Starting a new business is tough. The Small Business Administration estimates that half of all new businesses fail within the first five years after their creation, and only about one third survive 10 years or more. In addition to the economic and operational risks that every business faces, there are a number of legal mistakes made by small businesses which can and do have significant effects on their success or failure.
1. Failure to organize a business entity.
Far too frequently, entrepreneurs wait to form a business entity.
The reasons vary, but include expense, unfamiliarity with the process, or the feeling that only “big” businesses need to incorporate or organize an LLC. The truth is that the main purpose of forming an entity in which to conduct your business is to separate your business liabilities from your personal assets — protection which owners need right from the start.
2. Failure to adopt a well-thought-out business plan.
Most businesses start because the founder perceives there is a need in the marketplace that isn’t being met, or can be met more cheaply.
Where businesses fall down is by not determining the market for their product or service, the costs and profitability potential, and whether the business will generate sufficient cash flow or will need capital from outside the company. Any business endeavor needs to have a plan.
3. Failure to address employment issues.
Hiring the right employees is crucial in a small business, where a bad hire can have huge business implications. But in addition to finding the right people for the job, small businesses need to be aware of the legal relationship between the business and the employees, compliance with various state and federal regulations, and the impact and enforceability of employment agreements and restrictive covenants (non-competition and non-solicitation agreements).
4. Failure to do a buy/sell agreement.
Any small business that has more than one owner needs to have an agreement that covers items such as governance and management, voting protocol and profit-sharing; the addition of new owners, and solving disagreements or suffering an event that limits their ability to remain actively involved.
It is more likely than not the ownership group of the business will expand or change, and, much like a will that provides for an orderly disposition of assets upon death, having a well-considered agreement among the owners can head off or limit disputes down the road and promote harmony among the owners.
5. Failure to have a business succession plan.
Every small business should have a plan for what happens with the company’s ownership and management when the current owners and executives leave the company.
A buy/sell agreement can help determine what happens to the ownership interests in the company, but in addition to that the next generation of management should be identified well ahead of retirement or other departure of key employees, and a plan should be created to implement the changes either on a predetermined schedule or in case of emergency.
6. Failure to protect intellectual property and trade secrets.
Many entrepreneurs lump all types of intellectual property together, but it is important to distinguish the different types and determine how best to protect each type early in the operation of the business. Patents protect ideas or concepts which are novel and non-obvious. In order to claim patent protection, you must obtain a patent and, importantly, must file the application for the patent no later than one year after the idea is published, used in public, or offered for sale.
Trademarks protect words, designs or phrases which serve as the “brand” for a product or service. Trademarks are automatically protected under state and federal law simply by using them, although registration provides additional benefits.
Copyrights protect creative expression fixed in a tangible medium, such as prose, music, and video. Like trademarks, copyright law protects works automatically and registration is not required, but copyright registration can provide significant benefits as well.
Lastly, trade secret law protects commercial information which is not disclosed to the public (a good example is the Coca-Cola formula). In order to maintain trade secret protection, the business must maintain the secrecy of the information by not widely disseminating the information and requiring those with access to the information to agree not to disclose information.
7. Failure to understand the consequences of personal guarantees.
Many entrepreneurs will find that their access to credit is conditioned upon their personal guarantee for the loan.
Savvy lenders realize that newly formed businesses may not have the resources to repay a loan, and without recourse against a creditworthy individual they might not get paid. However, many entrepreneurs fail to fully appreciate the impact of guaranteeing their company’s debts, or personally guaranteeing other contractual obligations of the company. It is unfortunately common for small business failures to cause financial hardship or bankruptcy for the individual owners.
8. Failure to avoid costly litigation.
Litigation should generally be considered as a last resort. It is expensive and a drain on the time and efforts of any involved employees.
Before getting involved in litigation, any small business should try to temper the emotions that are caused by a dispute and consider the costs and benefits of the litigation, just like they would any other business decision, and determine any collateral effects of the litigation as well.
9. Failure to consider more than legal issues.
Although this article tends to promote care and attention to various legal issues, it is also possible to spend too much time on legal issues and not enough time on operating the business. While proper planning is wise, the organization and legal compliance issues related to the company should not cause the primary goal of the company (to make profit) to suffer.
10. Failure to hire legal services.
This point may seem self-serving, but working with a lawyer on legal issues is at least as important as working with an accountant on financial issues. Experienced counsel can help a small business spot and avoid legal issues before they become destructive to the company.