The Top 5 Startup Mistakes (Through The Eyes of a Startup Lawyer)
According to the Bureau of Labor Statistics, over half a million businesses start in the U.S. every year. About 20% of those businesses fail in the first year and only about half make it past year five. While it’s impossible to know the reasons behind every business failure, it’s safe to say that legal issues lead to the downfall of at least some of these businesses.
As a startup lawyer, I talk to small business owners every day, and I’ve heard the gamut of startup mistakes (along with many success stories). The unfortunate thing is that the vast majority of legal mistakes can be avoided with just a little forethought.
Here are the top five startup mistakes and what you can do to avoid them.
1. Taking Outside Investments - and Thinking No Strings are Attached
If you accept outside investors, your investors will expect something in return. Most often, they want a percentage of ownership (including a percentage of your profits) and/or a seat on the board of directors. So unless you are willing to cede some level of control over your business, avoid outside investments.
Another issue with taking outside investments is that there are many legal issues. Outside investments make things much more complicated for you as a business owner. You will be responsible for a host of regulatory requirements and corporate formalities as the recipient of those investments.
One often-overlooked legal issue is that you should generally take money only from “accredited investors.”
An accredited investor is a person whose income “exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year” or “has a net worth over $1 million… excluding the value of the person’s primary residence.”
So unless your investors are millionaires, or well on their way to becoming millionaires, it’s best to turn down outside funds. Taking money from non-accredited investors will only cause you to have to jump through more regulatory hoops. The interesting exception to this rule is crowdfunding platforms like Kickstarter. A new law went into effect in 2016 allowing non-accredited investors to invest through these sorts of platforms.
There are three main ways to fund a business: self-funding, loans, and outside investors. Often, self-funding, a.k.a. bootstrapping, may be the way to go. Bootstrapping allows business owners to maintain complete control of the day-to-day operations while keeping full ownership of the business.
Of course, not every business owner has the means to self-fund. If that’s the case, there are private, government-backed small business loans known as SBA loans. While they are difficult to qualify for, they do offer enticing interest rates. Conventional private loans are also an option and may be easier to qualify for, but they will likely be more expensive than SBA loans.
2. Not Setting Up Basic Contracts
I wish we lived in a world where a handshake deal was good enough. Unfortunately, informal deals leave too much opportunity for miscommunication, misunderstanding, or even fraud. When it comes to deals you have with your vendors, suppliers, customers, independent contractors, and even your landlord, you need to take responsibility for making sure you have written, signed contracts to lay out the terms of those deals.
I hear from small business owners way too often who fall victim to poor or non-existent contracts. Unfortunately, there is not much they can do after the fact. If you want to prove that the other party broke a promise - or that you never made a promise they accuse you of breaking - you need the terms to be written down and signed. That is why it’s important to set up and understand your contracts before the actual deal takes place.
I make a point to say “understand your contracts” because far too many people think that just because a lawyer or trusted partner set up the contract, they don’t need to read and understand what it means.
That could not be farther from the truth.
It is important that you know and understand your contracts so that you can identify when the contract has been breached. It’s not only important to be able to identify if the other party violates the contract, but it’s also important to know your responsibilities as outlined in the contract. Remember: as a business owner, your contracts are your responsibility.
There are free or cheap legal services online that offer contract templates. While these may sound appealing, it is important to note that every business is different so there is no one-size-fits-all contract. In some cases, you may be able to get away with using one of these templated contracts, but don’t expect them to protect you as well as a custom contract would.
3. Not Having an Operating Agreement
Speaking of basic contracts, an operating agreement may be the most often-overlooked contract.
Regardless of your type of business entity (LLC, partnership, corporation, etc.), you should have some sort of operating agreement in place. Different types of entities have different names for this document (partnership agreement, articles of incorporation and bylaws, etc.), but the general idea is the same. An operating agreement is a document that outlines your business’s financial and operational structure. It is like the constitution for your business.
This is the document that states how profits (and losses) are distributed, how decisions are made, how responsibilities are delegated, and much more.
If you do not have an operating agreement, you are opening yourself up to a lot of potential lawsuits down the road, especially if you are working with partners and other people with ownership stakes. As with any contract (or lack thereof), even innocent misunderstandings can lead to huge disputes down the road.
An operating agreement also helps show the world that your business is an entity separate and apart from you as an individual. This will help protect you from most personal liability as a business owner.
As with any contract, you can find operating agreement templates online. But again, you must make sure that you understand the terms and tailor the agreement to your individual needs, working with licensed professionals as necessary.
4. 50/50 Ownership
While we’re talking about ownership stakes, let’s talk about the pitfalls of 50/50 ownership.
At the start of any relationship, it’s hard to imagine anything going wrong. This is true in business and in life. Going in with a best friend 50/50 sounds like a great way to start a business, but once the honeymoon is over and the stress of owning and operating a business sets in, you might start to regret that 50/50 split.
When businesses and partnerships fail, the result is often heartaches and lawsuits.
If you have 50/50 ownership, you may reach an impasse in any disputed decision. You may also create resentment if the partners do not split all responsibilities exactly evenly. Are you going to be clocking each other’s hours in the office, dollars invested, time spent on vacation, etc.
If you insist on maintaining 50/50 ownership, it is imperative that you have an immaculately drafted operating agreement. You need to think through every potential area of resentment or dispute and how that will be handled. It is far better to think through those potential pitfalls now than to wait for them to come up in real life and try to improvise a solution.
What can you do instead of a 50/50 split?
If one partner does more for the business, invests more in the business, or has more (beneficial) ideas for the business, it might make sense to make that person the managing partner and give them a slightly larger piece of the pie (a 51/49 split, for instance). Making one person the majority owner allows for easier decision making and could prevent impasse.
Regardless of whether you choose 50/50 ownership or some other split, it is important to define the terms of your relationship as early as possible.
5. Misclassifying Employees
One of the most common mistakes that small businesses make is paying people as independent contractors when they should be paid as employees.
Business owners often do this because they think they’ll save money on taxes. But the potential lawsuits and penalties down the road could quickly pile up to be much more expensive than paying your taxes on the front end like a good, law-abiding business owner.
If you are caught paying someone as an independent contractor when they should be classified as an employee, you may have to pay back-taxes and additional penalties.
How do you know how to classify an employee?
In general, if you have someone working for you most of the time, and you dictate the time, place, and manner of their work; then they are most correctly and appropriately defined employees rather than independent contractors. The IRS offers its own guidance for business owners as well.
As with all things on this list, if you have any questions, consult a professional in your state who is familiar with your line of work.
The good news is that the most common startup mistakes can be avoided with a little preparation. When you’re starting a new business, you don’t know what you don’t know. That’s why Lyda Law Firm developed this 16-Step Legal Checklist for Startups to help provide a roadmap for new and aspiring business owners.
Of course, every situation is different. If you have legal questions about your business, it is best to consult with a professional in your state.
Disclaimer: All information provided is for educational and entertainment purposes only. This is not legal advice and should not be relied on as such. Every case is different. Consult a licensed professional in your state. Reading this article does not create an attorney-client relationship with Lyda Law Firm or any of its lawyers.
About The Author
Mark Lyda is an entrepreneur and lawyer. He is the managing attorney at Lyda Law Firm LLC, a firm focused on helping startups and small business owners. He has been named a Rising Star by Colorado Super Lawyers Magazine three years in a row. Mark Lyda graduated from the University of Notre Dame Law School and is licensed to practice law in Colorado.