Common Pitfalls and Pratfalls of Business Owners

Entrepreneurs are often “big idea” people. They get excited about possibilities and the seeming inevitability of their success. But this mindset may leave them vulnerable if they overlook the details of their business. As a corporate lawyer, I have seen many ways entrepreneurs get themselves into a pickle. Some of those predicaments are self-induced, but in other cases cynical people take advantage of the entrepreneur’s optimism and inability to focus on details.

Here just a few ways I’ve seen entrepreneurs get caught in a jam.

Intellectual property. Apart from selling a widget nobody wants, the biggest mistake I see entrepreneurs and startups make is failing to secure the legal rights to their intellectual property. It is common for a group of friends to form a company together, and each partner is expected to bring a different skill-set to the table. One partner may be the finance person and another may be the coder or technologist. But if the developer does not contribute his intellectual property to the company, then the company may never actually own the technology. If the founders just have a novel idea, but no technological skills, then they may outsource the research and development to a third-party contractor. If the third party-contractor does not assign the intellectual property to the company, then there will be a question about who actually owns the intellectual property rights to the technology.

You see where this is going.  If the founders ever decide to sell the company or take on venture capital investors, then it will be critical for the company to show that it has clear title to the intellectual property. But if it turns out that the company doesn’t actually have clear title to the intellectual property of the technology, then investors or buyers will walk away from the deal.

Breaking up is hard to do. Let’s take our group of friends in the previous example. It’s not uncommon for start-up to give everybody a piece of the fully-vested equity pie. But it’s important to have a way to legally (and amicably, if possible) part ways with non-producing partners. It’s hard to kick a fully vested equity partner to the curb (even if that’s where he belongs).

Perhaps the most common mistake I see entrepreneurs make is not ensuring they have a legal way to show deadbeat partners the door. We often talk about the need for partnerships and closely held companies to have a business pre-nuptial agreement (i.e., a buy-sell agreement). If a partner doesn’t contribute as expected, or if the partners can’t manage the company because they have a stalemate over major management decisions, then the buy-sell agreement will set the rules for how a partner is removed and bought out. In the absence of such an agreement however, the partners or shareholders will all lawyer up and sue each other while the company spirals down the drain. Closely held companies should also consider having founders’ equity vest over time rather than at the formation. This incentivizes founders to contribute to the long-term success of the company.

Deal or no deal? You may be surprised how often entrepreneurs get themselves entangled in contractual disputes over alleged verbal contracts. I have seen sales people claim equity in their employer’s company based on an alleged verbal contract arising from a casual meeting over coffee. I have seen independent contractors claim company ownership because they allege a general partnership was created despite the fact that the business was actually incorporated and the independent contractor was not a shareholder of such corporation. Such cases are a waste of time and energy, even when the entrepreneur prevails.

My advice to entrepreneurs is to memorialize their contracts as well as the absence of their contracts. For instance, I tell clients to follow up business talks with an email thanking the other side for a great “conversation.” Then, state that when they get closer to an agreement, they’ll have their attorneys write something up. In other words, make implicit explicit: there is no contract. This sort of email would be evidence that no agreement exists and that any future agreement will be written by attorneys and properly executed.

Bad Terms. Another way to screw an entrepreneur is with shady, cumbersome finance terms. I’m not really talking about venture capital finance based on industry norms. A VC firm relies on its reputation. If the word gets out that a particular VC firm is really a “venture capital” firm, then no attractive company will ever work with them again. However, there are occasional investors who will dictate terms to less savvy, early-stage startups that are not “market” and nearly theft. Unsophisticated entrepreneurs may just see the dollar signs and not think about what they’re giving up.

Before taking on investors, research their reputation. Talk with the companies with whom they have invested. Chat with people in the start-up ecosystem like incubators, accelerators and angel investor networks. Do some due diligence of your own on would-be investors. While you are at it, ask about what “market” terms would be for investments in companies like your own.

Final thoughts. I recommend business owners and executives learn to be skeptics. If it sounds too good to be true, then it probably is. Ask lots of questions. Demand that everything be put in writing.  Take the time to think things through. And don’t be afraid to say “no.” No deal is better than a bad deal. And if someone rushes you to make a business decision, take that as a sign to slow down and think.  Think about your intellectual property rights, your contractual obligations, and what’s at stake financially. And, without becoming jaded or paranoid, think how they might be trying to screw you.

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