Startups very often get off the ground with no prior experience in running or managing a business. Entrepreneurs therefore frequently underestimate just how many legal “i”s have to be dotted and “t”s have to be crossed at the outset to protect their company from liability down the road. These are among the most common mistakes that come back to bite startups, all of which are avoidable with proper legal preparation.

• Employee Misclassification & Documentation

It’s critical for startups to understand the legal lines between independent contractors and outright employees. Startups commonly start out defaulting everyone they employ to contractor status for cost reasons and to avoid tax and insurance complications, and in many cases that’s perfectly fine. Calling someone a contractor when they meet the legal definition of an employee can be an incredibly expensive mistake, however. Startups can be forced to pay benefits, overtime and even give up equity in some cases if they later lose a misclassification suit.

The state Department of Labor & Industry website has helpful guidelines in this area. The most basic criteria for determining whether or not someone can be legally called a contractor is a five-point test that examines how and where they do their work, how they are paid, what tools and materials are purchased and the right of discharge. That isn’t quite all there is to it, however. There are more complex legal rules about how much control is exercised over the work by the employer and whether they are providing their services to the company exclusively. If there is any doubt, it’s wise to consult with an experienced employment lawyer.

Another route that startups commonly pursue that can be problematic is payment in equity instead of wages. This can wind up landing you in hot water as regards minimum wage laws. Federal Fair Labor Standards Act requirements state that someone being paid equity in lieu of salary must have a minimum 20% stake in the company and must be actively performing management duties (in addition to any other duties). Minnesota has added exemptions for executive roles, but again, legal nuances here make it best to consult with an employment attorney before pulling the trigger.

• Stock Option Issues

Stock option rules will vary depending on how your business is organized (as an LLC or private corporation). In all cases, however, startups will need to ensure they are in compliance with all relevant SEC regulations to avoid costly liability issues down the road. A qualified employment attorney can assist in creating a legally sound option plan and in ensuring that your initial valuation is done properly.

• Overlooking Taxes

Tax issues are by far one of the most confusing and time-consuming issues for newly formed businesses. In the excitement of getting a business underway (and all of the work it involves), proper bookkeeping very often falls by the wayside. This can end up being very expensive. A company’s taxes are impacted right from the very beginning when they choose what form to incorporate under. Further issues that can get complicated quickly include taxation of equity as income, not documenting expenses properly and missing out on valuable deductions.

• Reliance on Oral Agreements

The mantra from the beginning should be, “It doesn’t exist if it isn’t in writing.” Out of haste and inexperience, many startups rely too heavily on handshakes and informal promises. A little time spent in the business world will quickly reveal how often legal disputes arise, however, even between parties that have a generally amicable relationship.

Gilbert Alden PLLC is a Burnsville-area firm that specializes in Minnesota employment law and business litigation. Feel free to contact us at any time; we would be more than happy to discuss the specific legal issues surrounding your startup with you.