Starting a new business is both rewarding and challenging. There are many pitfalls to starting a business that new business owners often are not aware of until it is too late. These pitfalls can lead to costly consequences that could have been avoided had the new business owner sought professional help or done their research.
Attorney Gary Bubb shares his insight on common mistakes new business owners need to avoid.
What mistakes do you see new business owners make?
- They don’t get advance advice on choice of entity/tax treatment. There are important differences between the federal tax treatments of C-corporations, S-corporations, partnerships and disregarded entities. Note that a limited liability company is generally the right entity, since it can elect to be treated as any of the above. The question is what the proper tax classification is.
- They execute business contracts personally rather than as the manager or other authorized officer of their new business entity.
- Assuming that the new owner has (or quickly admits to the new business) one or more partners, he or she fails to have a comprehensive written operating agreement or shareholder agreement, including an NDA with enforceable confidentiality, noncompetition and nonsolicitation provisions.
What are the most common ways new business owners can find funding?
Without giving pros and cons of each form, the most common mechanisms are (i) credit line from local bank, (ii) “investments” by friends and family, (iii) term loans guaranteed by the Small Business Administration, (iv) a “crowdfunding” round, and (v) a local team of angel investors or venture capital group.
What about when it comes to raising capital from friends and family?
In this situation, a mistake can be made because the business has an “informal” capital raise from “friends and family” without ensuring that the capital raise doesn’t violate securities laws regarding private placements. Business owners also tend to give away too much of the company equity in these early rounds.
When raising funds outside of from friends and family, are there any pitfalls to avoid?
The largest pitfall to avoid is giving away too much equity (voting or nonvoting) in early rounds. Other pitfalls include (i) giving away too much voting/governance leverage, usually in the form of “veto” rights over major transactions given to private equity or other investors, (ii) subjecting the founder’s initial equity to a “vesting” schedule.
Are there any best practices when developing a company name?
While it’s important to pick a good name in terms of identity among competitors and goodwill among customers, it’s not clear that there are any “best practices” (other than doing a trademark search to ensure that you’re not impinging on an existing trademark) as long as the founder chooses a name that reflects the founder’s values and mission, and cannot be confused with competitors’ brand names.
What do you think about naming family members as officers?
Not a good idea if it can be avoided. Generally, family members do not bring the differentiated skillsets that are required in a startup. Co-founders should have skillsets that complement, rather than duplicate, the skillsets of the other founders.
Is it ok for new business owners to use independent contractors rather than hire employees?
Often business owners improperly treat their initial employees as “independent contractors” rather than as employees, because they hope to avoid employment tax withholding, workers’ compensation, wage and hour laws and related headaches, but the classification is usually improper.
Are there any other pieces of advice you have for new business owners?
- Set up a separate bank account for the new business.
- Don’t mix personal and business expenses.
- Get an enforceable NDA (non-disclosure agreement with confidential information, IP protection, non-solicitation and noncompetition provisions) from every new hire.
- Don’t give away too much equity in the company in order to hire and retain talent.