- Startups need to prioritize on finalizing which business structure suits them, comply with tax obligations, work on licensing and permits, adhere to employer law requirements…the list goes on.
- A successful startup must lay down the legal conditions on paper, maintain proper HR documentation, create permits and registrations and more.
Kicking-off a startup business is not a walk in the park; it necessitates meticulous planning and effort. Before forming a new company, many factors must be considered, including – building a solid team, product development that meets market demands, project design and the concept proposal. The list does not end here; there are numerous other factors to consider besides completing several tasks. Because of the enormity of the responsibilities one has to should while launching a business, it is nearly impossible to avoid making any mistakes.
When launching a new startup, each step must be carefully considered. Many startups make poor decisions in the present that cause them problems in the future. Making errors while establishing a solid legal foundation is one of the most common startup mistakes. The catalyst for such mistakes is usually their lack of knowledge about the fundamentals of investing and starting a business. Let’s enlighten ourselves with the required expertise first.
Fundamentals Strategic Considerations For a Startup
1. Business structure
The most crucial decision to make when establishing a startup is the business structure you will use. To meet your organization’s needs and safeguard all its stakeholders, it is essential to determine which structure suits you. Your legal counsel can then advise you on the applicable state agency to initiate the process of filing the necessary documents. Here are a few common business structures that your startup can consider during registration:
- A Sole Proprietorship: This is the easiest and the most low-cost entity type. It usually requires very little paperwork or legal documentation. The startup entrepreneur holds overall responsibility for the company without any formal partner. You have total control of profits and are responsible for taxes and liabilities of the business. A sole proprietorship allows you to blend your personal and business funds, which is illegal for companies with multiple owners. Yet, this also means that the owner’s personal assets are at risk if the business is sued. Note that no document formation is needed to establish a sole proprietorship. As you and your startup are considered the same, there is no need to file separate business taxes.
- A General Partnership: It is a business entity in which two or more individuals or corporations collaborate in commercial activities. A partnership agreement detailing each general partnership member’s rights, responsibilities and obligations is signed. In a general partnership, the business’s financial commitments, earnings and losses are shared equally among the partners. This is also simple to establish, with no format filling required. The fact that each partner is liable for the business acts of the others makes this corporate type questionable. Therefore, if the partnership is sued, each partner’s personal assets are possibly in danger.
- Limited Liability Company: This is the most prevalent entity that provides tax and managerial freedom. An LLC might have one or more owners, known as members. The essence of an LLC is that its members are not individually accountable for the company’s debts or liabilities. This means that the personal assets of LLC members are safeguarded if the firm is sued. LLCs offer substantial tax flexibility, including pass-through taxation. Other advantages of the LLC entity include management flexibility, fewer administrative procedures and flexible profit sharing. Note that there may be an additional minimum annual tax that varies based on the LLC’s income.
2. Tax obligations
Regarding tax obligations, it is essential to be aware of and compliant with all overlapping taxes. Federal, state and local taxes are examples of taxes that a person may be required to understand and comply with. This also relates to the business structure you picked for your entity, as your business structure can impact your tax liability.
Obtaining licenses and permits for your firm may be your next step. It might take a lot of work to navigate the city and local administrations to obtain the necessary licensing documentation.
4. Employer law requirements
One of the final tasks is to determine the federal and state requirements for recruiting staff in terms of safety, labor and reporting regulations. It is essential to comprehend and adhere to such laws. Because rules vary from state to state and city to city, the challenge of determining this is amplified when a business has multiple sites.
A bewildering assortment of employment laws and regulations may apply to your startup. Therefore, it is essential to focus on comprehending and fulfilling its commitments from the start.
As much as startups want to act rapidly and grow when it comes to establishing a staff, it’s crucial to take your time, ensure compliance with employment regulations, and implement appropriate employment practices. To help with this, here is a compilation of 5 legal mistakes made by startups that they should strive to avoid!
Common Startup Legal Mistakes & How to Avoid Them
1. Not establishing the deal details with co-founders accurately
A startup is a dynamic structure wherein things can dubiously change, and the phrase “change is the only constant” proves itself. When starting a firm with co-founders, you should establish your business connection early. Failure to do so may result in significant legal issues in the future. The most common startup mistake is that the founders discuss this orally and don’t try to put it on paper. Here are the essential clauses your written founding agreement must include:
- How will the founders’ shares be divided?
- Is each founder’s percentage of the company’s equity subject to vesting based on continuous participation?
- What are the founders’ duties and responsibilities?
- Does the firm or the remaining founders have the right to repurchase the shares of a leaving founder? If so, at what cost?
- How much time should each founder devote to the business? What restrictions will be placed on external obligations?
- What, if any, salaries are the founders entitled to? How can this be modified?
- How will essential business decisions and day-to-day decisions be made?
- Under what conditions might a company’s founder be terminated from employment?
- What assets or funds does each founder contribute to or invest in the venture?
- How will the business’s sales be determined?
- What happens if a founder is not meeting the requirements of the founder agreement?
- What are the business’s overall mission and vision?
2. Not choosing an indisputable company name
It is essential to conduct research before selecting a company name to avoid trademark infringement or domain name conflicts and to guarantee that the chosen name is truly accessible for usage. Here are some measures to take to avoid naming conflicts and check if the name is already used:
- Perform a thorough name search on Google, the United States Patent and Trademark Office websitefor existing federal trademark registrations and Secretary of State corporate or LLC records in the states where the company will conduct business.
- Perform a search on GoDaddy.com or other name registrars. If the “.com” domain name is unavailable, this may indicate prior use and could be a red flag.
- Consider having your intellectual property attorney conduct a thorough trademark search.
- Create five appealing names and test-market them with potential employees, investors and customers.
- Consider the international ramifications of your selected name (you don’t want to choose a name that could have humiliating or unpleasant connotations in another language, for example).
- Avoid spelling variations of the name. This can lead to complications and uncertainty in the future.
3. Ignoring necessary taxes, permits, licenses, registrations
Startups must consider a variety of crucial tax problems pertinent to their businesses. This common startup mistake can hold you liable for taxes, fines and penalties you did not expect or foresee! Here are some of the most important tax considerations:
- Procure a Tax ID
Usually, you will need to obtain a tax ID from the IRS for your business. This is often referred to as an “Employer Identification Number” (EIN), and it functions similarly to a Social Security number for businesses.
- Section 83(b)
Section 83(b) A Section 83(b) election applies when someone obtains stock or options subject to vesting and can minimize the amount of income deemed taxable at the recipient’s ordinary income tax rates.
- Qualified Small Business Stock
Holders of “qualified small business stock” may be eligible for a reduced tax rate on the gain from the sale of “qualified small company stock” under Internal Revenue Code section 1202.
- Tax incentive
Depending on the nature of the firm, various tax incentives, such as tax credits for renewable energy and investment tax credits, may be available.
- Stock options
Stock option programs are a prevalent technique of attracting, motivating and retaining employees, particularly when a company cannot pay high salaries. It allows the company to grant stock options to workers, executives, directors, advisors and consultants, allowing them to purchase company stock when they exercise the option.
- Sales Taxes
Multiplying the purchase amount by the applicable tax rate yields the sales tax. The vendor must collect sales tax at the time of sale, file tax reports, and remit the tax to the applicable city/state. Your location determines which categories of products and services are subject to sales tax and which are exempted.
- Payroll Taxes
State and federal payroll taxes must be paid on employee compensation by startups. Typically, payroll taxes are determined as a proportion of the remuneration paid to employees. U.S. federal taxes include federal income tax withholding owing by employees, which is determined based on the amount submitted on IRS Form W-4 by the employee at the time of hire. The tax also includes sums paid for Social Security and Medicare (referred to as FICA taxes). The employer deducts the employee’s part (one-half of the amount owed) from the employee’s paycheck and pays the other half.
- Employees and independent contractors
It is crucial that your business accurately differentiates between employees and independent contractors. Numerous startups favor independent contractors to avoid paying Social Security, Medicare, unemployment taxes, and health insurance. Nonetheless, the IRS and states are focusing more on misclassification issues.
- Maintaining accurate records of income and deductible expenses
Every business must implement a system of recordkeeping that captures all income and tax-deductible expenses. Some firms utilize traditional checkbooks for this system, but most use computerized applications.
Apart from that, you need to check industry-specific permits for your businesses, sales tax licenses or permits, city/state/county business permits or licenses, zoning permits, seller’s permits, health department permits (such as for a restaurant), federal and state tax/employer IDs.
You’ll also need to protect intellectual property if your service is a unique product. Patents, copyrights, trademarks, service marks, trade secrets, and confidentiality agreements are a few things you’ll need to pay attention to.
4. Not maintaining proper HR documentation
The most run-of-the-mill mistake startups make is to take HR documentation lightly. Here is a list of the paperwork every startup needs to maintain:
- Board and shareholder minutes and resolutions
- Finalized contracts
- Stock option plan documents, executed stock purchase and option agreements, proof of payment for stock sales and share and option grants, 83(b) election forms, option exercise paperwork, and required state and federal filings.
- Application forms and resumes
- Employee offer letters & employment agreements
- IRS W-4 forms (Employees’ Withholding Allowance Certificate)
- Form I-9 completed by all personnel
- Policy against harassment and discrimination
- Benefit schemes
- Employee’s emergency contacts
- Documentation of disciplinary actions, including oral warnings
- Compensation and bonus history for employees
- Employee layoff notices
- PTO tracking documents
- Agreements on confidentiality and invention transfer
When you have registered your startup as a corporation, LLC, or a limited partnership, interests and sale of stock will be subject to state and federal securities laws. Unless exempt, most securities laws require compliance with specific disclosure, filing, and form requirements. Anyone could take it very lightly while issuing stocks to family or friends.
Failure to comply with applicable securities laws can result in severe financial penalties for the founders and the startup firm. It may include a requirement that the company repurchase all shares offered to the investors in the unlawful offering at the initial issuance price of the shares, even if the company has lost most or all the money it raised from the investors. To avoid such catastrophic (possibly fatal) repercussions, founders should use competent attorneys to document the sale of shares per the applicable legislation.
It’s a great plan to launch a startup. But, you need to be aware of numerous things to consider before starting the startup. To ensure openness, cooperation and mutual understanding, it is strongly suggested that each party consult with independent legal advice before agreeing.
Startups that avoid these legal pitfalls and mistakes have a better chance of success than those that fail to anticipate and plan for them from the start. It’s better to invest now in planning and expert advice to avoid significant problems later.