Legal Primer for Startups

As you launch your startup venture, there are a variety of legal issues that you’ll need to think about, from forming a corporate entity to protecting your company’s intellectual property (IP).  My experience is that you want to get as much of this as possible done correctly right at the beginning, so that as the venture launches you can be focusing all your energy on building a great business, not wasting time with legal and compliance issues. 

The big question: DIY or hire a lawyer?

Having a good corporate law firm is a great thing to have. As a startup CEO, it is incredibly beneficial to have an attorney you can call up anytime and run things by. Plus, a good corporate lawyer is usually very well-connected and can be a great source of referrals to other professionals, partners, investors, and perhaps even customers. 

But a good lawyer ain’t cheap, and many entrepreneurs start with the do-it-yourself (DIY) approach, with the intention to hire a law firm down the road after they have money. The good news is that there are many DIY legal tools and platforms available to startup founders today (see list at thelaunchpath.com). 

Finding a good lawyer: 

Referrals are almost always the best way to do this. Ask around, email your friends, ask your CPA, etc. You want someone who has experience working with startups (yes, a family law attorney could figure out how to form a corporation, but in the long run you will really benefit from an attorney with deep startup and corporate experience). 

In Silicon Valley, most law firms will give you a reduced flat-rate on corporate formation, because they want the long-term business with your venture (and they’ll probably want stock warrants in return). The Palo Alto law firm Wilson Sonsini handled the original corporate formation of Google on a special deal, and went on to make tens of millions on the IPO. Now every law firm is hoping they’ll be next.

Choosing and forming a legal entity.

One of your first legal decisions will be the sort of legal entity to form. Here are the options in the US (other jurisdictions have similar legal entity types, although their names may be different). 

Sole Proprietorship: This is the default under the law. If you do nothing, your business will be a sole proprietorship. Under this structure there is no legal separation between you and the company, which means that if the company gets sued or has debt, you are personally liable. For tax purposes there also is no separation between you and the business, so the business profits (or losses) are just simply part of your personal taxes. Also there is no equity structure (you can’t sell 23% of yourself to somebody), and no concept of survivability for the business (when you die the business ceases to exist, in the eyes of the law).

Partnership: Exactly the same as above, but more than one person involved with the business.

Limited Liability Corporation (LLC): Separate legal entity, so you are not personally responsible for the business debts, but there is full tax flow through (the company’s profits or losses go on your personal tax return). Equity structure allows for multiple “members,” but there is no concept of shares of stock (it makes it difficult, for example, for someoneto own 3% of the business (and no way to issue stock options or have classes of stock).

C-Corp: This is the standard “big daddy” corporate structure. Full liability shield (the business is a separate entity so you are not personally responsible for business liability). Separate taxation — the company files its own tax return. Maximum equity flexibility — issue as many shares of stock as you want, sell the stock to anyone (subject to a bunch of SEC laws), have different classes of stock, etc.

S-Corp: Like a C-Corp except with tax flow-through. There are also some limitations on the number and types of shareholders, and you cannot have different classes of stock.

501(c)3: The standard model for nonprofits (charity) organizations. The profits are exempt from taxation, and individual contributors can get a tax deduction for their donations (subject to certain limitations). Note that as an officer  of the nonprofit you can still pay yourself a full market rate salary (subject to standard income tax).

Benefit Corporation (B-Corp): Recognized by 33 states, a Benefit Corporation’s directors and officers operate the business with the same authority as in a traditional corporation but are required to consider the impact of their decisions not only on shareholders but also on society and the environment. In a traditional corporation, shareholders judge the company’s financial performance; with a benefit corporation, shareholders judge performance based on the company’s social, environmental, and financial performance.

What is the deal with Delaware?

In the US, corporations are formed at the state level, not the federal level, and a strange twist is that most major companies are incorporated in the tiny state of Delaware.  The reason is primarily that if your company ends up in court it will be more efficient to litigate in Delaware because the judges are experienced with business matters and there’s a whole court system called Delaware Court of Chancery, considered to be the best court for resolving business disputes. 

Venture capitalists prefer it, so if you intend to eventually raise venture funding then you might as well incorporate in Delaware as a “C-corp” because that’s the preference for most investors, but it will increase your cost and administration slightly, because you’ll need to be registered both in Delaware and in your home state.

Summary : 

If you plan to eventually raise venture capital, you’ll need to be a C-Corp in Delaware. If you don’t, then an LLC or an S-Corp may be easier and have some personal tax advantages. But do your own research and hire a good lawyer if you can. 

When should you form a legal entity for your startup?

Many startups begin as an informal, part-time side project, so when do you know it’s time to spend the money to form a legal entity? The short answer is that you should form a legal entity when you get to the point the business takes on liability. Examples might include signing a lease, signing a loan, or hiring employees. And these days even launching a website can potentially create liability. Along the journey from startup idea to a launched business, you will cross a threshold where you’re starting to take on personal liability. Form a legal entity before you cross that threshold to protect yourself by separating the business’s liabilities from your personal assets.

Protecting yourself from personal liability. 

One of the main purposes of creating a legal entity for your venture is so that, in the eyes of the law, you and the company are two separate things. Your personal assets and liabilities are separate from the company’s, and visa versa. So don’t mess this up! Make sure that all leases and purchases and loans are in the name of the company, not yours. Keep completely separate bank accounts and never mix personal funds with business funds. Make sure the company files its tax returns and other regulatory requirements. If your business gets sued at some point, the other side’s lawyers will try to “pierce the corporate veil” and come after your personal assets. One of the ways they will do that is by trying to claim that you weren’t really properly operating as a corporation and so you don’t deserve liability separation between your personal matters and your business matters. Don’t let this happen. Be smarter than that.

Protect your company’s intellectual property.

As soon as you create your legal entity, the next thing you should do is to transfer the domain name, the logo, software, sketches, and everything else to the company. Typically this is done by typing up a “Bill of Sale,” listing everything, and selling it to the company for some nominal amount. There are a bunch of reasons this is important — one of them is that in case of a future co-founder break-up you don’t want to find out that the domain name doesn’t actually belong to the company. Also, for any future investor conversations that are going to want to see documentation that everything belongs to the company they are investing in.

Next up is Confidential Information and Invention Assignment Agreement (CIIAA). All employees should sign one (including the founders!) with the company. Among other things, it states that anything “invented” by the employees while on the job belongs to the company, not the individual. Again, investors are going to require that these agreements be in place, and so you should too!

Trademarks, Patents, and Copyrights.

Protecting your company’s intellectual property is important, and there are three broad ways in which you can do this:

Trademarks are a way of protecting a recognizable sign, design, or expression that identifies products or services from a particular source and distinguishes them from others. These are relatively easy and inexpensive to file for. You can find out more on the website for the US Patent and Trademark Office (uspto.gov) and there are many online companies offering services for obtaining Trademarks. 

Copyright protects original works of authorship such as writings, illustrations, blog posts, etc. Once you publish something that you have created, you are automatically the copyright holder (often people will put “Copyright 2023 John Smith” at the bottom, just to make it clear. You can also register your copyright, just to make sure (especially if you plan to license rights), and you can read more about this at the US government website copyright.gov.

Patents are slightly trickier. A US patent gives you, as the creator of an invention, the right to exclude others from making, using, selling, or importing, an invention like yours. You can use Google Patents to search to see if anyone already holds a patent on something similar, and you can find more information at uspto.gov. There are many online legal self-help services available for patents, and a good IP attorney can add a lot of value to this process. Remember that just having a patent doesn’t necessarily do you much good — you’ll need very expensive litigation to protect it if you feel another company infringes upon it.

Privacy Regulations. 

If your startup has a website, it will need to be compliant with various online privacy laws. No matter where your startup is located, you’ll probably have website users in California and in Europe, so you’ll want to read up on the California Online Privacy Protection Act (COPPA) and the General Data Protection Regulation (GDRP in the EU) since those are the two operative sets of privacy regulations. If you are capturing self-help services available for patents, and a good IP attorney can add a lot of value to this process. Remember that just having a patent doesn’t necessarily do you much good — you’ll need very expensive litigation to protect it if you feel another company infringes upon it. 

Privacy Regulations. 

If your startup has a website, it will need to be compliant with various online privacy laws. No matter where your startup is located, you’ll probably have website users in California and in Europe, so you’ll want to read up on the California Online Privacy Protection Act (COPPA) and the General Data Protection Regulation (GDRP in the EU) since those are the two operative sets of privacy regulations. If you are capturing certain kinds of personal information (health information, for example) there are specific regulations surrounding that stuff, and if you expect to have users under 13 then there’s a new set of requirements. The point is this: if you are collecting any information on your users at all, you’ll need to do your research on the applicable data protection regulations. Compliance around online privacy is extremely important these days.

Taking Money from Investors

Types of investment structures are covered in Chapter 6, but the main thing here is to document everything clearly! There have been many disputes between startups and investors because a check was written without clear documentation on the terms of the investment. Avoid this! With an equity investment you will pretty much always need a law firm because you are selling stock, which gets into highly-regulated territory, and this is one of reasons that SAFEs have become a popular way of accepting early-stage investment without triggering the need for the complex legal paperwork of an equity financing. See Chapter 6 for more details on SAFEs and other investment structures and strategies. 

Employing People

In the US, most labor law is state-specific, and obviously around the world research on which employment regulations apply to your startup. But here are the three things you need to be especially aware of as a startup founder:

At the beginning, startups tend to like to hire people as freelancers, to avoid the cost and hassle of running payroll and paying payroll taxes. This typically runs afoul of labor law eventually, so proceed with caution. In California, for example, the number one thing that startups get fined for is paying people as freelancers when legally they should have been paying them as payroll employees. This can be painful and expensive. 

Once you form a corporation, as the founder you are now an employee of the company, subject to all labor laws. Strangely, this means that if you are not paying yourself then you are in violation of minimum wage laws. Yes, I know that’s ridiculous but it’s also true. So check the laws that your startup is subject to – you may need to pay yourself minimum wage in order to stay out of trouble. 

Every employee -even you and your co-founders – need to sign an employment letter with the company, clearly stating employment terms including confidentiality terms and IP rights (explicitly stating, for example, that any software code written belongs to the company and not the individual). In the “resources” section below you will find document generators that can produce a Confidential Information Invention Assignment Arbitration agreement (CIIAA) that every employee (even you and your cofounders!) should sign. 

There are many other employee issues, of course, that a good employment law attorney can review with you. The laws tend to be very employee-friendly, and penalties can be severe, so you want to make sure you are completely compliant in every way. 

Summary

Your startup will operate within a legal system that will protect you (and sometimes frustrate you). As a startup founder, you want to make sure you get this stuff right up-front, so that you can spend all your energy building a great company, not bogged down in legal and regulatory issues later.

Here are some excellent resources and do-it-yourself platforms:

• Nolo has long been the leader in legal self-help books. Today they have expanded beyond publishing into a full suite of products and services.
• CoolyGo is a resource every entrepreneur should know about. Cooley is a very large global law firm (1,200 lawyers) and they put together this site filled with free resources for entrepreneurs, including document generators.
• DLA Piper Accelerate is the same idea, from another large global law firm.
• RocketLawyer and Legal Zoom are both very comprehensive providers of online DIY legal services.
• Stripe Atlas has become a very popular company formation service.
• Clerky is an excellent service for startup legal paperwork.
• Gust is a startup service that offers an incorporation package.