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The TOP 9 Issues Startups Do Not Consider

Posted by Craig M. Morgan | Jun 01, 2018 | 0 Comments

Startup Strategy

         As a business attorney and entrepreneur I've seen many startups make the same mistakes.  Before your startup sees life, consider The Top 9 Issues Startups Do Not Consider.   

1.   The End Game: When starting a business consider the end. Buy-Sell Agreements are a must!

            Rarely do startups contemplate the end.  In its infancy, business owners are anxious to grow, to profit, to work.  Ending the business is not a common consideration.  But it is inevitable; at some point owners will exit. Smart business owners plan for the end game.

            Buy-sell agreements operate as a predetermined buyout agreement among owners.  The terms of the owner's exit are agreed upon in advance.  The buy-sell agreement is proactive and eliminates later stress and disagreement.

            Many business owners overlook buy-sell agreements. Yet consider how critical it can be.  Inevitably, the departing owner wants more money than the remaining owner wishes to pay. A business lacking a buy-sell agreement creates room for bitterness and struggle, lawsuits and frustration.

            A buy-sell agreement alleviates uncertainty surrounding a business exit since the terms of the departure are already in place.  The exit is, therefore, easy.

2.   The Operating Agreement: The most important non-mandatory part of your business.

            The majority of small business startups are incorporated as LLCs (limited liability companies).  LLCs can be great to work with primarily due to flexibility in structuring the company.  Said to be creatures of contract, a LLC is internally governed by an operating agreement.

            The operating agreement is critically important and all-powerful. Containing the terms of governance for the LLC, the operating agreement controls the entity.  It is the contract by which the owners are bound.   

            Yet despite its importance, it is not mandatory.  The state does not know if the LLC uses and operating agreement, since it is not filed with the Secretary of State.  The operating agreement is kept internally, within the LLC.

            Since it is not mandatory, it is frequently overlooked.  Startups regularly draft the bare minimum LLC paperwork and then hit the ground running.  However just because the operating agreement is not required does not mean startups should avoid doing it.  There are countless reasons to draft an operating agreement.  Operating agreements should address ownership interest, responsibilities of owners (called “members” in a LLC), voting, raising capital, adding owners, distribution of profit and debt and (especially) the buy-sell agreement.         

            The operating agreement is a must for a LLC.  The skill is in drafting the agreement to reflect the wishes of the member-owners.  As a business attorney, I make the agreement work for your business

3.   Success! (How to Grow)

            Future growth is often spoken of yet rarely planned. Discussion usually exists in the abstract, lacking tangible and concrete detail.  But a startup needs a growth strategy.  The startup should outline steps to grow in the business plan.  The growth strategy details should be contained in the operating agreement.  The primary consideration is how to raise additional capital.  Additional capital is needed to grow a business enabling the business to buy product or expand locations.  Companies raise capital by acquiring debt or selling a portion of the company (e.g. selling stock).  

            Essential to a startup's growth strategy is the choice of entity. It sets the stage for growth opportunity.  Choosing the proper entity can enable –or prevent- different methods of raising capital.  An LLC is a great choice for most startups, due to the protection it can afford its owners and flexibility.  Yet an LLC is not ideal if a startup wants to sell stock since ownership is allocated amongst its members. An S Corp can have a maximum of 100 shareholders and limitations exist on the stockowners.  Additionally, S Corps can only have one class of stock. C Corporations can be very large, having an unlimited number of owners and can have different classes of stock.

            Startup strategy must contemplate growth and plan accordingly with the correct entity.

4.   Non-Compete Agreements (that actually work)

            Non-compete agreements can be important to a business.  Businesses invest time training employees and wish to protect their investment.  But not all non-compete agreements are enforceable. 

            A non-compete agreement is invalid if it lacks consideration.  Consideration is a legal term meaning value.  For a business to legally bind an existing employee to a non-compete agreement, the business must provide something of value to the employee.  This makes sense as the employee is foregoing a legal right by signing the non-compete – the right to engage in lawfully competitive business practices after employment has terminated.  Since the employee is foregoing a right, she must receive something in its place.

            Another reason non-compete agreements are frequently invalidated is if they are overly restrictive in time and place.   This is a matter of public policy as courts disfavor unreasonable barriers on competition.  The determination of reasonableness can vary according to the facts.  For example, a restriction preventing a former employee from forever working in North Carolina is likely unreasonable, while a restriction preventing employment for several months has a much greater chance of being upheld as reasonable.  

            Startups should evaluate the use of non-compete agreements in order to ensure effectiveness.

5.   Marketing and Responding to Negative Feedback

           Marketing is hugely important for a small business.  Startup strategy should include a marketing plan.  The marketing plan should contemplate addressing negative online reviews (which are inevitable).

           Anti-SLAPP laws protect free speech by preventing business owners from filing lawsuits against the defamatory publisher if the comment was on a matter of “public interest”.  Public interest can be interpreted broadly.  States with anti-SLAPP laws provide business owners little recourse. 

           However, North Carolina has not adopted Anti-SLAPP laws.  Therefore, North Carolina business owners have a rare luxury– the ability to sue in response to defamatory comments posted online.

            Litigation is not the correct response for every situation.  Startup strategy should have a plan for dealing with negative comments, such as personally responding to unhappy customers. Yet the availability of litigation ,as a means of combating unreasonable defamatory comments, is a strong tool for businesses.

6.   Agency- Your Startup might be Liable for the Acts of Another

            A startup strategy should put serious thought into people employed to act on its behalf.  Your startup can be liable for the acts of someone outside of your organization.  This could occur due to a principal-agent relationship.

            A principal-agent relationship is very easy to form.  Agency exists between three parties: the principal (e.g. the startup), the third party public and the agent (e.g. the person acting on behalf of the startup).  A contract is not even required to form an agent-principal relationship.  If the startup directs the agent to act on its behalf the startup is contractually liable for the agent. 

            A startup could also be contractually liable for an agent if the startup ratifies the conduct of the agent.  This could occur if the agent enters contract with a third party, and the startup later learns of the contract yet fails to take action to prevent it.  In this instance the startup would be viewed as having ratified the agent's contract and would therefore be bound to it. 

            Startups need to be aware of the acts of their agents.  It is especially important to be mindful of the third party's vantage point, in regards to viewing the agent-principal relationship.  If it is reasonable for the third party to view the agent as having authority to bind the principal, or if the third party reasonably understands the principal to have ratified the agent's conduct, then the principal is liable for the agent's contract.  Considering the liability that could attach on behalf of the agent, startup strategy means having a plan to monitor those acting on its behalf.      

7.   Business Liability Protection might Not be Bulletproof - Piercing the Corporate Veil

            Business liability is one of the primary reasons for properly incorporating your startup.  The goal is to protect your personal assets from the liability of your business.  The risk is in the details – merely forming a company is insufficient to adequately protect yourself. 

            The legal doctrine “Piercing the Corporate Veil” exists to allows for individual owners to be accountable for the liabilities of the business, even if the business is validly formed and recognized.  The shield of protection a business affords can effectively be pierced and liability can attach to the owner.  This doctrine exists to prevent unjust corporate exactions and the evasion of liability.

            The shield of corporate protection can be pierced if the business is a sham.  A sham business is one that lacks legitimacy and necessary corporate formalities.  Such occurs if the individual operates the business as an extension of oneself, such as if there is an intermingling of personal and corporate finances and no business record keeping.  A business can also be pierced if the business is grossly underfunded and was so from its inception. 

            A vital component of startup strategy is following proper corporate formalities in order to reduce the risk of piercing the corporate veil.  A business should have bylaws or an operating agreement, maintain financial records and have separate corporate accounts, be adequately funded, and maintain corporate minutes.  Generally, the more legitimate the business the less risk of personal liability for the owner's.     

8.   Contracts –the document Must Contain the Terms of the Agreement

            I've written in the past about the necessity of a complete contract.  It is so critical that it is almost easy to overlook.

            The contract must be well drafted so as to contain all the terms of the agreement.  The reason is that disputes happen all the time – in fact, it is my advice to expect a dispute.  Every agreement contains considerable detail. If the agreement details are not noted in the contract, then serious issues will arise. I frequently encounter business disputes in which no clear contract exists.  Inevitably, both sides make claims not contained in the contract. It then becomes a matter of trying to construct a piecemeal contract incorporating emails and other extraneous communication.  If there isn't a complete contract, it is a mess. 

            Startups should invest in the contracts to be used for the business and develop processes for review.  By investing in clear, complete contracts startups can avoid litigation and headaches.    

9.   Commercial Space & Exclusive Use Clauses – Physically Protect Your Startup

            The location of your business can be critical to startup strategy.   The majority of startups will lease existing commercial space, especially in large urban markets.  When a business and landlord enter into a lease it is important to guard against competition from within the commercial space.  An exclusive use clause is an agreement preventing the landlord from leasing to another business of the same kind. 

            An exclusive use clause is an important benefit to the tenant/startup.  It assures the business that it will be the only one of its kind in the commercial space.  This is hugely important!   The business cannot control external competition in other commercial locations, so it is imperative to control competition from within.       

            The landlord also benefits from an exclusive use clause.  Landlords desire successful tenants.  Success yields less turnover in the commercial space, saving the landlord money.  Furthermore, landlords should desire a harmonious environment amongst tenants, effectively synergizing the different respective businesses.             Exclusive use clauses prevent the landlord from cannibalizing its tenants.  The clause promotes success throughout the commercial space, which should yield greater profit for the landlord.  It is imperative that a startup obtain an exclusive use clause in the commercial lease.   

Craig M. Morgan, Esq., Managing Attorney at Providence Law 

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About the Author

Craig M. Morgan

Craig Morgan's practice areas include business and corporate law, franchise law and general corporate counsel. He has represented a variety of businesses including franchise businesses and independent, privately held companies. Craig has represented clients in negotiations and ...

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