10 legal mistakes made by startups
Sunday March 27, 2016,
5 min Read
Setting up your startup involves a lot of work and effort. Many things need attention, including developing a proof of concept, finding product/market fit, and hiring the first set of employees. With these many things to be handled, slips are bound to happen. One of the most common areas where most startups make a wrong choice is establishing a solid legal foundation.
For startups, particularly in the sectors like e-commerce, payments, food or health care, it becomes all the more important to focus on the legal aspect. You don't want to make the same mistakes as someone else, rather learn from it, isn’t it?
Some of the most common legal mistakes made by startups:
1) Wrong legal entity
Choosing the right legal entity right at the outset is important. Some structures to choose from include a Registered Company (Public/Private Limited), LLP, proprietorship, and partnership. The more widely accepted one is a registered company, especially for any deals with foreign clients.
Go for a LLP or Limited Company if you do not want personal liability for the losses/liabilities of your startup. Choose the right form of legal entity to avoid any legal hassles and payment of higher taxes.
2) Not tracking expenses
Another mistake commonly made by startups is not keeping track of their expenses, however big or small it maybe, throughout the year. Many try and gather all receipts only when tax returns have to be filed! What is not documented is not deducted, and therefore, it is like leaving money in the open.
There are many options available to record and manage expenses. Entities can also hire accountants to manage these records, if volumes are high.
3) Lack of documentation
Each and every interaction, be it meeting minutes or anything else, must be on the record. It is important to have all documents in order at all times. Legal due diligence can make or break an investment deal.
4) Missing founders’ agreement
Every startup may or may not run or be essentially successful. It is therefore important to have a solid founders' agreement in place, because it is worth thinking about how you and your co-founders might deal with failure. The founders' agreement should contain all essential clauses such as ownership, vesting rights, and the roles and responsibilities of each founder, including salaries and terms of employment.
5) Mixing capital and revenue expenses
One of the major confusions for first-time business filers is about expenses. What expenses are considered assets /capital expenditure and which ones are called revenue expenses deductible in the P&L A/c. Higher-value items that will last significantly longer than one year are called Capital Expenditure/Assets/Equipment. For example, the expenses on laptop purchases are not deductible as revenue expenses in the P&L A/c, but only the depreciation/amortisation on them is deductible over a period of time.
Things that are consumed over the course of a year come under revenue expenditure. If the equipment or capital items are by accident deducted as revenue expense, the tax department can determine that the expense has been improperly characterised and a deduction does not apply. Hence, be careful in accounting all such expenses.
6) Mixing personal and business expenses
Time and money are the biggest investments in a startup, and often the personal and business expenses become indistinguishable. This can be a source of confusion when taxes are being filed, and in some cases, can lead to deductions being disallowed on an ad-hoc basis by the revenue authorities and higher tax outgo as a result. The company should therefore have a financial account at the onset and separate records as well.
7) Not protecting intellectual property
Intellectual property (IP) is a startup's most valuable asset. Trademarks, patents, and copyrights are the three essential components of IP. It is essential to not let anyone claim a right to your IP. Non-disclosure agreements are a way of ensuring this. Startups often neglect the protection of IP and suffer later.
8) Non-compliance with securities laws
Startup founders commonly issue stocks to angel investors, family, and friends. However, stocks issued without complying with specific disclosure and filing requirements under securities law can lead to serious legal issues at a later stage.
9) Missing regular tax payments
Businesses, be it sole proprietors or otherwise, are required to pay taxes in advance. This means they need to determine their taxes for the year in advance and pay as prescribed installments. They can get into trouble for not paying the taxes on time. It is therefore important to take regular stock of the profit/loss statement at each quarter and pay the advance taxes.
10) Not ensuring professional help for tax-related issues
A startup must appoint a tax consultant to ensure all regulations are being followed. This will also give you more time to focus on building your company, forming strategic relationships, and other things. It’s essential to make sure all regulations are being followed to the tee. Taxes are also not something that a company should revisit only once in a year.