5 Ways to Build a Solid Legal Foundation for Your New Startup
Most founders treat the legal setup as a task to be completed after they have started the real work. The decisions you make regarding the structure and registration of your company during the first week will stay with your company for years. Fixing them can be very costly and lead to tens of thousands in legal fees.
Pick the right entity from the start
The two structures you typically choose between when you start something entirely new are either an LLC or a C-Corporation.
Here's a good rule of thumb: if you're newly building and selling something, like a physical good or software, and you aren't raising venture capital right now, you should be an LLC. You might also consider becoming an LLC if you sell a specialized service, like a consultancy or agency; if you do client-work or agency-type services; or if you're selling a good with a lot of customization or personalization in the sale (like, say, bespoke furniture or wedding photography).
An LLC is typically the right default choice if you're bootstrapping and growing a company with a small number of employees (often just the founder initially) or co-founders (usually a small number when starting). For your second business, you still might decide that an LLC is the way to go and what you used for your first company will likely influence that decision.
Register properly and get your EIN before you spend a dollar
Before you sign a vendor contract, open a bank account, or hire anyone - even a contractor - you must finish your state filing and secure your new federal Employer Identification Number. This nine-digit number simply acts as your business's tax ID and is something banks will not only ask for, but will require in order to open an account. Your payroll system will need it. Clients will request it on a W-9.
It may seem small in the grand scheme of world-changing product-building, but your Articles of Organization - the piece of paper that officially forms your LLC in the eyes of the state - also has to be in order. Every state has a different online portal that will ask you for different things in different ways, and they will all take vastly different amounts of time and money to process your application.
For founders who would rather not lose a week navigating state bureaucracy, using a service that provides secure and efficient business registration services lets you get this done cleanly and move on to building the actual product. Don't forget that many states also charge an annual franchise tax - a fee for the privilege of maintaining a registered entity. Miss it and you risk losing your good standing, which can freeze your ability to open accounts or sign contracts.
Draft your operating agreement before you need it
An operating agreement is a document kept internally, as it does not need to be filed with the state. However, it is one of the most important legal documents your company will have. It outlines ownership percentages, decision-making processes, procedures for when a co-founder wants to leave, and how profits are distributed.
The error that founders commit is to completely disregard this in the beginning when everyone is getting along and it seems obvious how equity should be split. Fast forward six months, and one co-founder is not doing the work they committed to, or one of the founders wants to leave, and there are no clear processes to handle the situation. This is typically when things get messy and costly.
Put it in writing before you exchange the first dollar. Add a vesting schedule for founder equity, usually a four-year vest with a one-year cliff, so that no one owns a big share if they leave after six months. You might also consider a dispute resolution clause for good measure.
Assign your intellectual property to the company
If the product is being created by your developers, designers, or co-founders as individuals, rather than under employee or contractor agreements with your company, there's a good chance your company won't actually own what's being developed.
An IP assignment agreement physically transfers ownership of proprietary code, designs, branding, and processes from the creator to your corporate entity. This isn't optional. When you raise money or sell the company, your investors or acquirers will do their homework on your IP ownership and will use any deficiency as a reason to lower your valuation or, if you're lucky, delay closing for 6-9 months while your lawyers scramble to get the paperwork in order.
Get an IP assignment agreement signed by every founder, early employee, and contractor before they start work. It's a simple document, and it's a lot easier to get these signed in the calm before a project starts than under the gun of a financing or acquisition where a signature here or there can hold up millions of dollars.
Keep your business finances completely separate
One of the most common ways founders inadvertently expose themselves to personal liability is when they mix personal and business money. The legal protection you get from forming an LLC - the separation between your personal assets and the company's liabilities, often called the corporate veil - depends on you maintaining a real operational separation between personal and business finances.
If you commingle funds and a creditor or plaintiff challenges your corporate structure, a court can decide the distinction between you and your company isn't real - and hold you personally liable for business debts. That defeats the entire purpose of forming a separate entity in the first place.
Do these things:
1. Open a dedicated business bank account and a dedicated business credit card the week you form the company. Run all business expenses through them.
2. Pay yourself a documented distribution rather than just pulling money out when you need it.
The legal foundation of a startup isn't glamorous work, but it's the kind of infrastructure that either holds everything up or quietly creates problems you'll discover at the worst possible moment. Get it right early, and the rest of the business has something solid to stand on.
