way to make policies known. It can be
shared verbally, employees are fired every day for violating a spoken policy. In fact,
the firing is more proof of the policy.

Notwithstanding this, many companies mishandle employee issues. Companies that

are not careful when documenting relationships with employees and independent
contractors, accidentally may change their status – from an At-will employee to an
employee with special rights upon termination, or from an independent contractor to
an employee for whom the company must provide benefits and withhold taxes. In
addition, employee obligations such as non-competition, non-solicitation,
confidentiality and intellectual property obligations should be properly negotiated at
the time of hiring to ensure enforceability.
8. Ignorance of the Law

Just because laws are numerous and complex doesn’t mean your business can ignore
them. Learning little about the following basic areas of law can keep you out of legal
hot water:

• Basic contractual rules.

• How to protect your ideas and inventions (copyright, patent, trade secrets).
• Major employer-employee laws.
• Security laws effecting how you can raise capital for your business.
• Governmental regulation of your industry.

9. Getting Involved in Litigation

Litigation fees can be astronomical, and they can quickly drain management time and
resources. Consider alternative means of dispute resolution, such as mediation or
arbitration. Or, if a reasonable settlement offer is available, think seriously about
taking it instead of spending more time in litigation.

10. Failing to Hire the Right Professionals

A company that hires knowledgeable legal, accounting and tax advisors who are used
to working with early stage companies can avoid many of the common mistakes. A
company should hire and consult with those advisors in the early stages of its
formation. Compliance with applicable laws can be relatively inexpensive if
experienced professionals are brought on board at the right time. The cost to fix those
mistakes however, is not.