What are the most common legal mistakes made by entrepreneurs when launching and managing start-ups without legal tips?
Author: Alejandro Touriño, Co-director of the Master in Legal Tech. Managing Partner at ECIJA and recognized Most Innovative Lawyer by the Financial Times.
Six out of every ten startups fail. That’s the troubling conclusion that the American firm Cambridge Associates arrived at after closely analyzing the performance of around 30,000 startups. And while that statistic is better than others that have come out of the sector, the fact of the matter is that this high failure rate is largely avoidable. In other words, many mistakes can be overcome. And they can usually be attributed to inexperience or faulty legal advice given to the startup and entrepreneurs.
In the legal sector, receiving advice and legal tips is key in the evolution of any entrepreneurial project. It plays a critical role when starting projects, and it is just as important in investment and sales processes as it is in the dissolution of a project. Every step that a startup goes through—pre-seed, seed, growth, series A, series B, exit strategy, etc.—is key in the success or failure of a project. Having the wrong business formula, a misguided incentive plan, inadequate asset protection, a faulty shareholder agreement, or poorly handled drag-along or tag-along rights may turn a viable project into a nightmare for an entrepreneur.
Here are the most common legal mistakes in the life cycle of a startup:
1. Not getting professional business legal advice
Sources of law are those that are found in the Civil Code, as is the case in Spain, or in other legal systems. Unfortunately, Google isn’t one of these sources. That said, we can see many examples of entrepreneurs not seeking any type of professional legal advice. Instead, they opt to use legal tips and guidance they find on the internet and counsel themselves using what they have read online. Experience tells us that this leads to unexpected results, and sometimes prompts investors to not look into poorly built or high-risk businesses.
In the legal sector, receiving advice and startup tips is key in the evolution of any entrepreneurial project. It plays a critical role when starting projects, and it is just as important in investment and sales processes as it is in the dissolution of a project.
2. Choosing the wrong business formula and having an inadequate board
Selecting a corporate vehicle and having a proper board are other key elements an entrepreneur must keep in mind. We’ve come across unpleasant situations in which a third party has directly contacted an entrepreneur—and not a limited liability partnership—claiming that obligations had not been met or demanding payment for any variety of reasons. This happens when entrepreneurs make the wrong decision when going on the market and do not seek advice or use a limited liability partnership to safeguard their assets. Meanwhile, having a board that doesn’t work well together may also lead to dissatisfaction and disputes among partners.
3. Choosing to carry out economic activity in the wrong country
An entrepreneur’s citizenship should not be the determining factor when choosing where to operate a business. To this end, entrepreneurs should take into account other factors, such as the legal feasibility that the business would have in a given country, the applicable tax regime in a specific territory, and their ability to generate funds in that country. This decision, like many others, does allow for changes in the future. However, we have seen many cases in which one misstep leads to significant financial loss or to the business not being able to operate because it doesn’t meet the regulations of a given country.
4. Not signing a partnership agreement (an essential startup tip)
A partnership agreement can be thought of as planning for a “good divorce.” It is the agreement that establishes the relationship between the partners in a startup. A poorly written partnership agreement may make it impossible for the partnership to be sold even if the majority of partners wish to do so. It may also mean that the business can’t carry out other activities, or that the partnership becomes deadlocked and can’t operate.
5. Undervaluing the intangibles
If we look at large corporate and investment operations from recent years—some of which bring in millions—we see that the assets that buyers acquire are largely intangible. It is no longer about buying real estate, machinery or the like, but rather the acquisition of intangible assets such as databases, software, brands, algorithms, patents, know-how, industry secrets, and more. On an international level, laws regarding intellectual property, including industrial property, protect these intangibles. Experience shows us that proper business legal advice in this field puts the assets in the hands of the partnership and not the members. It also ensures that records are properly kept and that the company’s sensitive information is treated appropriately. Mismanagement of these assets can thwart due diligence in investment or sales processes.
6. Not respecting privacy
Europe has experienced and pulled the rest of the world through a journey in protecting individuals’ privacy. So one of the top legal tips must surely be: From the very beginning, never thinking twice about respecting client privacy is a must for any startup or entrepreneur. Today, not doing so will result in heavy penalties.
7. Not having the right working terms for employees or management
Every day, in the news we read too much about how some startups are in jeopardy because they chose to hire their workers as independent professionals and not as employees of the company. What’s more, when hiring workers and even establishing the entrepreneurs’ work and commercial terms, it is prudent to clearly define who owns the rights to what they contribute and create. It is also advisable to set forth the confidentiality requirements in regard to the information they have access to in their positions.
Nevertheless, it is very possible that, even after taking into account the above, the statistics on the number of startups that fail won’t have improved in the next ten or twenty years. If that’s the case, though, let it not be because we didn’t take the right steps in the legal, policy, and regulatory fields.
Alejandro Touriño is Co-director of the Master in Legal Tech at IE Law School, Managing Partner at ECIJA and recognized Most Innovative Lawyer by the Financial Times. Under his leadership, the Firm has been acknowledged as best TMT (Technology, Media and Telecommunications) law firm both at national and European level for several consecutive years. He has more than ten years experience in IT law, intellectual property, innovation and entrepreneurship law. He has been acknowledged by Chambers & Partners and Legal 500 as outstanding lawyer in intellectual and industrial property and new technologies. Alejandro is panelist before the World Intellectual Property Organization and President of the IT section of the Madrid Bar Association.
Note: The views expressed by the author of this paper are completely personal and do not represent the position of any affiliated institution.