Greater Gainesville is a city of entrepreneurial opportunity. Home to award-winning academic programs, medical facilities, research-labs, and incubators, the city is an ideal place for entrepreneurs to make their business dreams into realities. Compared with other startup hotbeds, Gainesville’s cost of growing a new business is cheap.
Overall, Greater Gainesville is big enough to provide a wealth of sophisticated resources, but it’s small enough that entrepreneurs mostly know one another, which allows for a friendly, welcoming, and collaborative community who celebrate one another’s successes. With a little bit of networking, a first-time founder/CEO can quickly find experienced entrepreneurs who are happy to to lend an encouraging word and a helping hand.
Even in an environment so rich with opportunity, mentorship, and camaraderie, a new company’s success and longevity is contingent on avoiding potential roadblocks and pitfalls. Even the brightest entrepreneurs with the most promising technologies can be tripped up by various legal, business, and accounting mistakes.
To help newer entrepreneurs navigate some of the more common challenges of starting a business, we’ve brought in Hutchison PLLC attorney, Robb Giddings (https://www.hutchlaw.com/) and counsel from James Moore CPA (http://www.jmco.com/), to discuss five of the most problematic legal, business, and accounting mistakes that startups and entrepreneurs should avoid.
Legal Mistakes
- Selection of legal entity and proper corporate formation: Selecting a legal entity (sole proprietor, LLC, corporation) is the first place companies tend to go astray, according to Giddings. The different types of legal entities have different legal, business, and tax consequences, so founders need to think carefully about their near-term, mid-term, and long-term goals/needs and then select a legal entity that best fits with their business model. Once the entity is selected, appropriate paperwork needs to be filed with the Florida Secretary of State and the company should prepare various internal governance documentation to specify who the members/shareholders are, describe how much of the company each will own, appoint initial directors, officers, and managers, obtain an EIN, and open a business bank account. “Fortunately, most corporate formation issues can be fixed, but it can be expensive to do so,” said Giddings. “For example, an LLC can fairly easily be changed to a corporation, but it takes more time and paperwork than if the company initially incorporated as a corporation instead of an LLC. Likewise, changing a corporation into an LLC can be done, but it usually has significant tax consequences and legal costs. Often you’ll spend less money and have less stress if you invest in setting up your company correctly when you first get started.” Though LLCs are common startup vehicles, the only type of viable corporation for venture capital investment is the C corporation. According to a Startup Lawyer article, the C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment as various administrative and other burdens are minimized for the venture capital firm, which allows entrepreneurs (and their capital) to optimize their focus on developing the startup company’s business better than LLCs permit.
- Lack of a founders agreement: “Early-stage companies have to minimize costs, so often co-founders will wait to negotiate a contract between one another until the business gains some momentum. Unfortunately, that’s like waiting to purchase car insurance until you really need it–by then, it might be too late,” Giddings said. Companies with multiple founders need to have some hard conversations about how much equity each founder will own, as well as each founder’s roles and responsibilities, level of commitment, and any other expectations. And the founders need to get those agreements in writing. “Most co-founders start out as friends, and they remain friends, even if their company doesn’t last. But for a small percentage of co-founders, things get ugly. Either their initial expectations weren’t aligned, or their expectations don’t remain aligned, and in either case, the company and the friendship are jeopardized. By documenting their initial understanding, even if the founders part ways, most of the time, both the company and the friendship will be fine.”
- Failing to acquire intellectual property rights: When a founder develops new technology prior to forming a company, the intellectual property rights to that technology will initially be owned by the founder. Thus, the company must obtain ownership of the technology/intellectual property via contract. “Occasionally, we’ll see a co-founder leave the company. If the rights to a technology aren’t assigned by contract to the company, when that co-founder leaves, there’s a risk that the rights to the technology also leave with the founder.” Giddings said. “If the founder leaves for a benign reason, he or she is usually more than happy to assign the intellectual property to the company once the oversight [of not having a written assignment] is noticed. But if the founder leaves because of a major difference of opinion, good luck getting the necessary assignment.” To protect their technology and their business, companies should require anyone who contributes (or might contribute) to the development of the company’s technology to enter into a written agreement that assigns applicable intellectual property rights to the company.
- Using equity as compensation: Early-stage companies don’t always have the funds to pay employees and service providers for their work. So, instead of paying them in cash, many companies use equity instead. Unfortunately, there are a lot of laws that apply to using equity as compensation: wage and labor laws, tax laws, federal securities laws, state securities laws, contract laws, and more. “Using equity as compensation is tricky, and mistakes can’t always be fixed without pretty expensive consequences–back taxes, penalties, interests.” To avoid these consequences, if you plan to use equity as compensation, hire a professional who has extensive experience with employment law, securities law, and tax law to help minimize risk.
Business Mistakes
- Failing to understand regulations applicable to your company: “Occasionally I’ll get a call from a tech company that is seeking legal support. I’ll ask some questions about the business and quickly realize that the company doesn’t realize that it’s not a tech company: it’s a medical device company. Instead of needing $50k-$100k to develop an app that will launch in 2 months, the company is instead going to need $500k-$1M to develop a regulated product that will require almost 2 years to launch.” Giddings said. “I can help the company tweak the design of its app so that it won’t be a medical device, or I can help the company learn about the requirements imposed on medical devices, but either way, the company is going to need to revamp its technology or its business model. f I speak with the company early enough, it’s not a big deal. But if I speak with the company after it’s been running down the wrong rabbit hole for a while, changing the technology or business model can be time-consuming, expensive, and challenging.” A company needs to understand the regulations that will be applicable to its business because those regulations will define compliance costs, investment needs, time-to-market, and so much more.
- Not doing thorough diligence: According to Giddings, entrepreneurs and founders should be thorough in their due-diligence when selecting service providers, investors, employees, and contractors. For example, when hiring a software developer to program a new app, you might ask: What is the developer’s record of success? Has the developer worked on a technology like this in this past? What kind of experience do they have? Can they provide references? Additionally, be sure to get bids from multiple companies to ensure the price is competitive.
- Being too head-strong and stubborn: A key personality trait of most entrepreneurs is that they are self-starters; confident do-it-yourselfers or competent delegators. They must wear multiple hats, while managing multiple projects, and often while leading multiple people. That’s the nature of being an entrepreneur. But, according to Giddings, entrepreneurs need to realize that “they don’t know what they don’t know.”
Giddings goes on to say that “the best thing about Gainesville is how supportive the entrepreneurial ecosystem is. Everyone wants everyone to succeed, and there is a virtually no adversarial competition. So I encourage entrepreneurs to constantly bounce ideas around; ask for advice; ask for input; ask for help. By doing so, you’ll be more likely to learn what you don’t know–even if you don’t master it, at least it will no longer be a blind spot.” Even if you think you don’t need any help, ask for it anyway: you might be surprised at the results.
- Being overly differential: At the end of the day, nobody knows your company as well as you do. You know your technology, you know your team, and you know which direction you want to take your company. While it’s essential to ask for help and feedback from other experienced professionals, it is just as important to understand that there isn’t a one-size-fits-all solution to anything. “I encourage entrepreneurs to make sure they challenge, in a constructive manner, advice that they’re given and to pressure test whether a given solution works for their particular business,” Giddings said.
- “The Right Way,” “The Wrong Way,” and “The Startup Way”: According to Giddings, there are three ways to grow an early-stage startup. There is “the right way,” “the wrong way,” and “the startup way.“ “The right way” is essentially what you would do if you had unlimited funds and could hire the best experts to help with the technical needs of a business: legal, business strategy, and accounting/tax. Very few companies have the necessary capital or a team of internal experts to do everything perfectly, so “the right way” isn’t right for most startups. “The wrong way” is just the opposite: charging ahead while making little or no effort, or a poorly calculated effort, to address the technical needs of a business. “The startup way” is the strategic approach to addressing the technical needs of a business: it’s essentially the Minimal Viable Product (MVP) model applied to legal, business strategy, and accounting/tax. “The startup way” means that things won’t be perfect–there might be some cleanup down the road once the company is thriving.” Giddings said. “But the big risks and the important issues needed to protect the business and facilitate rapid and sustainable growth will have been addressed in a compliant, efficient, and cost-effective manner.”
Accounting Mistakes
- Failing to consider your company’s specific tax obligations: Tax consequences vary by situation: LLC vs. corporation; LLC member vs. corporation stockholder; s-corporation vs. c-corporation; employee vs. consultant; self-employed individual vs. W-2 employee; equity vs. cash, and so much more. According to Giddings, “You need to understand how to withhold and report taxes for any revenues and expenses. Unfortunately, precisely how you withhold and report such taxes changes depending on a number of factors. I call CPAs and tax attorneys about once a month to help advise on various tax issues. I strongly encourage entrepreneurs to do the same.
- Using equity as compensation: As mentioned previously in this article, using equity as compensation can have significant tax consequences, in addition to the legal consequences. “Using equity as compensation implicates a lot of tax considerations: 83(b) elections, 409(A) valuations, non-qualified stock options vs. incentive stock options; imputed income; alternative minimum tax; self-employment tax; and more,” said Giddings. “The bottom line is that you need to pay the piper, and the piper is the IRS. Using equity as compensation can help with cashflow, but someone needs to pay taxes on the value of the equity provided as compensation. Figuring out precisely how to do that is the challenge, and it’s where most startup companies make mistakes.”
- Not keeping up-to-date and accurate books and records: According to James Moore CPA, many startups are left asking “where did all the money go?” after burning through their first round of funding. James Moore CPA provides startups with a three-step solution to keeping accurate accounting books and records. First, startups should ensure that their accounting systems are setup properly and that their record keeper has a thorough understanding of each expense purpose. Second, startups and entrepreneurs should schedule periodical budget or accounting projection updates to ensure that expenses are well-planned and cash flow is spent strategically. Finally, the firm offers the option of adopting the use of an accounting software application to track company spending.
- Tax planning: Entrepreneurs and startups that fail to optimize tax treatments could end up paying higher taxes. Giddings notes “You want to structure, operate, and grow your business in a manner that makes sense from a tax perspective. Successful startup companies can reach values in the 9- and 10-digit range. If you think about tax consequences only after your company has already hit some of its more substantial valuation inflection points, you could end up paying millions of dollars more in taxes. That’s a good problem to have because it means you’ve been incredibly successful. But I’d rather you keep those millions of dollars and reinvest them in Gainesville’s promising startup companies.” In addition to optimizing tax treatment, entrepreneurs and startups should optimize tax deductions. Just be sure to keep thorough documentation to support any deductions that you plan to take. As James Moore CPA recommends, it may be useful to utilize accounting softwares with features that allow users to photograph receipts and other documents to log expenses, save valuable time, and help you ensure that you have adequate documentation to file these tax writeoffs later.
- Incorrectly setting up payroll and not paying attention to payment requirements: According to Giddings, implementing appropriate payroll systems for your staffing needs is imperative. “Managing payroll yourself is a headache,” Giddings noted, “Payroll service providers have become very affordable, so I recommend founders focus on growing their businesses, rather than calculating withholdings and writing checks.
For emerging and established entrepreneurs and startups, avoiding the common missteps mentioned here can help accelerate growth, avoid costly and time-consuming consequences, and ensure long-term success.
Fortunately for entrepreneurs and startup companies alike, seasoned professionals and successful companies are accessible in the Greater Gainesville area. These individuals are passionate and excited about growing businesses in Greater Gainesville, and they’re almost always happy to provide guidance and mentorship.
Events like Gainesville Area Innovation Network’s (GAIN) annual Shootout provide a platform for startups to network, pitch their businesses to investors, and compete for a chance to win $7,000 in prizes. As a sponsor for the Shootout, Hutchison PLLC is happy to support the promising new businesses that are competing in Shootout. For more information on GAIN and the Shootout, visit: http://gainnet.org/gain-7th-annual-shootout/.
By Lana Nasser
