Your startup must consider important legal issues. Failure to do so will cost you money. At all stages of the startup lifecycle—birth, growth, and merger or death—basic legal planning is crucial. If you fail to plan, plan to fail. Smart planning helps avoid having to spend tens or hundreds of thousands of dollars on commercial litigation counsel like me to save you, your startup baby, or your assets in bet-the-company litigation.
Laws surrounding a Startup’s Birth
Congratulations on your new baby! “What are you having?”
Many founders give very little meaningful thought to the legal “kind” of startup they want to have, leading to problems down the road. Business entities are creatures of law, and you need to know about their blood lines.
Without a legal entity for your startup, your personal property may be available to your startup’s creditors for collection.
Having your startup operate as a separate legal entity may provide you with some personal insulation from your startup’s liabilities. (This sort of protection is eliminated if you sign a personal guaranty for obligations of your startup.
Similarly, if you do not follow corporate formalities, commingle your business and personal assets, or use business assets for non-business purposes, the doctrines of “alter ego,” piercing of the corporate veil, or in some cases reverse veil piercing may apply to put you or other entities on the hook for certain liabilities. It’s important to consult counsel so you know the law, know how to operate within the law, and know how to avoid those sorts of outcomes.)
One way to limit your personal liability is by using a Limited Liability Company, or “LLC.” The owners (or “members”) of an LLC can either manage the LLC or they can appoint a non-member manager for the LLC. Generally, an LLC will be responsible for the LLC’s debts and the LLC’s creditors can only collect from the LLC’s property (not the members’ personal property). [See the above note concerning entities or persons against whom a creditor may be able to recover. Also, the Colorado Uniform Fraudulent Transfer Act (“CUFTA”) or other states’ similar fraudulent transfer acts—sometimes in connection with the law of conspiracy—may in certain situations expand the liable parties for a business debt where businesses, their owners, or others take steps to hinder, delay, or defraud a creditor of the business.]
LLC members must consider the LLC’s governing documents (such as its Operating Agreement) and understand the legal rules that apply to govern an LLC. In my home state, the Colorado Limited Liability Company Act is important. (See Colorado Revised Statutes (“C.R.S.”) §§ 7-80-101, et seq., available at https://casetext.com/statute/colorado-revised-statutes/title-7-corporations-and-associations/limited-liability-companies/article-80-limited-liability-companies)
Most states have adopted some similar governing legal regime. (See, e.g., the various laws listed here)These statutory frameworks and/or the Operating Agreement govern the basic legal relationship between members and the LLC, members and other members, the LLC and the public, and the members and the public. Statutory or common law can set the applicable rules in addition to, in the absence of, or even despite a governing document like an Operating Agreement.
There may be other reasons to choose any number of different legal entity forms that are available. For instance, a partnership, a limited partnership, or a corporation may be the right business entity for you depending on how you see the startup being owned, controlled, managed, and raising money.
Different legal regimes can govern these different legal entities. Indeed, you may find yourself being governed by the laws of joint venture or partnership simply from an informal agreement to share profits and losses from an undertaking. In a partnership, every partner is typically individually liable for partnership debts, which can come as a nasty surprise to some—especially if your partner has gone off the rails in some way.
It is not uncommon for business owners or business officers to get dragged into disputes related to the business. Paying a lawyer can be expensive, and if you personally do not have the funds to pay, you will be hamstrung. Different legal regimes—or in some cases the operating agreement, articles of partnership, or other foundational documents for your business—may treat the business’ obligation to pay for your personal defense, or even personal judgments against you, in different ways.
This “indemnification” right is important to consider for both disputes with external third parties like vendors, but also with respect to internal disputes with fellow co-owners or managers. (Indeed, if a business is obligated to indemnify you, your fellow startup owners may be less likely to sue you because they may essentially be financing some of your defense through their co-ownership of the business.)
While it’s never pleasant to contemplate disputes with your partners, if you don’t address the rules of the game at the outset with thoughtful choice of entity and its foundational documents, you may be in for some surprises down the road.
Another reason to put real thought into what your foundational documents look like is to have explicit rules on internal controls for the business. For instance, clarifying who has the power to make major (or even minor) decisions for the business is important. What decisions need unanimous consent of the owners? Is a majority or a supermajority of owner consent sufficient for certain decisions?
What decisions or tasks can be delegated to a manager? What internal controls are in place to ensure the business functions as it should? What happens if someone wants to get out of the business (see “Startup Death,” below)? Address these issues in your business formation documents, or risk being surprised by the application of a default rule!
Laws affecting a Startup during its Growth
As your startup grows, you will have to deal with a host of new issues. Chief among these is the raising of new capital for your business. While standard loans may not present too many issues, business owners should be very careful to not run afoul of securities laws when courting investors.
Depending on the nature of how an investment in your business is sold, and what is disclosed in connection with that sale, you could be exposing yourself to both civil and criminal (Securities Fraud is a Class C federal felony, punishable by up to twenty years in prison and $5 million in fines.) liability if you run afoul of securities laws.
Additionally, you may need to expand your team and hire employees. But how do you safeguard your business if an employee decides to later compete with yours or takes something from your business that they shouldn’t? When hiring, you need to think about how you treat your trade secrets and whether your employees sign non-compete agreements.
However, you should also know about the (possibly changing!) state of the law. In early January of 2023, the Federal Trade Commission announced that it would be pursuing a new rule that would ban employers from imposing noncompete clauses on their employees. The FTC’s proposed new rule would make it illegal for an employer to:
- enter into or attempt to enter into a noncompete contract with a worker;
- maintain a noncompete contract with a worker; or
- represent to a worker, under certain circumstances, that the worker is subject to a noncompete contract.
The proposed rule would apply to independent contractors and anyone who works for an employer, whether paid or unpaid. It would also require employers to rescind existing noncompete clauses and actively inform workers that they are no longer in effect.
Whether, when, and in what form, the FTC’s proposed new rule will take effect remains to be determined and is subject to the FTC’s rulemaking process. Moreover, the legality of any adopted rule is almost certain to be tested through litigation. As it is currently contemplated, the FTC’s new rule would supersede any state statute inconsistent with the new rule. (Colorado law itself recently changed—effective August 10, 2022—concerning noncompete agreements.
Noncompete agreements entered into or renewed after August 10, 2022, are deemed void under Colorado law unless an exception applies. [See HB 22-1317 § 2(2) (clarifying that the recent change is not retroactive].
If you have a legal issue related to a noncompete agreement that predates August 10, 2022, consult an attorney for advice concerning the application of earlier law).
The main exception is for “highly compensated” workers—$112,500 in annual compensation for 2023—where the noncompete clause “is for the protection of trade secrets and is no broader than reasonably necessary to protect the employer’s legitimate interest in protecting trade secrets.”)
Other state laws may be more protective of an business’ ability to protect its trade secrets. For instance, Colorado law concerning trade secrets includes the following definition:
“Trade secret” means the whole or any portion or phase of any scientific or technical information, design, process, procedure, formula, improvement, confidential business or financial information, listing of names, addresses, or telephone numbers, or other information relating to any business or profession which is secret and of value.
To be a “trade secret” the owner thereof must have taken measures to prevent the secret from becoming available to persons other than those selected by the owner to have access thereto for limited purposes. [C.R.S. § 7-74-102(4) (emphasis added)].
Whether information qualifies as a “trade secret” in Colorado or elsewhere likely requires a case-by-case evaluation. When a departing employee misappropriates trade secrets for his or her personal gain or a new employer’s benefit, the former employer has a range of remedies, including suing the employee and any new employer for injunctive relief or damages, but generally care should be taken to ensure that sensitive information is protected, including with new hires.
Other laws may restrict the enforceability of agreements with your employees that they not solicit your customers to do business with them—or solicit your employees to leave with them—when the employee leaves your company. (Colorado’s noncompete law does allow for agreements to not solicit customers if the worker earns at least sixty percent (60%) of a “highly compensated” workers’ compensation—$67,500 in 2023. The nonsolicitation covenant must be no broader than necessary to protect the employer’s legitimate interest in protecting trade secrets.) Given the varying state laws concerning nonsolicitation agreements, it is important to consult an attorney for advice concerning your situation.
Finally, as your company grows, it is likely to come into more and more contractual relationships with other vendors, suppliers, subcontractors, etc. It is important that you have legal counsel help review your contracts! One especially important issue is whether your contracts have a prevailing party attorney-fee shifting clause.
Throughout the U.S., the law is generally consistent with “The American Rule”—each party bears their own attorney fees in a dispute, win or lose, in the absence of a specific statute or contractual provision to the contrary. All too often, I get calls from business owners who have a good claim for anywhere from $1,000 to $50,000, but their contracts do not have an attorney-fee shifting clause. Many times, I cannot help them, as the last thing I want to do is have them rack up a huge legal bill than is more than the value of their claim with no hope of recovering the attorney fees.
Litigation is expensive. Can you afford to be in a situation where you cannot pursue your rights if you’re not paid what you’re owed under a contract? That’s exactly the position you will be in if your contracts do not contain the proper attorney-fee shifting clauses.
Laws Governing a Startup’s Death
No one enjoys thinking about what would happen if your startup goes down in flames. But if you don’t think about it, you might go down with the ship!
In your organizational documents, it is smart to address the end game. For instance, a properly-drafted buy/sell agreement can provide you and any co-owners with a predictable way to ensure that the business can continue to operate even if an owner wants out. In the absence of a buy/sell agreement, co-owners can feel “stuck” in a bad situation or may heavily dispute the terms of a “business divorce.” (In my experience, a business divorce can be just as acrimonious as a marriage ending.)
Alternatively, without properly-drafted organizational documents, a business may face judicial dissolution, especially in cases where ownership is deadlocked as to major decisions. In a judicial dissolution, a total stranger to you—a judge—may make major decisions for your company with no guarantee that you’ll agree. Moreover, the remedy of partition in some situations may permit a judge to divide up certain commonly-owned assets.
Thoughtful attention to your company’s governance structures during its “birth” can make for a much less painful “death.”
At all stages of your business operation—but especially before a dispute arises—thoughtful attention to your business’ “legal hygiene” will pay dividends. Either at the outset of a new undertaking or as a disagreement is unfolding, consult an attorney to best protect yourself and your business.
By reading this post, you are not forming an attorney/client relationship with Aaron D. Goldhamer or Keating Wagner Polidori Free, P.C. Your situation likely requires bespoke legal counsel. To request a complimentary intake interview concerning a litigation or business matter, email email@example.com