By Richard Harroch, Lynne Hermle, and Ellen Ehrenpreis
When launching a new startup, you can face significant business and legal challenges. We have seen plenty of mistakes made by entrepreneurs and startup companies.
The following are some of the more common and problematic legal mistakes made by small and growing companies. These mistakes are made at the initial formation of the business, in the early stages of growth, and when dealing with employees.
Mistake #1: Not Making the Deal Clear With Co-Founders
If you start your company with co-founders, you should agree early on about the details of your business relationship. Not doing so can cause significant legal problems down the road (a good example of this is the infamous Zuckerberg/Winklevoss Facebook litigation). Think of the founder agreement as a form of “prenuptial agreement.” Here are the key deal terms your written founder agreement needs to address:
How will the equity be split among the founders?
Is each founder’s percentage ownership in the company subject to vesting based on continued participation in the business?
What are the roles and responsibilities of the founders?
If one founder leaves, does the company or the remaining founders have the right to buy back the departing founder’s shares? If so, at what price?
What time commitment to the business is expected of each founder? What constraints will be imposed on outside commitments?
What salaries (if any) are the founders entitled to? How can that be changed?
How will key decisions and day-to-day decisions of the business be made? (by majority vote, unanimous vote, or are certain decisions solely in the hands of the CEO?)
Under what circumstances can a founder be removed as an employee of the business? (usually, this would be a Board of Directors’ decision)
What assets or cash does each founder contribute or invest into the business?
How will a sale of the business be decided?
What happens if one founder isn’t living up to expectations under the founder agreement?
What is the overall goal and vision for the business?
Similar mistakes are sometimes made with employees, through email or oral promises, such as “you’ll get 5% of the company” without vesting schedules, role definitions, decisions about what happens on termination, etc.
Mistake #2: Not Starting the Business as a Corporation or LLC
One of the very first decisions founders must make is in what legal form to operate the business. Because founders often start businesses without consulting lawyers, they incur higher taxes and become subject to significant liabilities that could have been avoided if they had structured the business as a corporation or a limited liability company (“LLC”).
The types of business forms that are generally available to a startup business are as follows:
Sole Proprietorship. Generally speaking, a sole proprietorship requires no legal documentation, fees or filings other than state and local business permits. On the other hand, there are disadvantages to operating in this form: (1) a sole proprietorship only has one owner, and if additional capital is required from other investors, the form is not available and a partnership or other entity form is required; and (2) a sole proprietorship provides no protection for the founder against creditors of the business (in other words, creditors can directly sue the founder), in contrast to corporations and LLCs where, generally speaking, the founders are insulated from creditor and other third-party liability. We don’t recommend sole proprietorships.
General Partnership. A general partnership is sometimes chosen as the legal form of business entity if there are multiple founders. Preferably, the founders will execute a partnership agreement to “set the rules” among themselves; however, if the founders do not enter into a partnership agreement, most (if not all) states have existing laws that will step in and supply the rules of engagement. In addition, the income of a partnership is taxed directly to the partners generally on a pro rata basis (i.e., according to percentage ownership of the business). Finally, each partner is generally liable for the debts of the business such that the personal assets of each partner are exposed to the full extent of the business’ obligations. We don’t recommend forming a general partnership for a startup business.
C corporations. These are formed under state law (usually in the state where the business will first operate or, commonly, in Delaware, which is known for its well-developed body of corporate law). Most venture capital-backed companies are C corporations.
S corporations. These, like C corporations, are formed under state law. An S Corporation is a closely held corporation (not more than 100 stockholders) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. The election results in the corporation becoming a pass-through entity for tax purposes (meaning that the S Corporation itself does not pay income tax; rather, profits and losses are passed through and divided among the corporation’s stockholders).
LLCs. These are formed under state law, are a hybrid form of corporation and limited partnership, and have certain tax advantages over C corporations. They provide limited liability protection to the owners, in keeping with the corporate form, but they also provide for flow-through taxation to the members (as with an S Corporation). If you plan on bringing in venture capital investors at some point, it is best to avoid starting the company as an LLC (which generally can’t invest in pass-through entities).
Limited partnerships. These are formed under state law, often to hold investment real estate, and also are often the investment vehicle of choice for private equity firms, venture capital firms, and hedge funds.
Corporations, LLCs, and limited partnerships are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax and accounting issues. Each can offer advantages for founders (and subsequent investors) not available in the case of sole proprietorships and general partnerships, including liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital. The C corporation (formed in Delaware) is by far the leading choice for technology startups across the country.
Sole proprietorships and partnerships can be converted to a C or S corporation, an LLC, or another form of legal entity, but keep in mind that the costs of conversion can be significant and, depending on the manner of initial formation, can result in a lengthy process.
Mistake #3: Choosing a Company Name That Has Trademark Issues, Domain Name Problems, or Other Issues
When picking a company name, it is important to do research to help you avoid trademark infringement or domain name problems and to ensure that the name you choose is actually available to use. You may be infringing on someone’s trademark if your use of a mark is likely to cause confusion among customers as to the source of the goods or services. Here are some steps to take in order to avoid naming issues:
Do a Google search on the name to see what other companies may already be using the same or a similar name.
Do a search on the U.S. Patent and Trademark Office site for federal trademark registrations on your proposed name.
Do a search of Secretary of State corporate or LLC records in the states where the company will do business to see if anyone is using the same or a similar name.
Do a search on GoDaddy.com or other name registrars to see if the domain name you want is available. If the “.com” domain name is taken, this could signal the potential of prior use and is therefore a red flag.
Make sure the name is distinctive and memorable.
You might consider having your intellectual property lawyer do a professional trademark search.
Don’t make the name so limiting that you will have to change it later on as the business changes or expands.
Come up with five names you like and test market them with prospective employees, partners, investors, and customers.
Think about international implications of your chosen name (for example, you don’t want to choose a name that could turn out to have embarrassing or negative connotations in another language).
Avoid unusual spellings of the name. This can cause problems and confusion down the road (although some companies like Google or Yahoo have been successful with unusual names, such success is often the exception rather than the rule).
See 12 Tips for Naming Your Startup Business.
Mistake #4: Not Complying With Securities Laws When Issuing Stock to Angels, Family, or Friends
If founders form a corporation, limited partnership, or LLC, the sale of stock, limited partnership interests, or LLC interests to the founders and later investors will be subject to federal and state securities laws. Most securities laws require that such sales comply with certain disclosure, filing, and form requirements unless the sales are exempt.
Failure to comply with applicable securities laws requirements can result in significant financial penalties for the founders and the startup company, including a requirement that the company repurchase all shares sold to all investors in the unlawful offering at the original issuance price of the shares, even if the company has lost most, and perhaps all, of the money it raised from the investors. There can also be fines and other penalties (civil and criminal) imposed for failures to comply with the securities laws. To avoid such damaging (potentially fatal) consequences, founders should hire knowledgeable lawyers to document the sale of shares in compliance with such laws.
Mistake #5: Not Adequately Taking Into Account Important Tax Considerations
Startups need to pay attention to a variety of key tax issues germane to their businesses. Without proper planning, founders can find themselves or their startups liable for unintended and unanticipated taxes, fines, and penalties. Here are a number of the key tax issues to consider:
Obtain a Tax ID. In most instances, you will need to get a tax ID from the IRS for your company. This is also known as an “Employer Identification Number” (EIN), and it’s similar to a Social Security number, but for businesses. Banks will ask for your EIN when you open a company bank account. You can get an EIN online through the IRS website (the process is simple and quick and an EIN is issued immediately). In some states, a state tax ID may be necessary as well (for example, California, New York, and Texas require a state ID, which can also be obtained online).
Choice of Legal Entity. There may be valid reasons to choose a flow-through tax entity, such as an LLC or S corporation (see explanation of entity types in mistake #2 above). For example, flow-through entities allow for business losses to flow through to the shareholders’ individual tax returns, which allows the shareholders to offset the losses against any gains in the same fiscal year. As noted above, most venture capitalists and institutional investors prefer (indeed, may require) that the entities they invest in be C corporations (generally due to tax exempt limited partners that cannot receive active trade or business income due to their tax-exempt status).
Section 83(b). Founders and employees need to consider whether they can mitigate potential tax issues by an IRC Section 83(b) election. A Section 83(b) election relates to when someone receives stock or options subject to vesting and can minimize the amount of income deemed taxable at ordinary income tax rates to the recipient.
Qualified Small Business Stock. Holders of stock in qualified small business corporations may be entitled to a reduced rate of tax on gain from the sale of “qualified small business stock” under IRC § 1202. The tax savings can be substantial, making preservation of the exemption key for investors.
Tax Incentives. Depending on the nature of the business, various tax incentives may be available, such as renewable energy tax credits and investment tax credits.
Stock Options. Stock option plans are an extremely popular method of attracting, motivating, and retaining employees, especially when the company is unable to pay high salaries. A stock option plan gives the company the flexibility to award stock options to employees, officers, directors, advisors, and consultants, allowing these people to buy stock in the company when they exercise the option. The primary tax issue for the company in granting stock options is that the company needs to make a determination of the fair market value of its common stock in order to set the exercise price of the option, pursuant to Section 409A of the Internal Revenue Code. This is often done by hiring a third-party valuation expert.
Sales Taxes. The business may be subject to taxes from the sale or lease of goods and services, commonly referred to as a “sales tax” and in some instances as a “use tax.” The sales tax is calculated by multiplying the purchase price times the applicable tax rate. The applicable tax rates vary by state (California has the highest sales tax rate). In some states, cities and counties can levy an additional sales tax. Sales tax is required to be collected by the seller at the time of sale. The seller must file tax returns and remit the tax to the state and city/county that imposes a sales tax. The categories of goods and services that are subject to sales tax depend on the state, city, or county, and there are typically many exempt categories of goods or services.
Payroll Taxes. Startups have to pay state and federal payroll taxes on employee compensation. Payroll taxes are usually calculated as a percentage of the compensation the company pays to its employees. The taxes are taken out of (withheld from) employee pay, are collected by employers, and paid by employers on behalf of the employees and the company. U.S. federal taxes include federal income tax withholding owed by employees, which is calculated from the amount provided by the employee on IRS Form W-4 at the time of hire. The tax also includes amounts paid for Social Security and Medicare (called FICA taxes), where the employer deducts the employee’s share (one-half of the amount due) from the employee’s paycheck, and the employer pays the other half.
Employee vs. Independent Contractor Issues. It is critical for tax purposes that the company correctly determines whether individuals providing services to the business are employees or independent contractors. Employers run the risk of improperly characterizing independent contractors. Many startups prefer to use independent contractors to avoid paying Social Security, Medicare taxes, and unemployment taxes, and to avoid providing health insurance coverage. But the IRS and states are paying more attention to misclassification issues. In fact, companies like Uber that treat workers as independent contractors are under increased scrutiny (California’s Assembly Bill 5, signed into law last year and effective as of January 2020, requires many workers formerly classified as independent contractors to now be reclassified as employees). If the employer has significant control over the worker, the IRS or the state may claim the worker should have been classified as an employee. Companies must give their employees IRS Form W-2 setting forth their compensation for the year, and must give their independent contractors Form 1099 by February 1 of each year.
Properly Documenting All Income and Deductible Expenses. Every business needs to employ a recordkeeping system that accurately and completely captures all income and deductible expenses. Some businesses use an ordinary checkbook for this system, but many businesses choose to use electronic software programs such as QuickBooks. The IRS website lists the types of records a small business should keep by category.
For a complete discussion, see Pay Attention to These 9 Essential Startup Tax Issues.
Mistake #6: Not Having the Right Legal Counsel
In a misguided effort to save on expenses, startup businesses often hire inexperienced legal counsel, including lawyers who are friends or relatives, or those who offer steep fee discounts. In doing so, the founders deny themselves the advice of experienced legal counsel who can help avoid many legal problems. Founders should consider interviewing several lawyers or law firms and determine if the lawyers or the law firms have expertise in some, if not all, of the following legal areas:
Corporation, commercial, and securities law
Executive compensation and benefits law
Intellectual property law
Real estate law
Data security, cyber, and privacy law
Although it is not necessary that the lawyer or law firm retained by the founder have experience in all of the foregoing areas because certain problems can be “farmed out” to different lawyers or firms, it is often best that the founders retain a firm that can handle some, if not many, of the areas of expertise listed above so as to provide continuity between the founders and their lawyers.
To locate competent legal counsel, founders should:
Check with friends and business acquaintances to ask for referrals.
Consider state bar referral services.
Review local incubator/accelerator websites for lawyers who serve as advisory board members.
Attend programs featuring presentations by startup counsel and other relevant subject matter experts.
Review legal websites (e.g., Lawyers.com).
Mistake #7: Not Maintaining Proper Corporate and HR Documentation
Companies are often sloppy in maintaining proper corporate and employee/HR-related documentation. This can become problematic when the company pursues financings, is involved in an M&A activity, or is involved in claims or litigation with an employee or regulatory agency. Here is a compendium of the types of documentation the company should consider maintaining carefully:
Board and shareholder resolutions and minutes
Signed contracts (including documentation reflecting any loans to or from founders or other company employees)
Stock and option records including, among other things, stock option plan documents; executed stock purchase and option agreements; proof of payment for stock sales and share and option grants (as well as for other securities sold or issued by the company); 83(b) election forms (plus proof of form filing with the IRS); option exercise paperwork; and required state and federal filings
Job applications and resumes
Employee offer letters
IRS W-4 forms (Employees’ Withholding Allowance Certificate)
Form I-9 completed by all employees (eligibility of the employee to work in the United States)
Anti-harassment and discrimination policy (and, if employees confirm their compliance with the policy, those acknowledgments or confirmations)
Employee personnel files (including performance appraisals)
Employee complaints and the responses to those complaints
Workers’ compensation documents, unless maintained by the company’s workers’ compensation insurance carrier
Emergency contacts for employees
Records of any disciplinary proceedings taken, including documentation of oral warnings
Versions of company and employee policies, including but not limited to current and historical employee handbooks (as well as employee acknowledgements of receipt), codes of conduct, anti-discrimination and harassment policies, data security and privacy policies, and whistleblower and other policies relating to the reporting of employee misconduct
Employee compensation and bonus history
Employee-related posters mandated by law to be posted in the workplace
Employee termination notices (and any separation and/or severance agreements with departed employees)
PTO tracking records
Confidentiality and invention assignment agreements (described in mistake #9 below)
Mistake #8: Not Determining Which Permits, Licenses, or Registrations You Will Need for Your Business
Depending on the nature of the business, you may need the following permits, licenses, or qualifications:
Industry-specific permits for regulated businesses (aviation, agriculture, alcohol, etc.)
State qualification to do business
Sales tax license or permits
Home-based business permits
City and county business permits or licenses
Health department permits (such as for a restaurant)
Federal and state tax/employer IDs
Mistake #9: Not Carefully Considering Intellectual Property Issues
If you have developed a unique product, technology, or service, you need to consider the appropriate steps to protect the intellectual property you have developed. Both the company’s founders and its investors have a stake in ensuring that the company protects its intellectual property and avoids infringing the intellectual property rights of third parties. Here are some of the common protective measures undertaken by startups:
Patents. Patents are the best protection you can get for a new product. A patent gives its owner the right to prevent others from making, using, or selling the patented invention. The key requirements of patentability are: (1) only the concrete embodiment of an idea, formula, and so on is patentable; (2) the invention must be new or novel; (3) the invention must not have been patented or described in a printed publication previously; and (4) the invention must have some useful purpose. Patents are obtained from the U.S. Patent and Trademark Office and the application process can take several years and be complicated. You typically need a patent lawyer to draw up the patent application for you.
Copyrights. Copyrights cover original works of authorship, such as art, advertising copy, books, articles, music, movies, software, etc. A copyright gives the owner the exclusive right to make copies of the work and to prepare derivative works (such as sequels or revisions) based on the work.
Trademarks. A trademark protects the symbolic value of a word, name, symbol, or device that the trademark owner uses to identify or distinguish its good from those of others. Some well-known trademarks include those belonging to Coca-Cola, American Express, and IBM. You can obtain rights to a trademark by actually using the mark in the regular stream of commerce. You don’t need to register the mark to get rights to it, but federal registration does offer some advantages. Trademark applications are filed with the U.S. Patent and Trademark Office.
Service Marks. Service marks resemble trademarks and are used to identify services.
Trade Secrets. A trade secret is a form of intellectual property that is not generally known to the public, confers an economic benefit on its holder because the information is not publicly known, and is the subject of efforts by the owner to maintain its secrecy. A trade secret right allows the owner of the right to take action against anyone who misappropriates the secret through theft or other improper means. Trade secrets can range from computer programs to customer lists to the formula for Coca-Cola.
Confidentiality Agreements. These are also referred to non-disclosure agreements or NDAs. The purpose of a non-disclosure agreement is to allow the holder of confidential information (such as the holder of a secret product or business idea) to share it with a counterparty who is then prohibited from further disclosure of the confidential information to another party. There are standard exceptions to the confidentially obligations imposed by an NDA, which are generally built into the agreement (such as when the information becomes known to the counterparty through wholly separate means without violation of any obligation owing to the holder of the confidential information).
Confidentiality and Invention Assignment Agreements for Employees. Every employee should be required to sign such an agreement. It accomplishes several purposes. First, it obligates the employee to keep confidential the proprietary information of the business, both during employment and after employment ends. Second, it ensures any inventions, ideas, products, or services developed by the employee during the term of employment and related to the business belong to the company and not the employee (see the discussion in mistake #13).
Another potential intellectual property issue arises when a founder starts a new company while employed elsewhere. Founders and investors should take care to avoid claims by a prior employer that the intellectual property contributed by the founder was misappropriated from the prior employer.
Mistake #10: Not Coming Up With a Great Contract
Most companies should have standard form contracts for dealing with customers or clients. Of course, every contract can be tailored to be more favorable to one side or the other. The key is to start with your form and hope it appears sufficiently reasonable that the other side doesn’t attempt to negotiate its terms. Here are some key points:
Get sample contracts of other companies in the industry. There is no need to reinvent the wheel.
Make sure you have an experienced business lawyer who has good experience (and also good forms to start with) do the drafting.
Consider making the form look like a standard preprinted contract with typeface and font size.
Don’t make the contract so long that the other side will throw up their hands when they see it.
Make sure the contract clearly spells out basic terms, such as a description of the deliverable(s), agreement on pricing, when payment will be due, what penalties or interest will be owed if payment isn’t timely, and how the contract can be changed (most commonly only by written agreement of the parties).
Minimize or negate representations and warranties about your product or service.
Include limitations on your liability if the product or service doesn’t work or fails to meet the buyer’s expectations.
Include a “force majeure” clause relieving you from breach if unforeseen events occur.
Include a dispute resolution clause and make sure to designate the governing law and venue for dispute resolution. Our preference is for confidential binding arbitration in front of one arbitrator in the city or county where you are based, perhaps under the streamlined rules of a commercial arbitration administrator (for example, JAMS).
How the site can be used and the limits imposed on users
Disclaimers on warranties
Limits on liability of the site owner and its employees, officers, affiliates, and directors
How disputes will be resolved (e.g., through confidential binding arbitration precluding class actions)
Representations and warranties of the site user, and indemnification to the site owner
Rights to refunds and returns if products are sold
Intellectual property rights (e.g., copyrights)
What information the site collects
How the site uses the information collected
How the information may be shared or sold to third parties
How the site deals with children under 13
How the site can be accessed through third-party services such as Facebook and Twitter
The steps taken by the site owner to protect confidentiality and security of the information collected
Privacy policies shouldn’t blindly be copied from other sites. They should be tailored to the specific business situation to lessen the potential exposure of the site owner.
The company must also consider the myriad of privacy data protection laws being enacted, including the GDPR and the California CCPA.
Mistake #12: Not Using a Good Form of Employment Agreement or Offer Letter When Hiring Employees
Oral agreements often lead to misunderstandings. If you plan to hire a prospective employee, use a carefully drafted offer letter, which the employee should be encouraged to review carefully before signing. For senior executives, a more detailed employment agreement often makes sense. A good offer letter or employment agreement will address the following key items:
The job title, role, and responsibilities of the employee
Whether the job is full time or part time
When the job will commence
How long the offer of employment is open to the employee
The salary, benefits (including vacation, relocation, etc.), and any potential bonuses
Whether the position is “at will,” meaning either party is free to terminate the relationship at any time without penalty (although employers may not terminate employees for legally prohibited reasons, such as for age discrimination or retaliation from sexual harassment allegations, etc.)
Confirmation that the “at will” agreement may not be changed unless the change is put in writing signed by an authorized officer of the company
Confirmation that the employee will need to sign a separate confidentiality and invention assignment agreement
If the company chooses, a statement that any disputes between the parties will be resolved solely and exclusively by confidential binding arbitration, but that the employee may opt out of the dispute resolution provision within two weeks of signing the offer letter (note: California law is in flux about whether such an arbitration agreement can be mandatory with respect to certain claims)
Any stock or stock options to be granted to the employee, subject to the approval of the board, and the terms of any vesting (plus a statement that terms are to be laid out in a separate stock purchase or stock option agreement)
The supervisor to whom the employee will report
Protective language stating that the offer letter constitutes the entire agreement and understanding of the parties with respect to the employment relationship, and that there are no other agreements or benefits expected (unless additional provisions are laid out in a handbook, which should be referenced if applicable)
Companies should ensure that the employee and the company sign the letter and any first-day paperwork (such as the IRS W-4 Form for withholding and the I-9 form mandated by law).
For a good sample employee offer letter, see 13 Key Employment Issues for Startup and Emerging Companies.
Mistake #13: Not Requiring All Employees to Sign a Confidentiality and Invention Assignment Agreement
Companies pay employees to come up with ideas, work product, and inventions that may be useful to the business. Employees have access to a good deal of their company’s confidential information, which can be very valuable, especially in technology companies.
One basic way to protect proprietary company information is through the use of a confidentiality and invention assignment agreement. This type of agreement deals with confidentiality issues, but can also ensure that the ideas, work product, and inventions the employee creates that are related to company business belong to the company—not the employee.
A good employee confidentiality and invention assignment agreement will cover the following key points:
The employee may not use or disclose any of the company’s confidential information for such employee’s personal benefit or use, or for the benefit or use of others, without authorization.
The employee must promptly disclose to the company any inventions, ideas, discoveries, and work product related to the company’s business that they make during the period of employment.
The company is the owner of such inventions, ideas, discoveries, and work product, which the employee must assign to the company.
The employee’s employment with the company does not and will not breach any agreement or duty that the employee has with anyone else, nor may the employee disclose to the company or use on its behalf any confidential information belonging to others.
Upon termination of employment, the employee must return any and all confidential information and company property.
While employed, the employee will not compete with the company or perform any services for any competitor of the company.
The employee’s confidentiality and invention assignment obligations under the agreement will continue after termination of employment.
The agreement does not by itself represent any guarantee of continued employment.
Venture capitalists and other investors in startups expect to see that all employees of the company have signed these kinds of agreements. In an M&A transaction in which the company is being sold, the buyer’s due diligence team will also be looking for these agreements signed by all employees.
A sample form of employee confidentiality and invention assignment agreement can be found at the Forms & Agreements section of AllBusiness.com.
Similarly, it will be appropriate that all consultants of the company also sign a confidentiality and invention assignment agreement. See Key Issues with Confidentiality and Invention Assignment Agreements with Consultants.
Mistake #14: Asking Interview Questions That Are Prohibited by Law
Federal and state laws prohibit employers from making hiring decisions based on protected categories: gender, race, age, color, religion, disability, and others. Asking the wrong questions could lead to a discrimination claim against the company, even if decisions are not made on that basis. Here are examples of the types of questions to stay away from:
How old are you?
What is your religion?
Do you have any medical conditions we should be aware of?
Have you ever been arrested or convicted of a crime?
Do you have any disabilities that would hinder you in performing the job?
Have you had any recent illnesses or operations?
Are you married?
Do you have children or plan to have children?
How long do you plan to work?
Do you drink or smoke?
What is your political affiliation?
Is English your first language?
What type of discharge did you receive from the military?
What country are you from?
Where do you live?
Do you take drugs?
Some of these may be obvious. The following questions may be less obviously problematic but should also be avoided:
What is your maiden name?
Do you own or rent your home?
Where is your family from?
Can you give me the name of a relative to be notified in case of emergency? (The problem is asking for the name of a relative. But you can ask, “In case of an emergency, whom can we notify?”)
See the California Department of Fair Employment & Housing Fact Sheet—Employment Inquiries: What Can Employers Ask Applicants and Employees?
Mistake #15: Not Taking the Proper Steps Prior to Firing an Employee
Terminating an employee, even an “at will” employee, entails legal risk if not properly handled and documented. Laws prohibit termination based on color, national origin, ancestry, gender, race, age, disability, marital status, religious preference, sexual orientation, absenteeism due to jury duty or military service, retaliation for sexual harassment, discrimination, or other allegations by the employee, and many other factors.
Here is some practical advice on what to do in connection with terminating an employee:
Have an employee handbook or a set of policies which confirm the company’s intent to act lawfully, with disciplinary policies for violations. Clear violations of company policies will support termination.
Consider adopting an employee reference policy, which explains how a departing employee can seek references and what supervisors should and should not say about departed employees.
When issues arise, investigate the situation to have a full understanding of the facts.
If the employee has poor performance or violates company policy, make sure he or she has been coached or warned and that documentation of those communications is included in the employee’s personnel file. A warning may be more appropriate than an outright firing for a first-time offense, unless it is significant misconduct.
Review the offer letter or employment agreement to ensure there aren’t steps or notices you have to undertake.
Consult with employment counsel to ensure that the termination will not be in violation of applicable law.
Consider a progressive discipline approach first, if the termination is not serious misconduct.
Conduct an exit interview, perhaps attended by another company employee who can serve as a witness, and terminate the employee in a dignified manner, in private, and document the discussion.
Be brief, accurate, respectful, and truthful about the termination.
Make sure all legal requirements are fulfilled, such as having the employee’s last paycheck ready together with any accrued but unpaid PTO (this is important in California and some other states).
If you are going to offer a severance package, make sure you get a complete and full release from the employee. The release should be in writing, signed by the employee, cover all known and unknown claims the employee may have (other than with respect to claims that cannot be waived as a matter of law), and be supported by adequate consideration. Note that special rules for releases will apply if the employee is located in California or is 40 years old or older, and the law may prohibit certain types of non-disclosure provisions.
Make sure the employee’s access to your computer network, voicemail, and email is revoked immediately upon termination, other than as agreed upon.
At the exit interview, ask for the return of company laptops, phones, keys, security fobs, and the like.
Ensure that the employee has the information necessary to obtain COBRA and unemployment benefits.
Make sure the employee understands that he or she will have continuing obligations under any confidentiality and invention assignment agreement.
Have the terminated employee leave the premises immediately, but give him or her an opportunity to pack up personal belongings privately and discreetly. Do not use security guards to escort the employee unless there is a concern about violence or other security threat.
In anticipation of litigation, make sure that all relevant emails and other documents concerning the employee are preserved.
Make a plan for how the terminated employee’s workload will be picked up by other team members. That may also require a debriefing with the team, but be sure to protect the privacy of the departed employee.
Terminating an employee is never easy, and the employer has to ensure it is taking the appropriate legal steps in doing so.
Startups that manage to avoid these legal pitfalls and missteps have a better shot at success than do those companies that fail to anticipate and plan for them from the beginning. Invest in planning and obtaining expert advice now to avoid major problems later.
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About the Authors
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on Internet, digital media, and software companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of a 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He was also a corporate and M&A partner at the Orrick law firm, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and 250 startup financings. He can be reached through LinkedIn.
Lynne C. Hermle is a partner specializing in employment law at Orrick in Silicon Valley. She was the successful lead defense counsel for Kleiner Perkins Caufield and Byers in the gender discrimination and retaliation claims alleged by Ellen Pao. She has handled hundreds of employment claims involving sexual harassment, discrimination, retaliation, and wrongful termination throughout her career, and continues to litigate such cases before juries and in arbitration. She is a member of the American College of Trial Lawyers and received the Daily Journal “California Lawyer of the Year” as well as other awards for trial successes. She writes frequently on employment and trial topics, and has represented a number of the largest corporations in the world, including software, media, Internet, and other technology companies. She can be reached through the Orrick website.
Ellen Ehrenpreis is a partner specializing in tech startups at Orrick in Silicon Valley. She has spent more than twenty years in the tech and venture ecosystem and leverages her broad network and deep understanding of both the tech sector and legal landscape to effectively and strategically advise emerging companies and investors on a wide range of critical needs. On the company side, Ellen’s clients range from early startups to mature private companies. She advises companies and founders on formation, venture financings, governance, M&A transactions, corporate and securities matters, commercial transactions and litigation strategy. Ellen’s approach is holistic and pragmatic. Her unique skill set and business-driven approach derive from her decades-long career as a Silicon Valley lawyer and her broad experiences earlier in her career as both a successful litigator and business owner. Ellen also works closely with some of the leading venture capital and growth equity firms, whose principals she advises in connection with financings, equity structuring and corporate governance. Ellen’s company clients have represented a broad swath of the technology ecosystem, including both hardware and software, and, as a result, her industry experience is wide-ranging. Her clients have included companies in the semiconductor, SaaS, renewables, fintech, aerospace, digital retail, online sharing, biotech/biopharma, media, design and data analytics fields, among others. She can be reached through the Orrick website.
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