5 Common Legal Issues to Consider When Starting a Business

To successfully launch, grow, and operate a business, entrepreneurs must find ways to comply with, and utilize, various laws and regulations to protect their business, while not letting legal issues distract them from running their business. Here are five common legal issues that entrepreneurs should think about when launching a business:

1. Business Types

The first thing to consider in starting a business is figuring out which entity structure to use. There are multiple types of business structures to choose from. The most popular structures in recent years have been limited liability companies (“LLCs”) and C-corporations, which can protect business owners from corporate liability. Each entity type has its pros and cons when it comes to taxes, personal liability, and fundraising abilities.

For example, the LLC structure may be more favorable for businesses that prefer less record-keeping requirements and an easy distribution of profits and responsibilities between owners. However, LLCs come with some drawbacks in comparison to the C-corporation structure. LLCs may not be appropriate if the business owners are seeking to raise capital from a large number of investors. Further, the entire income of LLC members is subject to self-employment tax contributions, which can be avoided with a C-corporation.

The C-corporation structure may be more favorable for businesses that intend to raise venture capital or investor money as it allows investors to view the business as a maturely established company thereby making it easier to raise capital. The downside of a C-corporation structure includes double taxation, high cost to form, and extensive paperwork and record-keeping requirements.

It is important to properly form the company early in the process. Each state carries its own specific requirements for forming and running a company. Delaware has been a popular state for incorporating businesses due to its well-developed corporate laws. Nevertheless, depending on the type of the business, it may make sense to establish the company in the state where it regularly conducts business.

2. Founders’ and Operating Agreement

Many business ventures fail due to the lack of well-written agreements between owners. If the business is owned by multiple people, it is crucial to ensure that each person understands their rights and responsibilities within the company at the outset of forming the company. Some of the issues that need to be addressed include how company decisions get made, either by unanimous vote or majority rule, how ownership is structured, and how the company’s assets would be divided in the event of dissolution.

The rights and responsibilities of each business owner should be clearly defined in a written agreement and signed by each owner. Depending on the structure of the business and jurisdiction, articles of incorporation and shareholder agreements may be required.

3. Securities Law

Entrepreneurs are subject to various federal and state securities laws, especially when it comes to raising funds from investors. Federal and state securities laws require that the sale of equity securities must comply with certain disclosure, filing, and form requirements unless such sales are exempt. Non-compliance with these laws can result in significant financial penalties for the founders and the company. The most popular and useful exemption requires the founders to raise money from accredited investors. Accredited investors may either be individuals or entities, but they must meet certain criteria defined by the Securities Act of 1933.

Those entrepreneurs seeking to secure financing from an individual accredited investor should make sure to check whether the investor has either (1) earned income exceeding $200,000, or $300,000 when combined with a spouse, during each of the previous two full calendar years, and a reasonable expectation of the same for the current year; or (2) a net worth greater than $1 million (either alone or combined with a spouse), excluding the person’s primary residence.

4. Employment

New businesses often encounter problems from inadequate employment documentation. One common issue is misclassifying their workers as employees or independent contractors. Misclassifying workers may result in lawsuits from workers or regulatory actions by the government.

Whether a worker is considered an employee or an independent contractor is not determined simply by assigning the title to the worker but by how much control the employer exerts on the worker. Businesses should contemplate the following questions to properly categorize their employees’ status:

a. Does the company control or have the right to control what the worker does and how the worker performs the work?

b. Does the company control the workers’ business? In other words, who controls how the worker is paid, whether expenses are reimbursed, or who provides the necessary tools and supplies.

c. Is there a written contract of employee benefits such as a pension plan, insurance, or vacation pay?

It is also important to have a clear employment agreement with key employees that define and govern the relationship, including the ownership of intellectual property and restrictive covenants. Depending on the type of the business, entrepreneurs should consider creating stock option documents, employment offer letters, and confidential information and inventions assignment agreements.

5. Intellectual Property

Intellectual property (“IP”) is an important asset of many businesses, which consists of patents, copyrights, trademarks, and trade secrets. Entrepreneurs need to consider appropriate steps to protect their unique technology, service, or product. In addition to filing patents, copyrights, and trademarks to protect the company’s IP, businesses that routinely create IP should enter into confidentiality and assignment agreements with its employees to ensure that the work product belongs to the company, not the employees.