The biggest risk of disappointment for your startup happens right at the start—not setting up a possible legal foundation.
Entrepreneurs are known for their power and thoughts. They’re willing to take risks. But startup creators may be taking the biggest risk of all when they don’t set up a solid legal structure for their new business.
If you are starting a new business, these six legal papers for startups can make the difference between a successful experience and one that is headed for failure.
Company Formation Documents
All startups should be organized as a formal business entity. The right business formation limits owners’ liability for company debts and can have important tax implications:
- If you hope to attract outside financing or you want to indemnify employees with shares in the business, you should likely form a corporation.
- If you want flexibility in the way you manage the business and share profits, a limited liability company, or LLC, may be a more suitable choice.
To form a corporation, you must prepare articles of incorporation and file them with your state. LLCs are formed by filing articles of association with the state.
Corporations must have bylaws that describe how corporate officials and directors are chosen and what they do. Bylaws also determine the rights and responsibilities of corporate shareholders, including the way shareholder meetings will be conducted.
An LLC should have a similar legal document, called an operating agreement, that describes the way the LLC will be managed, the way profits and losses will be allocated, and the rights and obligations of the LLC’s owners, who are known as “members.”
Entrepreneurs sometimes think they can bypass these important documents because the business partners are good friends who will just figure things out as they go along. But disagreements are inescapable in any business.
Without bylaws or an operating agreement to guide you, you’ll waste time and money resolving your differences, and your business may even fail under the strain.
Intellectual Property Assignment Agreement
Many startups are founded on intellectual property and high hopes. The intellectual property might be software copyright, a secret recipe, or a pending patent for a new device. But without an intellectual property assignment agreement, the company may not truly hold the intellectual property.
For example, if one of your founders created software before your company was formed, he or she owns the copyright to that software unless there is a written assignment agreement transferring the copyright to your company.
The same is true of a freelancer who creates intellectual property for you. This can cause big problems if the founder leaves the business, the freelancer refuses to assign the copyright, or outside investors ask for evidence that the company owns its intellectual property.
Your founders, employees, and independent contractors should sign intellectual property assignment agreements at the outset to guarantee that your startup does own its intellectual property assets and to contain any challenges later.
A nondisclosure agreement, also known as an “NDA,” covers your startup’s confidential information. An NDA typically describes what type of information is considered confidential and represents the way the information can be used or disclosed to others. NDAs are essential to protecting any sort of company data that you don’t want to be released to the general public, including such things as development information, financial data, and sales and marketing plans.
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NDAs should be signed by anyone who has access to personal information, including employees, independent contractors, dealers, outside professionals, and potential investors. A nondisclosure contract offers important protection against having your information disclosed to competitors who might steal your product or use the data to gain a competitive advantage.
Shareholder Arrangements and Buy-Sell Clauses
While bylaws represent the shareholders’ relationship with the company, a shareholder contract defines the shareholders’ connection with each other. A shareholder contract should include buy-sell clauses that explain how to handle a shareholder who leaves the business. In an LLC, buy-sell clauses can be included in the LLC operating contract.
It’s not unusual for the founders of a startup to move on to other ventures. With a buy-sell agreement in place, valuing and accepting the departing founder’s shares is a fairly orderly process.
But, if there is no agreement, relationships can sour as the creators battle over how to handle the departure. It’s almost always more comfortable and less costly to reach an agreement at the outset than to try to settle differences later.
In most states, employees are “at-will” and can leave at any time unless they are obligated by an employment contract. A startup with workers who are critical to the company’s early success may want to put employment agreements in place to ensure that these workers stick around for a specified amount of time.
Other arrangements that employees might sign include NDAs, terms of intellectual property, and non-compete agreements.
If an employee will be compensated with stock in the business, there should be an agreement that specifies how that payment will be calculated and paid.
If you use independent contractors, have them sign an independent contractor agreement that specifies the terms of that relationship.
Starting a new business is a lot of work, and it can seem like there aren’t enough hours in the day to get it all done. But by paying attention to your legal startup documents as you create your business, you can protect your investment and prevent a lot of troubles down the road.