Many of my clients in the startup phase are younger and generally share a few common traits: “tech competent,” “socially minded,” and “risk-tolerant.” Young lawyers interested in success in the startup space should keep these client traits and the lessons in mind when forming or considering forming a startup.
Understand the Startup’s Business Purpose to Select the Proper Entity
As lawyers, our job is to limit our clients’ liabilities. We advise our clients to form an entity that, at a minimum, does just that. The proper entity will depend on each client’s business purpose. Many startups will select a limited liability company due to the following features: liability protection, centralized management and flexibility, pass-through taxation, and a level of privacy not traditionally available to corporations depending on your jurisdiction.
Your client’s goals may include creating a business that exists not merely to turn a profit but also for the benefit of some social good. Your client may want to consider an entity like a benefit corporation or a low-profit limited liability company, depending on the legal framework available in your jurisdiction. If your client is willing to give up control and profit to attract donors who can make a tax-deductible donation to their startup, then a nonprofit corporation with 501(c)(3) tax-exempt status might be the best fit.
Do Not Neglect Corporate Formalities
A problem common to most startups (particularly younger entrepreneurs) is a lack of cash flow. If a lack of cash flow is a driving factor, startup owners may neglect to engage legal counsel to prepare the formation documents and, instead, may set up their own entity and inevitably overlook establishing corporate formalities. If you represent a startup, make sure your client understands the importance of adopting corporate formalities like stock certificates and operating agreements. These documents are worth the expense. They establish the owners as separate from the legal entity and act as a “liability shield.” Without these documents, owners are more susceptible to personal liability claims.
Create the Startup with the End in Mind
Before forming the business, it is crucial to develop the business owners’ exit strategy and memorialize it in an operating agreement or shareholder agreement. This contract will allow the owners to answer many questions including the acceptable manners of exiting the business (e.g., death, disability, withdrawal, expulsion). Also, consider the division of ownership percentages. If there are only two equal owners who can deadlock the business decisions, discuss including a deadlock provision in the contract.
Develop Key Contracts at the Beginning
Clients come to you with optimistic outlooks on the potential of their new business. Lawyers sometimes have to provide broader perspectives and advise the client of all the ways things could go wrong (e.g., if the business hires a key salesperson who, upon exit, leaves and takes company information, solicits customers, and forms a competing business). To mitigate this risk, at the beginning of employment, a client should have a new employee sign a contract with restrictive covenants (e.g., confidentiality, non-solicitation, and non-competition) allowed in that jurisdiction. Things can also go wrong if a startup does not have terms and conditions (TnCs) in place with customers. TnCs allocate risk away from the business and toward the customer by speaking on critical issues such as payment terms, right to cease work, limited warranty scope, limitation of damages, indemnification, and dispute resolution.