Avoiding Common Legal Pitfalls of Small Businesses

Small businesses make legal mistakes all the time. Many may go unnoticed. But some of these mistakes can be very costly and difficult to recover from. For decades we have represented many start-ups and emerging businesses, and we have seen the same mistakes being made over and over.

This article is the first in a series designed to help small business owners avoid making the same errors. Having experienced business legal counsel on your team will help you avoid these traps.

Mistake #1: Ignorance of the law

• Best practices for setting up and operating your business (from a legal perspective)
• Major employer-employee laws and how to handle them
• What to know if using independent contractors
• Basic contract rules
• How to protect your ideas and inventions (patent, copyright, trademark, trade secrets, confidentiality agreements)
• Securities laws – if you ever want to raise outside capital for your business
• Governmental regulation of your business – particularly if you are in a heavily regulated industry such as banking or other financial services, insurance, etc.

Mistake #2: Starting or maintaining your business as a sole proprietorship or general partnership rather than a corporation or limited liability entity

In a sole proprietorship, the owner of the business is liable for all debts and obligations of the business. Under state law, partners are jointly liable for the debts and obligations in general partnerships. If the business encounters a problem, all of your investment in the business – as well as all of your personal assets – are potentially at risk. Legal entities such as corporations, limited liability companies (LLCs), and limited partnerships provide a “shield” to protect your personal assets.

But beware – it is not as simple as going on-line, creating an LLC and saying “whoo-hoo, I am all good now!” And please do not use online self-help tools to incorporate your business. While these ideas seem tempting, often times you will wind up paying down the road. There are many legal considerations in properly setting up and operating your business from a legal perspective that deserve the attention of and your investment in experienced legal counsel.

Mistake #3: Not clearly documenting Owners’ rights and responsibilities

Shareholders, members or partners should have a written agreement that answers the following questions:

• How much capital will each person contribute?
• What happens if the business needs more capital?
• Can an owner sell their interest to an outsider?
• How much time and effort is each person expected to contribute to build the business?
• What happens if one person leaves the business? Divorces their spouse? Dies?
• Will the stock or other interest be bought back from the person leaving the business, the surviving spouse, or the estate of a deceased owner? How? And on what terms?

Owner’s agreements are critical to avoiding costly and protracted distractions when circumstances change.

Mistake #4: Not keeping proper corporate records

Improper record-keeping can cause problems with the IRS and state taxing authorities, result in personal liability and limit your ability to obtain bank financing or raise equity capital. Yet small businesses are notorious for failing to keep required corporate records. Failure to document meetings of the board of directors and shareholders, failure to record stock issuances, and failure to document stock transfers are just a few of the common infractions of rules that exist to protect the status of a corporate entity.

Good corporate governance and practices are essential to maintaining the “corporate shield” that protects your personal assets. And don’t forget about your financial and tax matters. Having an experienced business accountant on your team to assist you with keeping sound financial records and preparing your taxes is critical to avoid tax problems. It will also prove invaluable should you seek to sell your business down the road.

Mistake #5: Not having good written agreements

All of your important business agreements should be in writing, whether with customers, suppliers, independent contractors, or others. Oral agreements are hard to enforce and leave you with uncertain recourse for compensation or legal action. Your contracts need to be well thought-out, suited to your business, drafted in your favor (but fair), and give you flexibility and protection. Sometimes specific legal disclosures are required, particularly if you sell to consumers. And always be proactive and keep a finger to the pulse of your customers through customer support, surveys, e-mail or other methods. Promptly address all customer satisfaction issues.

Mistake #6: Unclear expectations and rules for employees

In most businesses, employees are 60% – 70% of your expense base. Why wouldn’t you be extra careful to protect this investment? Employees should be hired with great care to ensure they are a good fit with the work ethic, culture and customs in your business. All employees should have job descriptions, regular performance reviews and appropriate reward or discipline for their performance. Employee training is often overlooked but so very important! Inform your employees when they are hired and on a regular basis, at least annually, that discrimination, sexual harassment, and other illegal acts won’t be tolerated.

Your employees should acknowledge in writing at the time of hire that they are “at will” employees, which means they can quit or be let go at any time without exposing your business to liability. Consider a well-drafted employee handbook as a “rules of the road” manual that clearly sets out all expectations, policies, etc. for your workplace. It should be acknowledged in writing at the time of hire or when any substantive change is made to the handbook. But also be careful- if not written properly, an employee handbook may be construed as an employment contract.

Mistake #7: Disgruntled employees

As a business owner, this may be one of your most common legal headaches. In America, employees have far more rights than in many other countries, in the form of unions and reasons for “wrongful termination”.

If you terminate a non-performing employee, make sure there is a written roadmap of how you both got there, that the reasons for leaving are clearly documented, and that he or she signs a document carefully drafted by an experienced attorney when terminated to make the terms of dismissal crystal clear. Letting an employee go without any formal terms leaves the door wide open for legal actions. What are some of the common matters that cause legal issues with employees?

(a) See Mistake No. 6: unclear expectations and failure to document expectations and performance.

(b) Discrimination/Harassment in the workplace: the legal ramifications of alleged discrimination, whether sexual, ethnic, age or otherwise, can cause your company serious problems. Make sure you are prepared to handle these issues should they arise. During the hiring process, obtain and keep resumes from all applicants should allegations of discrimination arise to prove that you hire the most qualified individuals, regardless of gender, ethnicity, age, etc. Hold regular meetings to oversee co-worker relations and ensure that discrimination on a smaller scale is not occurring between office cliques, or influencing the decisions of managers.

Harassment – sexual, racist, religious or otherwise – can be a serious problem in an integrated workplace with workers from various ethnic and religious backgrounds and social classes. Regular meetings and interviews with staff will allow your managers to see transgressions, which should be eliminated quickly through the swift termination of offenders. Victims of harassment and discrimination tend to attract lots of media attention, which can hurt your company’s public image as well as drain your legal budget. Be proactive and stamp out these problems before they start.

(c) Wage and Hour issues. Improperly classifying employees as exempt under the Fair Labor Standards Act, and failing to follow good practices, has blind-sided small businesses with huge damage verdicts.

(d) Immigration Issues: You should make sure that all your company’s employees can legally work in the United States. I-9s must be completed at the time of hire. You can use background checks on a periodic basis to identify illegal immigrants with falsified documents. The U.S. government has been known to conduct extensive surprise immigration audits that can cripple a company if it is found to be using illegal labor.

Mistake #8: Not proactively considering how to deal with litigation

As an owner of a small business, the danger of crippling litigation should be at the top of your priorities. Litigation, especially in America, can take you by surprise and severely hurt your business’ bottom line. Litigation fees can be astronomical, and litigation requirements quickly drain management time, energy and resources.

Consider alternative means of dispute resolution, such as mediation or arbitration. Or, if a reasonable settlement offer is available, think seriously about taking it instead of spending more time and money in litigation. Put arbitration clauses in your contracts. And then there are the issues of records retention and preservation of evidence should litigation be threatened or started.

Mistake #9: Ignoring intellectual property issues

Even “low-tech” companies have intellectual property issues that may be important to the future success of the business. For example, do you require your employees and consultants to sign confidentiality and invention-assignment agreements? Have you registered for a trademark for an important company logo or product? Do you put copyright notices on your marketing and other written information? Are your trade secrets adequately protected?

Cutting-edge companies in the tech industry often face aggressive patent litigation. Companies may sit on their patents for years, hoping that another company inadvertently violates them, to get easy money through patent infringement lawsuits. In the product development phase at your company, make sure you research patents and copyrights related to your product, to avoid a messy legal battle should you step on a competitor’s toes. If in doubt, run any potential issues by an experienced attorney. Erring on the side of caution may help you avoid the dire consequences that can overwhelm many small business owners.

Mistake #10: Not properly insuring your business and its owners

Having an experienced insurance advisor/ agent on your team is critical. Most problems can be insured against. Sadly, many small businesses do not conduct proper risk assessments to ensure that the business and its owners, directors and shareholders are properly protected against foreseeable risks through insurance. And the lack of adequate insurance can be used as an indication of not acting like a legal entity by protecting others against foreseeable risks.

Mistake #11: Not preparing for the future through Succession and Estate Planning

Every business has a lifespan. There is inception, growth and maturation, adulthood, and eventually some sort of passing. Often times the death of a business coincides with that of its owner(s). But it does not have to be that way. Whether you eventually want to sell the business or pass it on to another generation, while you enjoy your retirement, it is critical that you plan accordingly.

By doing so you help maximize the value of the business to a potential buyer, give the business the best chance of surviving after the key owners retire or pass away, and protect the wealth of owners and shareholders to enjoy the fruits of their labor during retirement.

Mistake #12: Not having an experienced business law attorney on your team

Every growing business faces issues that require the services of an experienced attorney. Many of the issues outlined in this avoiding common pitfalls series deserve the attention of a business lawyer experienced in representing start-up and emerging companies. Yes, attorneys cost money; but in the long run, the money you spend on experience will save you time, aggravation, and significantly more money. As the saying goes, you can pay one now, or pay one (or more) later.

Above all, make sure you are proactive in solving problems before they start. Understanding, anticipating and preparing for issues before they come up, good communication in the workplace and with customers, and a hands-on approach to management are the best deterrents to legal problems.