Entrepreneurs are known for their energy and ideas. They're willing to take risks. But startup founders may be taking the biggest risk of all when they don't set up a solid legal structure for their new enterprise.
If you are starting a new business, these six legal documents for startups can make the difference between a successful venture and one that is headed for failure.
1. Business formation documents
All startups probably should be organized as a formal business entity. The right business formation limits owners' personal liability for company obligations and can have important tax implications:
- If you hope to attract outside financing or you want to compensate employees with shares in the business, you may want to 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 better choice.
To form a corporation, you must prepare articles of incorporation and file them with your state. LLCs are formed by filing articles of organization with the state.
2. Governing documents
Corporations must have bylaws that describe how corporate officers and directors are chosen and what they do. Bylaws also define 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 responsibilities 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 inevitable in any business.
Without bylaws or an operating agreement to guide you, you'll waste time and money resolving your differences, and your company may even fail under the strain.
3. Intellectual property assignment agreement
Many startups are founded on intellectual property and high hopes. The intellectual property might be a 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 own 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 company, 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 prevent any challenges later.
4. Nondisclosure agreements
A nondisclosure agreement, also known as an NDA, protects your startup's confidential information. An NDA typically explains what type of information is considered confidential and describes the way the information can be used or disclosed to others. NDAs are critical to protect any sort of company information that you don't want to be released to the general public, including such things as product information, financial data, and sales and marketing plans.
An NDA should be signed by anyone who has access to confidential information, including employees, independent contractors, vendors, outside professionals, and potential investors. A nondisclosure agreement offers important protection against having your information disclosed to competitors who might steal your product or use the information to gain a competitive advantage.
5. Shareholder agreements and buy-sell clauses
While bylaws describe the shareholders' relationship to the corporation, a shareholder agreement defines the shareholders' relationship to each other. A shareholder agreement should include buy-sell clauses that explain how to handle a shareholder who leaves the company. In an LLC, buy-sell clauses can be included in the LLC operating agreement.
It's not unusual for the original founders of a startup to move on to other ventures. With a buy-sell agreement in place, valuing and buying out the departing founder's shares is a fairly orderly process.
But, if there is no agreement, relationships can sour as the founders battle over how to handle the departure. It's almost always easier and less expensive to reach an agreement at the outset than to try to resolve differences later.
6. Employee contracts
In most states, employees are “at will" and can leave at any time unless they are obligated by an employment contract. A startup with employees who are critical to the company's early success may want to put employment contracts in place to ensure that these employees stick around for a specified amount of time.
Other contracts that employees might sign include NDAs, assignments of intellectual property, and noncompete agreements.
If an employee will be compensated with stock in the company, there should be an agreement that specifies how that compensation 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.