Top Ten Legal Mistake Made By Entrepreneurs

This blog post has been inspired by an article I read at the Harvard Business School’s working knowledge paper by the same title. You can read the complete story by clicking here.

However, the article mentioned above completely focused on legal mistakes made by US entrepreneurs. This blog post has been modified to include Asian, African and European businesses. There are also some aspects which have been discussed in the article which I do not necessarily agree with. While these are common mistakes made by entrepreneurs the world over, the way in which the mistakes are made and the methods used to deal with them vary in various parts of the world.

10. Failing to incorporate early enough.

This is one of the key aspects discussed in the article. In my opinion, however, the mistake lies in failing to incorporate at the right time. It makes no sense to start a company too early. The entrepreneur should identify the right time. This could be any time before a major investment is made or the launch of a product or marketing campaign. If you incorporate the company too early and decide not to go ahead with your venture, you might have a dormant company. Sometimes, you might even forget to close the company (if you incorporated and did not pursue your venture) or file returns which will lead to additional problems in the future. Hence, the company always needs to be incorporated at the right time. Taxes are another aspect. In many jurisdictions, corporation tax is calculated from the date of incorporation and if you incorporate and don’t do any business, even though you might not have to pay tax, you may still need to file returns. This is an unnecessary hassle for something you have not done. So it is worth keeping these points in mind.

9. Issuing founder shares without vesting.

“Simply put, vesting protects the members of the founding team who take the venture forward. If people remain on the team and are productive, their shares will vest. If they leave earlier, that stock can be retrieved and given to whoever is brought in to replace them.”

This is a good point and will be beneficial to all the members of the founding team. However, with a good shareholder’s agreement this can be circumvented even by the non-active member of the team. A shareholder agreement might be a good idea as well.

8. Hiring a lawyer not experienced in dealing with entrepreneurs and venture capitalists.

“Many venture capitalists say that they often rate the judgment of entrepreneurs by their choice of legal counsel. Lawyers who have no experience working with entrepreneurs and venture capitalists will most likely focus on the wrong things while failing to recognize some of the more subtle potential traps. It’s better to hire someone who has played the game, who knows what’s standard and what isn’t, and who will get the deal negotiated and closed promptly.” –

While this is a fact, and it would make sense to choose lawyers who are experienced with VCs as well, this is not how things are done in the real world. We need to be keep in mind that some of the VC and PEs can be very sleazy by highlighting this particular point, not because the lawyer you have chosen is bad, but mostly because, the lawyer is a tough negotiator or someone who does not blend in with what the VCs perceive to be the “right one”. Since most VCs have relation with a lot of firms, it can be argued that they would prefer to choose the firm they worked with at some point as opposed to a lawyer who you are comfortable working with.

7. Failing to make a timely Section 83 (b) election.

“If the advice in 9 is followed, then shares will be issued, subject to vesting, to the founders as well as new employees. If stock is acquired and it’s subject to what the IRS calls a substantial risk of forfeiture, then the IRS doesn’t view the purchase as being closed until that risk goes away. When the stock vests, that risk evaporates, so the IRS considers the deal closed. The IRS then calculates the difference between the price paid at the outset and the fair market value at that later date, then taxes this difference as ordinary income. An 83 (b) election allows the tax computation to be made based on the value at the time the shares are issued, which is often pennies per share.”

– True pertaining to the American scenario. The same can’t be said about other parts of the world.

6. Negotiating venture capital financing based solely on the valuation.

“Valuation is not the only thing one should consider when selecting a venture capitalist or when negotiating the deal. There are many other ways for venture capitalists to get compensated if they end up paying a high price for shares. These include requiring participating preferred with a high cumulative dividend, redemption rights exercisable after only several years, and ratchet anti-dilution protection with no cap. One must ask, what’s the reputation of this firm? Do they have a history of standing by the entrepreneur if the entrepreneur stumbles? Do they have good contacts in the industry? In trying to build alliances, do they know the big players? A no-name firm offering the highest valuation is often not the best source of equity.”

Completely true.

5. Waiting to consider International Intellectual Property Protection.

Patent application takes a lot of time depending on the country where it is filed. It is highly recommended that once an application is filed in a jurisdiction where it is easy to get a patent, you should go ahead since many applications might take a long time to be completely considered.

4. Disclosing inventions without a nondisclosure agreement or before the patent application is filed.

If patent protection hasn’t been obtained or in cases where a patent is not available, the only protection you have is maintaining the trade secret. To do so, one must show that they’ve taken reasonable steps to keep it a secret from competitors. Is it wise to get potential venture capitalists to sign a nondisclosure agreement? In the best of all worlds, yes, but most won’t. Make sure this is only disclosed if the VC or company you are disclosing it to have a very good reputation about their integrity in the market.

3. Starting a business while employed by a potential competitor, or hiring employees without first checking their agreements with the current employer and their knowledge of trade secrets.

“The law is clear that if someone is currently working for a company, particularly if her or she is a key employee, they cannot operate a competing business [this is true in most of the common law jurisdictions]. Even just incorporating may spark a lawsuit from the current employer. Would-be entrepreneurs should first go to their current employer and either resign or tell them what they’re doing and ask them if they’d be interested in investing. Amazingly, that’s often a very smooth way of ending that relationship. Under no circumstances should they misrepresent the nature of the new business.”

In an ideal world this would be the right thing to do. However, discussing your plan with your employer is not the wisest thing to do. If you are currently employed, firstly you would need to examine your contract and the restrictive covenant with your employer. It is certainly advisable to leave your employer on an amicable term. The last thing you need is to have to spend time and money on an unwanted lawsuit.

2. Promising more in the business plan than can be delivered and failing to comply with state and federal securities laws.

“If someone promises to do something and knows that they can’t perform that promise, that’s considered fraud. In a business plan, one must make an honest appraisal of what’s doable and set forth their assumptions, so the person putting up money can judge whether they are realistic. Can entrepreneurs be sued by their funders for fraud? Yes. Trying to squeeze out a little extra valuation by fudging the numbers erodes credibility, makes investors less trusting, and ultimately impairs the ability to get subsequent rounds of financing.”

True again.

1. Thinking any legal problems can be solved later.

You may be tempted to assume,

“Once I get my funding, once I’m up and running, I will have time to hire the lawyers; right now, I’m running as fast as I can to get my business plan done and raising money.”

This is shortsighted logic. Many of the points made here are problems that can’t be patched up later. Does that mean that one should devote all their time, effort, and money to the legal issues? No. That’s a good reason to hire a competent lawyer. Excellent legal talent can be retained for a relatively small amount of money up front at the early stages. It will cost you a lot less to get it right at the beginning than to try to sort it all out later and correct it. You also need to ensure that your lawyer understands, sympathizes and works with the same sense of urgency you have in launching your business. Lawyers from different parts of the world work differently. There is a tendency amongst some lawyers to take their time doing the work. An entrepreneur should ensure that the lawyer they hire can work, if not at a quicker pace, at least at the same pace as the person hiring them.