Top Ten Legal Mistakes Entrepreneurs Make (and how to avoid them)

October 27, 2010

Here are my top ten legal mistakes entrepreneurs make and how to avoid making them, based on this author’s 26 years of experience providing legal advice to entrepreneurs. The focus is on how to avoid getting into legal trouble, rather than a checklist of specific legal documents that you might need. In my experience entrepreneurs often get into trouble when they do not follow this advice.

1. Failing to conduct your business to avoid litigation.

Of paramount importance when starting and managing a new company is to avoid ending up in litigation. Litigation is a terrible way to resolve disputes. It is very expensive, and even more importantly, it takes away your mental energy. While you are in litigation win or lose, your company will suffer. Much of the rest of this top ten addresses ways to avoid litigation.

2. Failing to put it in writing.

All of your major agreements should be in writing. It may sound obvious, but there are many types of agreements that often don’t get put in writing.

When a company has only a small number of owners, there should be a written shareholder or partnership agreement among the owners. Often people will tell me that they are good friends and they don’t need an agreement. They are wrong. Friendships sour, people change, and people die. Peoples’ priorities change when money is involved. It is far easier to put that agreement in writing now while you get along with each other rather than after you are already fighting.

Often founders of a company will bring technology, valuable trademarks, or other proprietary information that they have already developed, with them into the company. After the company is formed, who owns this intellectual property? There should be a written agreement that clarifies ownership.

When you start to work for a new company, or when your company hires a new senior person, the basic terms of employment should be in writing. These terms include salary, bonuses, stock options, job responsibilities, and term of employment. If the new hire has to move to take the new job, is there a minimum period of employment? Does the company pay moving expenses? Any stock related agreements should also be in writing (see # 6 below).

3. Rushing into agreements.

Do not rush into agreements. Read all important agreements before you sign them. Have your attorney review all major documents. Too often, in the rush of making a business grow, entrepreneurs sign whatever is put in front of them, especially if it comes from someone they think they can trust, such as one of their partners or a venture capital firm. There is always time for review. You can and should look after your own interests. This does not mean that you are trying to kill the deal or be an obstructionist. Whoever drafted the contract took some time to prepare the document. You are entitled to take some time to review it and make sure it says what it is supposed to say, and treats you fairly (or at least as fairly as venture capitalists can treat entrepreneurs).

4. Not planning for the unexpected.

You may think nothing is going to go wrong. It is healthy to have that kind of optimism when starting a new company, and entrepreneurs are inherently optimistic people. You have to be to start your own company. But things do go wrong. You need to plan for the unexpected.

Go over your plan of action for your company and try to think what could go wrong and what would happen if it did. For example, what would happen if one of the founders died unexpectedly?

Anticipate that founders will have disputes. Fifty percent of all marriages end in divorce. The divorce rate among entrepreneurs is probably much higher. You may think that “even if the founders have a dispute or one of us leaves the company, we will be able to work out our differences. After all we are all reasonable intelligent people and we are friends. Nothing will come between that.” But it often does, especially when money is at stake. Plan for the unexpected now while you are still friends.

This is another reason to use attorneys. Clients rarely come back to their attorney to tell them the agreement worked exactly as planned; it is only when something goes wrong that they call their attorney. So attorneys are used to thinking about and planning for the unexpected. Your attorney can help you anticipate problems and prepare to avoid them or at least find a way to deal with them in an orderly non-litigation fashion.

5. Trusting people who say “You can trust me.”

If someone says “We don’t need the lawyers” or “We don’t need fancy contracts because you can trust me,” run, do not walk, and run away fast. Someone who can be trusted never has to say “trust me.” They have nothing to hide. They say, “Sure, we can put it in writing” and “Sure, have your lawyer review this.” and “What else do you need from me to assure you?” (For further discussion of this issue, see my blog entry Don’t Trust People Who Say You Can Trust Me.)

6. Using vague terms in agreements.

Try to use specific terms in any agreements you enter into. Watch out for vague almost meaningless terms like ‘profits’. The amount of profits in a venture is whatever the accountants want it to be. Don’t agree to giving or getting a percentage of profits, or any other subjective term. Use objective easy-to-measure terms instead, like ‘revenue’. Warner Brothers produced the highly successful Harry Potter movie series, with over a billion dollars in revenue. The company agreed to give a percentage of the profits from the movies to various people and companies. But according to the Warner Brothers accountants, these movies have not made any profit. (See STUDIO SHAME! Even Harry Potter Pic Loses Money Because Of Warner Bros’ Phony Baloney Net Profit Accounting.)

Specify stock options in detail. It is common in an offer letter that the company gives senior staff stock options worth around 3% of the company and that is all the letter says. At what price can you purchase the options? When do they vest? When do they expire?

Another vague term is ‘percentage of the company.’ What do they mean by 3% of the company; 3% of outstanding issued stock, with or without taking into account vested and unvested stock options; 3% at the time the letter is written, or at the time of vesting (after several diluting stock events) or when exercised (often after several more stock diluting events)? Be specific when offering or accepting stock or stock options.

7. Not having your own attorney.

Don’t expect venture capitalists (VCs) to look after your interests. When your company is ready to raise funds, the fund provider, usually a VC or two, will be represented by legal counsel. The VC will usually insist that the company hire a fancy law firm that has experience with corporate finance and securities. But who is representing the entrepreneur? Often, no one. You need your own independent legal counsel. You may be hesitant to hire an attorney because you do not want to kill the deal or seem like you are getting in the way. But a good attorney will look out for your interests in a way that does not hurt the company. The same is true if the company is going to be bought by another company.

But be sure to hire an attorney who is experienced in dealing with entrepreneurs and venture capitalists. Your family attorney or your friend’s divorce attorney will not be able to provide you with the counsel you need. Their poor advice will reflect back on how the VCs perceive you.

I remember reading once that the husband and wife founders of Cisco Systems, Inc. wished they had seen their own attorney before signing the documents presented to them by the venture capitalists. They say that they walked away with only 100 million dollars. (One article says before they left the company, they had also sold shares worth another 100 million dollars for a total profit of 200 million dollars.) That may not seem bad, but it is nothing compared to the billions the venture capitalists made.

Hiring your own attorney does not mean that you are causing trouble. It just means that you are looking after your own interests. I once represented an early founder who was no longer with the company, but still had a less than totally clear legal interest in the company. The company arranged to be bought by a larger company. My client was to receive very little of the sale proceeds. I stepped in on his behalf. But I made it clear that my client was not trying to kill the deal. Nor was he trying to be greedy and force the company to buy him off if they wanted the deal to happen. All he wanted was his fair share. Once the remaining founders understood that, we were able to negotiate an agreement quickly and the sale took place on schedule, and everyone was satisfied.

8. Not facing problem areas up front.

It is human nature to want to avoid conflict. There is the hope that if you delay a problem, it will go away. That does not work. The problem does not go away, it just gets worse. If there is a problem area in your future, try to deal with it now. Don’t kid yourself. The problem will come up, and if it comes up later, your options are more limited, and you are much more likely to be unable to resolve the dispute and end up in litigation, which is something you want to avoid; see #1 above.

Most startups are short on cash and on time. The founders can focus on only so many problem areas at once. Work with an experienced attorney who can help you anticipate problems and will advise you when you should take various legal steps. A good attorney will not tell you what to do–that is your job. Instead, the attorney will give you a risk assessment, tell you what kinds of problems can arise, what will happen if they do, and what you can do to prevent them. Then do not put off dealing with these issues because you think they will not happen or you can deal with them later when they do. Make sure that resolving problem areas sooner rather than later is part of your business strategy.

9. Expecting too much value in return for sweat equity.

Sweat equity is not worth much. Be aware that if you contribute sweat equity to a company, you may never be compensated. In many startups the founders forgo salary during the first year or two. They work hard for the company and expect to be compensated once the company is successful. This hard work is called sweat equity. Usually the salary accrues on the books as company debt. Meanwhile, investors have put up money and taken stock and/or stock options. Don’t expect to get paid for your sweat equity unless the company is really successful. Money always trumps sweat equity. The people who contribute the money will be able to dictate terms and will be sure that they are paid back first, before the founders are compensated for the time they have put into the company. I often see that the founders have not put their employment agreements in writing (see #2 above). Then, when the company folds and everyone is fighting over the assets, or the company is sold and everyone is fighting over the proceeds, the people who have worked hard for the company for a long time find that they are on the short end. No one wants to pay them for their past work.

Sometimes founders will avoid having to borrow money for a while and will build up accrued sweat equity compensation in the form of deferred salary and stock options. But even if you have this value on the company books, do not expect to ever see any of it. As soon as you need to raise money, the new investors will insist on erasing all of the sweat equity debt. They do not want to invest money in a company to pay for past performance. They will only want to invest in the future.

10. Failing to keep current on taxes and wages.

Timely pay the IRS and pay your employees or shut down. It is that simple. If you do not pay the IRS and some of your employees, you will probably end up personally liable for these debts.

Most entrepreneurs are optimists. They have to be to choose to be entrepreneurs. They always think that the company is on the verge of taking off and becoming successful. In many startups money is tight and gets tighter over time. Entrepreneurs have a strong temptation to forgo paying employee payroll taxes, and sometimes arrange not to pay their senior staff at all. They figure that they can make up these company obligations as soon as the product ships and sales take off. Instead they use the money that should have been spent on payroll taxes and employee wages to fund the development and marketing of the product. This is not a good idea.

Generally the company will be held liable for back taxes along with penalties and interest, and will also be liable for back wages. In many states including my home state of Washington, the company is liable for twice the amount of wages and any attorneys’ fees incurred collecting the wages. In many states including my home state of Washington, it is not a valid excuse that the company could not afford to pay the wages. If the company did not have the money to pay the employees, then the company should not have let them work and accrue wages; it should have laid them off instead.

But the real nasty surprise is that under the federal tax law, anyone who has any responsibility for writing checks and paying taxes will be held personally liable for unpaid taxes. In many states (perhaps all of them; I have not checked), these same people are also liable for unpaid wages, plus penalties and interest. I successfully represented two senior employees of a failed and obtained a large personal judgment against the founders of the company for back wages plus penalties and interest.

It is your responsibility to make sure that you do not ask people to do work that your company can not pay for. If the company does not have the money to pay wages and payroll taxes, then shut down before your employees do the work and you accrue company debt that you can and will be held personally liable for.

 Other Articles on this Subject

Here are two other good top ten lists with a different focus from my list. You may want to check them out too.

Top Ten Legal Mistakes Made by Entrepreneurs by Harvard Business School Professor Constance Bagley

Top Ten Legal Mistakes Made By Entrepreneurs, by J Mathew Lyons, Andrews Kurth, Austin, Texas

Top Ten Intellectual Property (IP) Licensing Agreement Drafting Tips

October 1, 2010

Drafting an effective Intellectual Property (IP) Licensing Agreement is more difficult than it may seem. Here are some drafting tips to help you.

1. Draft Contract terms to avoid litigation.

Of paramount importance when drafting a contract is to avoid ending up in litigation. Draft contract terms with this goal in mind. Litigation is a terrible way to resolve disputes. It is very expensive, and even more importantly, it takes away your mental energy. While you are in litigation you will have difficulty focusing on work and on your home life. They will both suffer.

Litigation results are unpredictable and somewhat random. Lawsuits are a good way to get a final resolution of a dispute. But they are not designed to get the best possible resolution. Rather they focus on 1) getting a resolution so that both parties can go on with their lives, 2) getting that resolution in a somewhat timely manner, and 3) getting that resolution at a reasonable price to the taxpayers who end up paying the costs of running the courthouse. Litigation results are never satisfying to either party. What you often get is a vague ruling from a judge with a dollar figure attached that seems to come out of the air.

My personal opinion is that the better contract attorneys are also litigators or have been litigators in the past. They understand from first-hand experience the importance of drafting contracts to avoid litigation. [By way of full disclosure I am both a litigator and a contract attorney, so I may be biased.] Much of the rest of this top ten addresses ways to avoid litigation.

2. Put everything in writing.

All of the essential terms of your deal should be written down. A contract is a plan of action – what the parties will do for each other. Think of it as a specialized business plan. Until you put the steps of the plan in writing, it is hard to see if you have left anything out. Until you put the plan in writing, it is hard to know if you and the other side are actually talking about the same thing. People’s memories fade over time and people tend to remember agreements in their favor. But they can not argue with the written word.

Remember to put things in writing even if you are licensing IP from yourself. Many founders of companies have already created much of the IP that the company will use before the company was founded. Who owns that IP? Under what terms can the company use that IP? This should be clearly spelled out in writing.

3. Use attorneys to draft documents.

Do not try to draft complex IP contracts yourself. Experienced IP attorneys know how to draft IP contracts. They know what to include and what traps to avoid. They understand how to draft a contract that works. I have heard and seen too many horror stories of clients who do it themselves, often cutting and pasting from other licensing agreements. Several of my clients ended up in litigation because they tried to save a little money by writing the licensing agreement themselves. They did not do a very good job. When problems arose, they ended up paying me far more to solve the problem through litigation than if they had just let the attorneys write the contract in the first place.

Although I wish that you could just buy a form on-line or cut and paste from your last contract, it does not work. Imagine what would happen if your attorney tried to write a software program by cutting and pasting code from existing programs. It would be a disaster. Don’t try to do the attorney’s job with a cut and paste job either.

4. Face problem areas up front.

It is human nature to want to avoid conflict. There is the hope that if you delay a problem it will go away. But it does not work. The problem does not go away, it just gets worse. If there is a problem area between the parties, deal with it now. The time to discuss it and resolve the differences is at the beginning of the relationship. The problem will come up, and if it comes up later, your options are more limited, and you are much more likely to be unable to resolve the dispute and end up in litigation, which is something you want to avoid, see #1 above.

I negotiated a contract where the other side agreed to a contract term regarding the payment of licensing fees from existing licenses. My client knew that the actual payment according to this term would end up being over one million dollars, while the other party thought it would be around $100,000. I insisted that my client disclose this fact up front and redraft the contract term. They gave up their legal claim to one million dollars, but the other side was never going to pay that amount anyway. Instead they negotiated a fee that both sides thought was fair, and they avoided litigation

5. Plan for the unexpected.

A contract should be a plan of action. But a contract should also deal up front with what will happen if the unexpected happens. What if things do not go according to plan? How should the parties deal with the unexpected? It is far easier to come to agreement on how to deal with the unexpected at the start of the relationship then after the unexpected has already happened.

A client of mine drafted his own license agreement against my advice. He was to distribute the other party’s software. Both sides were counting on the other party releasing a major upgrade to the software shortly after the agreement was signed. My client made a major investment in setting up his business in anticipation of the major upgrade. I asked him what would happen if the major upgrade did not happen. He insisted that it would and he did not have to worry about that, and he refused to plan for the unexpected. Three years later when the upgrade had still not been released, he came back to me and we ended up litigating the issue of what happens now.

Go over your plan of action and try to think what could go wrong and what would happen if it did. This is another reason to use attorneys. We see lots of cases when things have gone wrong, and we are used to thinking that way. Clients rarely come back to their attorney to tell them the agreement worked exactly as planned. It is only when something goes wrong that they call their attorney. So attorneys are used to thinking about and planning for the unexpected.

6. Make the terms fair.

If the contract terms are fair and reasonable, you are far less likely to have a dispute. You certainly want to try to negotiate a contact that is in your favor. But if the contract terms are too one-sided in favor of one party, the other party is less likely to want to perform, and you are more likely to end up in a dispute. Do you want to be in the IP licensing business or the litigation business? If you want to be in the IP licensing business, then draft a contract with reasonable terms so that both sides are able and willing to perform. That way you are not likely to end up in litigation.

There is a difference between a contract that is a good deal for you, and one that is a totally in your favor. Many attorneys try to get the most one-sided contract that they can. They are not doing their clients any favors. They are just setting their clients up to end up in litigation.

When possible, build incentives towards compliance. Don’t just say that a new product version is due by a certain date, say that there is an extra payment if the project is done on time, and the payment goes down if the new version is late.

7. Be wary of multiple agreements and/or attachments.

Sometimes a deal consists of multiple agreements and/or an agreement with attachments and schedules. If so, then think through how they will work together. Too often the agreements are negotiated as separate contracts even though together they constitute one deal. Attachments are often added as an afterthought, after the negotiations are finished. Do all of the documents make sense together? Are they consistent? What happens if one of the deals falls apart, and the others do not? One way to avoid potential problems is to make separate deals that stand on their own whenever possible.

I had a client who wanted to sell her IP to another company. She got a small lump sum payment and a favorable employment agreement with the new company, with salary bonuses tied to the success of the IP. She considered her new job to be part of the compensation for selling the IP. I told her that these deals did not work well together. She should sell the IP for what it is worth, and sign an employment agreement for what she is worth. She did not take my advice. She did not last long at the new company, and is now suing them to them to get her IP back.

8. Say it in plain English.

There is no need for a contract to use secret lawyer language that no one else can understand. Say it in plain English. If you don’t know what it means, ask. There are plenty of times when I read something prepared by an attorney, and I have no idea what it means, so I ask them to rewrite it.

Define technical terms, even if the parties know what they mean. It is fine to use acronyms, abbreviations, and initials in an early draft of a contract. But the final version of the contract should make sense to anyone, not just those in the know. First, there is less agreement on those shorthand terms than you may realize. Second, if there is a disagreement about the contract, the legal standard is what it would mean objectively to a normal person reading the contract, not what it means to the tech people. You never know who will be reading the agreement and trying to understand how it works. Remember that if you end up in litigation the ultimate arbiter will be a Judge, and most Judges have very limited technical knowledge.

The clearer a document is, the more likely both sides will understand it, and the more likely both sides will be able to honor the terms of the contract, and the less likely that there will be misunderstandings and litigation.

9. Make sure you are agreeing to the same terms.

When you think you have finished negotiating and you have come to an agreement, make sure you and the other party have agreed to the same terms. In the very old days, invoices and purchase agreements would fly back and forth by mail or personal delivery. A while back faxes would fly back and forth. Today it is usually emails and email attachments. It is very easy to think you have agreed to the same terms, when you are actually each referring to a different version of the contract. This type of misunderstanding happens more often than you might think. Make sure that you know what version you are agreeing to. When you think you have an agreement, pull all the contract terms together in one document and make it clear that this is the version you are all agreeing to.

10. Make sure the contract fits your particular needs.

      Keep in mind what you are trying to accomplish with your new agreement. Too often clients and their attorneys jump right in and start to write the standard contract, whether it fits what the client needs or not. I always try to start with asking my client “what are trying to accomplish here?” Then I draft a contract that fits the client’s needs.

There are times when a creative solution is better than that standard boilerplate. My favorite example is a telephone company with commercial clients. The telephone company would often end up in billing disputes over $3,000 to $5,000 dollars with its customers. This was not enough money to justify litigation. Besides, the company did not want to alienate its customers. So the telephone company wrote into its contract that there was mandatory arbitration of billing disputes. The result of the arbitration was only binding on the telephone company. If the customer did not like the result, the customer could still file a lawsuit. The customers were more than willing to go along with this contract term. It turned out that customers rarely took their claims to court even when they lost. The client really just wanted to have a voice, a chance to have their say. The telephone company had a fast and inexpensive way to resolve its dispute and keep its customers satisfied.

Write a contract that is easy to understand, fits your needs, is reasonably fair to both sides, and is likely to avoid litigation.