This information has been curated to help startups understand some of the major legal challenges facing startups today. Whether you just have an idea or are already operating, this information can be relevant to you. A startup’s legal compliance issues might be the difference between a lull, a lapse, or a lawsuit. Having a good understanding of some of the differences in the various types of business structures can help you with your business.
There are several different structures a business can take. Each one has different pros and cons. What is important is to determine early if you are starting a lifestyle business or a venture capital (VC) backed high growth start-up. The best distinction I have heard is VC startups are intended to grow large so investors can make large returns on their investments and lifestyle businesses are intended to give a great quality of life to its owners. Some might break it down in relation to technology, growth potential, or novelty of an idea. But I think for anyone trying to find their place in this space, they need to think about their long term goals. Though it may seem counterintuitive to think about exit strategy upon starting a venture, it is important you have a plan for your idea. Of course, even the best plans can change over time.
The major types of business structures are sole proprietorships, partnerships (general and limited liability),Corporations (S and Corps), and Limited Liability Companies (LLC). For the purposes of this article we will only get into LLCs and Corporations. If you are starting a business, regardless of the form, one of the first things you will need is a bank account. One of the reasons to decide what form your business will take is to ensure that bank accounts are setup properly. In order to set up a business bank account, you need an Employer Identification Number (EIN). This is FREE to get via the IRS and only takes 15 minutes. When you complete the form for the EIN, you need to know what structure your business will take, which is why I mention it now. When researching these structures, you might see a focus on taxation or liability protections, however that is only one piece of the puzzle. Since this is not a “one size fits all” approach, I will break down each in a chart. I think the easiest way to explain this through businesses that actually exist.
The first company I want to mention is a Delaware LLC. This company is a lifestyle business in the food industry. They offer one novel product line, they sell regionally, it was founded by one person, it’s highly re-creatable, it has no intellectual property other than its recipes and some machinery. Its funding has been raised by friends, family and Kickstarter. The owner was told about the tax benefits of having an LLC and that Delaware was the best place to incorporate. In this situation, an LLC made a lot of sense because it offers some liability protection, this company would not be seeking VC funds, there are few equity partners, and taxation will be to the owners. You may wonder why this business was formed in Delaware. Since the business operates in Pennsylvania, it is difficult to say whether it should be in PA or Delaware. When you incorporate in DE and you do not actually have an office there, you have to deal with paying registered agent fees. These fees are annual and makes paperwork slightly more complicated. If you are operating in another state you also have to worry about foreign qualification or foreign entity registrations. In this case, “foreign” refers to a company that is outside of the state. This too has a cost. Fees are paid to the states in which you want to operate. In DE, you also pay an annual franchise tax which also comes with a filing fee. You will also have to do any required reporting annually in the state(s) in which you operate as well as in DE. So for this business, it is a lot of extra work and money to have incorporated in DE rather than in PA. However, changing state registration also has a cost. This company to date is still a DE LLC.
The next company was started by two international students. They incorporated as an LLC in DE. They had a 50/50 income split in their business. They were growing fast, getting press, winning competitions and got into an accelerator program. Many accelerator programs want the companies to be C-corps because the accelerators take equity stakes similar to VCs and might even be run by VCs. In this case, the company needed to change its structure in order to participate in the program. The issue is the founders could not agree if the equity they already vested should remain the same or if they should start again. What happened was that one co-founder was trying to push the other out and by taking this opportunity to restructure, he was hoping to renegotiate a better deal. With both members having equal equity, no compromise could be made because there was no one to break the tie. The company is still in limbo while in the accelerator with a no cash, no equity deal. This is a high growth, high tech business. If they had organized as a C-corp in the beginning they would not be facing this challenge of not being able to accept cash investment. However, the structure of your company can not save you from having greedy co-founders. Therefore, always choose your partners carefully.
These are only two cases. There are many other variables but the idea is that no two companies are the same and that only you, your team, and your lawyer can best decide what is best for your company.
Who will do the paperwork?
There are a lot of business service providers on the market. Choosing the right one for you, can also be a challenge. Services often bundle things for you for flat fees. The problem is that you probably don’t know what you need and what you can go without. The other thing is that these services can upcharge you for things that are free if you did them yourself. *FOR EXAMPLE: the IRS will give you an EIN Number for free and it takes 15 minutes*, LegalZoom charges $79, RocketLawyer $60, Harvard Business Services $65 (As of 10/9/17).
Even services that may seem cheap and easy are not always transparent. That is not to say that you shouldn’t use these services if you wish, just be an informed consumer when making that purchase. Knowing what they will charge for a registered agent, if that is necessary, will also help you understand future costs. You can hire attorneys to do the work as well, but this will come at an additional cost. However, this may save you in the long run when it comes to structuring. Some law firms have deferred payment plans, for when you start making money. If you think you need a lot of legal help, finding a firm that will take on a flexible payment structure may be very helpful. Each state has its own fees, and if you operate in other states, that’s more paperwork and fees. Also, please note to close down a business, you will need to file paperwork with the state(s) as well. Typically there are fees associated with this.
Every startup will need to have legal documents at some point past the idea stage. There is a lot of information online about what documents you will need, how you should structure your company, where you should incorporate, etc. The reality is that there is not one approach to forming a company. The first issue is timing. When should you form a business after the idea stage? For some people, the second they have an idea they jump to their favorite business incorporation web service provider and get incorporated. I would urge anyone with an amazing idea to do some market research before forming a business. Potential outcomes you might find in your research is that there are not enough customers, that the market is already saturated, that the costs may be too high for the returns, or other issues. If you don’t put in the time up front, it may cost you a significant amount of money. Many people I have talked to have said that for $200, they want peace of mind that they are protected. The reality is that until you have a product, a patent, intellectual property, or sales there really is nothing to protect. The other side of this is that if nothing comes out of the idea, you still have to pay to close down the entity with the state. You CANNOT just abandon the company without addressing the state where it is incorporated and informing them that you no longer want to be in business. This can cost HUNDREDS of dollars. There will be more on market research below and the tools to use but for now, let’s assume that phase is over.
Notarize An Agreement
A simple fix some people have done to protect the business idea is to create a document with a co-creator that details your plan for the idea. This could include the business strategy, percentage of the idea you want to own, who keeps which assets if you don’t ultimately create a company, etc. Once complete, get this document notarized. Having it notarized, means that each person’s identities have been verified and that each person agrees that they understand what they are signing. This can help in the court system later, if a legal battle arises. It is especially helpful, if the company hasn’t been formally created. Notaries charge nominal fees and there are even online notary services now. This is just one way of protecting an idea early in the business development cycle for a low cost. A Founder Collaboration Agreement can be found online to help outline this process.
Some of the key documents a startup might need
NDA (Non- Disclosure Agreement)
EIN filing with the IRS
Business Entity Documents
• Articles of Incorporation/Formation (may have other names)
• Operating Agreement or Founders Agreement
• Shareholder Agreements
• Foreign Filing (if necessary)
• Registered Agent (if necessary)
- Intellectual Property Assignment Agreement
- Employee Contracts and Offer Letters (if necessary)
- Independent Contractor Agreements (if necessary)
- Financing Documents (if necessary)
There are many ways of getting help with documentation. Hiring a lawyer is usually the best option. However, you might not be at that stage and are interested in doing more research. There are free resources online that can be used to find documents. Some services provide free documents, however, you usually have to provide an email address at a minimum. Make sure to read the TOS and PP of those sites. There is a community database of legal documents called Docracy. This is a socially curated platform, where organizations and startups have posted documents. For those who need documents, but are not ready for the full “lawyered up” approach, this could be a good resource to find documents that might be modifiable. I have to reiterate that hiring a lawyer is almost always a better option. Many startups struggle with not having Non-Disclosure Agreements and that can put intellectual property at risk. Documents are subject to interpretation by the courts so documentation is not 100% foolproof, but it is the best way to define outcomes and strategies so all parties can manage expectations.
*For more information on specific documents please check out our Documents Explained article.
There are 4 main types of Intellectual Property (IP)
Copyrights – Copyrights protect original works of authorship
More information can be found at https://www.copyright.gov/
Patents – A patent grants property rights on an invention. Types include:
Resources can be found at Google Patents and USPTO
A trademark (™) is a word, phrase, symbol, or design that distinguishes the source of products of one business from its competitors
A Service Mark (SM) is a word, phrase, symbol, or design that distinguishes the source services of one business from its competitors
Resources can be found at USPTO
Trade Secret– A trade secret is a formula, process, device, or other business information that companies keep private to give them a competitive advantage over other businesses. Examples are:
• Soda formulas
• Customer lists
• Computer algorithms
More resources and information can be found in the Defend Trade Secrets Act of 2016
I can not stress enough that you should consult your favorite search engine to research an idea, before you spend any time developing a product. I knew someone who wanted to build a product and was modeling and prototyping and asked me for help. I searched his idea and found the exact product on the market. He was lucky because the company had actually failed, so there were no active competitors in the space. However, that may point to some other red flags. He had an idea and just jumped into development, without domain expertise, without a plan, and without doing any research! PLEASE DO SOME RESEARCH BEFORE development. This will save you time, money and resources. Once you have decided to move forward, you need to figure out what category your IP falls into.
US Patent and Trademark Office:
Intellectual Property Rights Information & Assistance:
Not all ideas can be patented. Understanding what can and cannot be patented, is really important to the development of your product. If something is a great idea and has a huge market, but you can’t get a patent, then you need to protect the idea. Understanding that patents are not the only forms of intellectual property. is key to business development. Trade secrets, for example, are extremely valuable but hard to manage. Making sure your documentation is clear is a huge help in protecting trade secrets, but also making sure only mission critical team members have access to the information is an additional way of keeping trade secrets actual secrets.
Not everything that can be patented should be patented.
If you are in a highly regulated industry like pharmaceuticals, you will most likely want to use a patent to protect your idea. Drug companies patent drugs so they have a lock on the market for 20 years and they can set the price. After that, generics come onto the market at reduced costs. Because of all the regulation around the drug industry, it is really the only way to protect a drug. But not all products fall into that category. Coca-cola and WD-40 are examples of formulas that were not patented but instead are trade secrets. By doing this, no one else in that market ever gets access to their formula so they cannot replicate it exactly. There may be substitutes on the market that are similar, but no product will be exactly the same. You and an attorney are the only ones who can decide if your idea should be patented. If you want to do some preliminary research on your own, Google Patents and USPTO will have information on patents already filed.
A copyright is something you may have heard of but don’t know how it applies to you. If you create anything that resembles literary works, music, dramatic works, pantomimes and choreography, sculptural, pictorial, and graphic works, sound recordings, artistic works, architectural designs, computer software or other forms of creative expression, you most likely have copyright IP. As long as your works are in a fixed tangible medium of expression, your IP can be covered under copyright law. The other helpful piece is that registration is voluntary and that the copyright exists from the moment the work is created.
A common misconception amongst startups is that a trademark must be federally registered in order for it to be established. When you use your IP, that qualifies as a trademark. You are helping your organization acquire it by use so your protection can begin even if you haven’t reported it to the USPTO. However, most organizations want to enforce their trademark more easily. They can do this by registering with the USPTO. Like with any IP, doing your research before filing is important. To make sure you are not infringing on someone else’s trademark or to make sure something else similar does not exist, check with federal and state databases. This will save time and money in the future.
There are three commonly used trademark symbols: (™), (SM), and the letter ® in a circle. Companies that want to avoid the fees attached to applying for a trade or service mark can put the ™ or (SM) symbol in their logo until they are able to apply for a legal trade or service mark. The protections attached to the trademark and service mark symbols are limited, but limited protections are better than nothing. If another company has a legally trademarked logo that is similar to an unmarked logo or a logo with the trade or service mark symbol, the limited protections do not apply. If you do register your trademark you would use the ® to receive the full protections for the trademark.
How to use a Trademark
• There is no requirement to use the TM or SM symbols
• Their use has no legal significance, but it is good to do so
• Using TM or SM notifies the public of your claim of branding rights (possibly dissuading others from use)
• Federal registration symbol “®” is regulated by federal law
• If filed to use ®, one should use it every time so you don’t forfeit your right to recover lost profits and money damages
• The appropriate symbol typically appears in superscript in the upper right-hand corner of a mark/logo
• Adherence to norms is strongly advised but not regulated by law when placed in layout
• For written documents, it is only necessary to use a symbol with the first instance of the mark or in the most prominent display
More information can be found at: http://www.inta.org/Media/Documents/2012_TMUseMediaInternetPublishing.pdf
You cannot protect trade secrets by registering them with the government. The only way to protect these is to create in-house practices on how you limit and segment information. Documents like non-disclosure agreements and other security measures are the only real ways to protect this information.
*To find out more on steps you can take to protect Trade Secrets, visit Protecting Your Ideas.
Unfortunately, there are no police that will enforce your IP for you. The only way to enforce IP is to take a potential infringer to court. This costs time and money. There are ways to report IP infringement. Depending on the type of case, there are organizations that may be able to help. More information can be found below.
U.S. Copyright Office – https://www.copyright.gov/
WIPO – World Intellectual Property Organization www.wipo.int/
National IP Rights Coordination Center – https://www.iprcenter.gov/
StopFakes – https://www.stopfakes.gov/
Intellectual Property Rights e-Recordation (IPRR) https://iprr.cbp.gov/
US Customs and Border Patrol (CBP) – https://www.cbp.gov/trade/document/publications/intellectual-property-rights-brochure
Naming Your Entity
Naming a business I cannot stress enough how important it is to name a business correctly in the beginning. This might seem like a simple task and you might be totally in love with a name but I would challenge you to really reconsider any original ideas if while completing the following steps you run into some problems.
- Search results
- Handles (twitter, Instagram, Facebook, pinterest, youtube, linkedin)
- Startup accounts – Angel.co, f6s.com