The Biggest Legal Mistakes New Business Owners Make (And How to Avoid Them)

Thinking about leaving your corporate job to start or buy a business? Before you file your LLC paperwork or give your notice, there are some critical legal decisions that could impact your business—and your personal wealth—for years to come.

In this episode of The HENRY to Wealthy Podcast, Carla sits down with business attorney Jordan Segal to discuss the legal foundations every entrepreneur should have in place before launching a business. They cover common mistakes new business owners make, including choosing the wrong business entity, overlooking employment agreements and non-compete clauses, and failing to document ownership and partner relationships from the beginning.

Jordan also explains why 50/50 partnerships can create deadlocks, the key legal documents every founder should have, and how intellectual property, customer contracts, and clean governance can significantly increase the value of a business when it's time to sell.

Finally, Carla and Jordan discuss why legal planning isn't just about avoiding lawsuits—it's about protecting your downside, creating future options, and building a business that becomes a valuable asset rather than just a source of income.

Whether you're considering entrepreneurship in the next year or already own a business, this episode will help you think strategically about building a company that's designed for long-term success and wealth creation.

Transcript

SPEAKER_00 2:20

Today's episode is for all of you out there who are thinking about leaving your corporate job and either starting a business or buying a business. And often when people start thinking about owning a business, they focus on the exciting parts, the idea, the growth potential, the flexibility, and the opportunity to build wealth. But they don't always think about the legal foundation that can either support that growth or create major problems down the road. Some of the most expensive mistakes business owners make happen long before there's significant revenue employees or even customers. So today I'm really excited to have another guest, Jordan Siegel, who is an attorney and works with business owners. So, Jordan, let me turn it over to you to introduce yourself before we get into it.

SPEAKER_01 3:21

Thank you so much for having me. My name, as you say, is Jordan Siegel. I'm a partner at Madden Houser. And yeah, I work with business owners all day long. That my clients are all business clients. They range from mom and pop startups to Fortune 500s. I help businesses come into existence. And ultimately, I help them sell or whatever other disposition is appropriate.

SPEAKER_00 3:48

Great. Thank you, Jordan. So yeah, let's get right into it. What are the most common legal mistakes people make when starting or buying into a business?

SPEAKER_01 4:00

I think a lot of times people don't give any real thought to the form of business that they're creating or that they're buying into. There are a lot of options. There's corporation, there's limited liability company, there's partnerships, there are sole proprietorships. All of these things have different protections and different tax structures and different management structures. And understanding what you want to do and how you want to do it leads you very naturally into which form of business you want to create. And, you know, the one of the things that I always ask my clients who are who are starting a business is what is your long-term goal? What do you want the business to do in the long term? And that almost always informs how we create it from the outset. So for example, if you're creating a business that you intend to go and seek private equity money or venture capital money, those types of investors down the road really like to see Delaware C Corps. Whereas if you're looking to build something for yourself and you're going to operate it and it's going to be your business until you retire 50 years from now, you might want something that's more simple, more local. And so maybe a Michigan LLC is more appropriate. There are also tax consequences for every single one of those decisions that you make. And so there's always a bit of a balancing act between management, control, formation, what you want the business to look like. And I think a lot of times people just sort of jump into the LLC because it's easy, it's understandable, and it's something that can be accomplished very, very, very quickly. And they end up missing out on a lot of longer-term benefits that you can have if you start off as a corporation or a partnership with some other form. The really important thing there is however you do it, that it's a deliberate decision, that you don't say, well, I'll just figure it out as we as I go. This is something that a lot of times you can't change. You can change your form really very quickly, but there are things like qualified stock, small business stock, and other advantages that you need to really have set from the get-go. And so making that plan, coordinating with your legal counsel, coordinating with your tax counsel or tax advisors and financial advisors is always really important when you're starting your business.

SPEAKER_00 6:23

Yeah, great. Or especially people that just start sole proprietorship with zero personal liability protection, right?

SPEAKER_01 6:30

That's right. I mean, look, the the LL of the LLC is really the important part. And I think a lot of people don't understand just how great a limited liability shield can be. It really is from my perspective as a lawyer, the best protection I can give a starting business owner is to get them some form that has a limited liability. And to explain to your listeners what that means, the the analogy I always use is if your iPhone explodes in your hand, you can sue Apple. You can't sue Apple shareholders. So by the same token, if something goes wrong with your business, the other side in whatever dispute that is sues the business. But your personal assets that are not in the business are protected from that dispute.

SPEAKER_00 7:13

Yeah, so important to wealth protection. So when someone is leaving a W-2 job or thinking about leaving a W-2 job to start a business, what should they think about and know before they officially resign?

SPEAKER_01 7:31

So the first thing to think about is what are your existing obligations to your employer? And what of those obligations will persist after you leave? So there's a lot of discussion, and I see this a lot where people say, well, restrictive covenants and non-competes, those are out the window, right? The answer is no, they're still very much enforceable. There's increasing scrutiny. I think a lot of legal scholars and commentators have said that there's been an overuse of non-competes. And I think there's some impetus on behalf of governments and judges and things to push back on them, but they still are very much enforceable. And so you don't want to quit your job and find out you got to wait two years before you can start your business because you're non-competed out. Now, I will say non-competes are, they do have to have some limitations and they're very specifically enforced. So what's on the page is very, very important to how that will be interpreted down the road. So again, that's something that you should talk through and look at very, very closely before you jump ship. The other thing that is along those same lines, you know, not just a restrictive covenant as regards competition, but also ownership of ideas and confidentiality agreements. So if you're starting a business based on something, some idea, some invention that you've developed for your current employer, you want to be sure that that idea, that intellectual property is yours and not your employer's. You go out and start a business based on an idea that's not yours, you're going to run very quickly into a lawsuit that could be sort of a death sentence for your business. So you want to make sure that if you if you are basing your new business idea on something that you've created while employed, that you have clear ownership rights, that you have clearly that it belongs to you and not to your employer. It's not workmake for hire, it's not assigned to your employers. A lot of employment agreements will have language that says innovations that you create during your uh employment belong to the business. And so you want to make sure that if you are doing something like that, that you can actually show that you own your idea and it doesn't belong to someone else.

SPEAKER_00 9:49

Yeah. So, you know, some people may be starting businesses totally on their own, or they might want be wanting to have a business partner, whether it's 50-50 or some other percentage. So, what should people be thinking about if they're going to have a business partner about how they split the equity and just ownership structure in the beginning?

SPEAKER_01 10:14

So if you have very simply, if you have an even number of partners, you always run in the possibility of deadlock. And by default, the legal remedy for deadlock is you dissolve the business.

SPEAKER_00 10:25

Wow.

SPEAKER_01 10:26

So you want to think about what happens if you have you and one other person, what happens if you disagree? If you're 50-50, there's no mechanism to navigate that. So you want to build something into the operational documents. And that can be done in a number of ways. So first, you could give one side or the other a tiebreaker based on some criteria. You can change it to be not a 50-50, you know, maybe it's 5149 or something like that. The other thing you can do is set defined roles and say, you know, I'm responsible for marketing, and within marketing, I make all the decisions. You're responsible for some other piece of the business, and within that, you have all the roles. The other thing I've done frequently is say either partner can make decisions within sort of a set of what I would call sort of daily decisions, right? So low-level, you know, you don't want to have to call a member meeting every time you want to buy a pack of stamps or something like that. But big ticket items, purchase of real estate, taking out a loan, settling a lawsuit, these things that have a dollar value over, say, 25,000 or whatever it is, that requires both of you to agree. And that sort of a setup minimizes the risk of that sort of deadlock. And making sure those decision-making authority matrix is clear and built into your authority documents is crucially important because, again, what you guys agree to now may not be the things that you agree to tomorrow. And you want a mechanism to prevent a lawsuit between the partners that ultimately results in the company just getting split up.

SPEAKER_00 12:07

Yeah, this is also interesting because a lot of clients that I work with head up divisions of their own companies and they're essentially running a small business and highly qualified to be starting or buying up a business. But it's all of these little details that most people don't even think of because they're already in that sort of structure where all that is set up. So sort of in line with that, what documents should founders or new owners have in place early on?

SPEAKER_01 12:38

This is a crucial question, at least for me, because this is what I do every day. Every form of business, every form of entity will have its own governing document. For an LLC, that's an operating agreement. For a corporation, it's a shareholder agreement, for a partnership, it's a partnership agreement. And that goes through all the things that we've been discussing. So management control rights, it sets out who owns what percentages, things like that. And having that in place is very so you can imagine, say, an LLC that has not just two members, but will also have maybe other investors who are silent investors who don't have management rights, but have a profit interest or have some other financial incentive. The operating agreement is where all of that is spelled out. And for a single member LLC, where if it's just you, it's a real short document because frankly, you're not going to sue yourself. But it's still useful to have, number one, because people on the outside, people doing business with your business, a lender, for example, giving you a loan, will want to see the documentary proof of how you've set up your business and how you've set up your entity. If you do have partners, the couple of other things that you will want to have in there are in particular is a buy-sell provision, which sets forth the conditions on which one partner might buy out the other partner or vice versa. You might see things along those lines, you might see something called a drag-along right or a tag-along right, which sort of sets forth, if someone comes in and says, I want to buy the business, can one of the two partners put the kibosh on that deal? Or could they require that this third party coming in to buy the business buy them out as well? And so again, these are all conversations you want to have ahead of time, because when someone comes in and says, I'm really ready to buy your business for a million dollars, you don't want to have to stop that transaction because there's a fight between the two partners or there's a fight among the many partners. Frequently, as an owner, you are, particularly in a small startup, you are not just an owner, but you're also an employee. And you're gonna want to have those employment agreements detailed separately from your operating agreement, again, particularly if you have other partners, because you have to think of it as you're wearing different hats. And you wanna be able to show when you're wearing your employee hat and when you're wearing your owner hat, and you have different responsibilities when you're wearing each of those hats. And so you want to have those sorts of transactions clear. And particularly for tax purposes, if you're taking money as an employee, as a W-2 employee or as a 1099 from your business, that looks a lot different from a tax perspective than if you're taking a distribution from the profits. The last thing that's really important, as we've sort of mentioned this already, is your IP assignment or confidentiality rights with regard to your intellectual property. Again, you want to think about who owns the idea, the secret sauce that makes your new business venture worthwhile and valuable. Do you own it or does the company or the business own it? And if you're transferring that intellectual property to the business, you're gonna want an assignment agreement that sets forth what that looks like and how that's your capital contribution and things like that. And on the flip side, if if you're retaining ownership, you're gonna want to license it to the business so that if anyone, again, if you're ever going to sell the business, or if there's anyone who ever questions it, you have a document that establishes that the business has a right to use that idea to make money, even though you still own the idea. These are things that as you pass through diligence on a on a sale transaction, there's sort of questions one, two, and three. These are the things the other side pops up and says, you know, I need to know how the business has the right to use the idea because that's what I'm buying. And the more documentation you have there, the more valuable your business is gonna be. Because what the way it ends up playing out is if you can't establish that, number one, either your buyer walks or they come to you and say, Well, we're still interested in buying it, but since you can't establish this thing and we're gonna have to worry about it, our purchase price is now getting, is now getting cut in half. And the more opportunities your buyer has to do that, to renegotiate or retrade the deal, the lower your purchase compensation is gonna be. So the more you have that set forth on the on the front end, the better off you're gonna be on the back end.

SPEAKER_00 17:18

Yeah, makes a lot of sense. And I think one thing that's really interesting too is that, you know, some people start a business and it's just them. And I don't know how common it is for other industries. I know it's very common for financial advisors and attorneys. Maybe there's one founder, and then later on, more partners join the firm. And so I think that all of this is really important for people to keep in mind when starting a business, even if it's just them, a lot of these documents are going to be more simple, but just always have in the back of your mind that even when you get a business partner, that a lot of thought and probably legal work and documents need to be drawn up at that point, even though you already may have an established business at that point.

SPEAKER_01 18:06

I've had many, many times I've had conversations with really even sophisticated businessmen. And you sort of have to say, well, when you give equity to another person, you're no longer the 100% owner. You're no longer the sole shareholder. And, you know, sort of that's just how math works, right? Anything you subtract anything from 100, you'll get less than 100. And I think what that shows isn't that they don't know what math is. It's, I think the issue is people don't really always understand what equity means. And that you have to understand that your equity in your company, if you're a 100% member, if you're 100% shareholder, you have all the equity, you have all the ownership rights. That equity is a measure of your ownership of the business. And think of that as sort of a bundle, the legal analogy that we use a lot is a bundle of sticks. And, you know, think of it as sort of each stick within that right of equity might be, you know, your right to profit distribution, your right to management control. You can divvy those out to other people, but it's important that you have that in writing in an agreement that everyone understands and that is clear. So that down the road, you don't have someone pop up and say, hey, I was, you know, I was given a 5% interest. I'm entitled to X, Y, and Z. I'm entitled to a say in management. And if that wasn't what you intended, you're going to end up with a fight on your hands. And there's nothing that kills a business faster than a shareholder fight.

SPEAKER_00 19:32

Yeah. Yeah. So this podcast is really focused on how high earners building wealth. And a lot of people do build wealth through starting a business. So let's let's talk about that a little bit, Jordan, please.

SPEAKER_01 19:47

Sure. Running your own business is very frequently, I think, as you pointed out right at the top, is one of the best ways to build wealth, to build equity, to build a long-term plan. In particular, for a lot of people, it's the best way to get out from underneath someone else's thumb, right? You become your own boss and you sort of you can become put yourself in a position where you eat what you kill. You make, you get to keep the business that you generate. And that can be very, very attractive to a lot of people and for good reason. And then at the end of it, it's also a sort of its own built-in retirement plan, because the retirement plan is ultimately I've built this fabulous business that makes multiples of IBITA that will get me millions of dollars that I can then retire on. But you always have to remember that a business is not worth what you think it's worth. It's worth what the buyer can diligence. So at every stage of this chain, at every stage of your business, you want to be thinking about what is my buyer going to be thinking about when they're trying to buy my business? And how can I make that story? How can I make that documentation clearer? How can I make that more consistent so that that buyer has fewer opportunities to come in and say, I have a problem with this, I need a price reduction to account for it. A clean governance story, a clean governance contracts and agreements really become key there. And along with that, also having proper contract forms with your customer, right? So a lot of smaller businesses, the value of these smaller businesses is its goodwill, right? So what you're building is the relationship that you're developing with your customers. And if you can't show that that relationship can be transferred, that relationship only has value to you. No one's going to buy it, right? So what you want to make sure you have are ways that you've locked in your customers. SaaS businesses, the software as a service businesses and other technical and computer long-term contracts, do this extremely well. What you always or a lot of times will see with those sorts of businesses is you have an ongoing, what we would call an evergreen contract, right? It renews constantly every year. And you have only a limited window during each contract term in which you can terminate the agreement. Those become extraordinarily valuable in that business model because you can transfer that goodwill very, very easily by transferring those sorts of agreements. In manufacturing businesses, you may have a long term purchase agreement that requires a certain amount or a certain percentage of annual need produced by you or acquired by. You, depending on where your business sits in a supply chain. That's the sort of way that you generate that value to those contracts. It's something that you can then transfer to a buyer. That's what gives that value, not necessarily just that you're making money off of those transactions, right? So I can sell a million widgets a year and make a lot of money. But if I can't give a buyer that value, if I can't give them that relationship, that transaction only has value to me. And I'm not going to get anything out of it when I want to retire. By the same token, again, we talked about IP ownership. If I can't transfer my intellectual property, if I can't make sure that a buyer gets the benefit of my idea and they can then sort of use my idea the way I have, my business isn't going to be valuable to a third party. These are all the sorts of considerations that we talked about that you want to have in place, even if you don't have the actual agreement in place at the start, you have the plan in place and you know exactly how you're going to be handling that. I mean, it's all well and good to say I'm going to lock in my customers for a million years, if no one in the market will agree to that kind of contract. So that might not be the way that you develop that kind of goodwill. So there's always a lot of long-term planning and tweaking to those plans as you go. But the key item here is that you've had that conversation, even if it's with yourself. Hopefully it's with your business advisor and your financial advisor, your tax advisor, your legal advisor as you go forward.

SPEAKER_00 24:02

Yeah, definitely. And I think a lot of business owners are attracted to the idea when they start the business of getting a decent revenue and income stream from their business. And is and it isn't until later that they realize, hey, there's actually something of value that when I retire, I want to be able to sell this. And again, maybe some people really just want that income during their working years. But you know, if you build a business the right way, hopefully you can have this wonderful exit plan and cash in on what you've built too. So getting all the pieces in place and thinking really long-term and not just year by year, how much money can I get out of this business is really key.

SPEAKER_01 24:48

It isn't and shouldn't be one or the other. I submit to you and I submit to your listeners that the businesses that navigate that tension the best, the ones that have that can generate both short-term revenue in the short term and lock that revenue in for the long term, aren't just going to be the more the the businesses that are valuable at sale. They're going to be the more successful businesses. So it's it's not only is it useful for your long-term exit planning to have these sorts of conversations and these sorts of plans up front, it's also going to make your business much better off in the short term. So there's sort of a wide range of advantages. And the idea is you do all this planning now so that it locks in place these roadmaps that you've built for yourself. That not only gives you the best approach as you go, but it also locks in your value on your exit. And so I talk a lot about exit planning. And I talk, and for someone just starting a business, saying the words exit plan might seem premature. So I want to stress that it's the exit plan is your ongoing plan. It's the same thoughts, the same things that it that gives you a stronger exit will make you a stronger business in the short term.

SPEAKER_00 26:02

Yeah, I think that's a really great point. So, Jordan, if someone is thinking about starting a business in the next year or two, what should they be doing right now?

SPEAKER_01 26:15

That's a great question. And and I want to stress, I think that's exactly the right time frame. So I think if you do want to start a business, that's I think the best frame to get all your ducks in a row. Don't think you're starting a business tomorrow. Get your plan in place. And it that whole journey takes probably about a year or two, even two years. Again, I think the first step is to review your existing obligations to your employer, to your lenders if you have lenders. You want to make sure that as you transition, you're not hamstrung by, you know, all of a sudden you can't compete with your current employer. Maybe you have to shift your geographic focus, or if you're shifting from one industry to another, that might solve the problem. Again, having legal input here is real important. You want to think through your ownership structure, your financing structure, and your personal exposure. I talked earlier about the importance and sort of the gold standard of limited liability. Lenders will frequently make you bypass that real fast by making you personally guarantee your startup financing. If I'm a bank, I'm giving you a loan. I'm going to say, well, I'm giving the loan to your LLC, so you're protected from it. But I'm also going to ask you to sign a personal guarantee so I can get around the limited liability structure. Now, that may well be the best option for you at the startup phase, but it does create risk. And so you want to balance those two items, your risk exposure, against the need for that money. And it may well be that that's the best option, or it may be that a better option would be to find an investor that can give you that startup capital, not for debt, but rather for a piece of that equity, right? So, you know, I'll buy in for $500,000. That gets you your startup capital, but I take a 20% interest in the business, something. And as you do that, you want to think about how you're locking in your customers and how you're locking in your clients on a long-term basis. What is it that you're actually selling? And how do you protect all up that value into a product that you can then sell on the outside? And again, that does two things. First, it locks in your customers. So you know you have a solid customer base as you go forward. That generates your income and your revenue as you go. But in the long term, it means that you can transfer that goodwill and you can transfer that value to a buyer. Both of those things need to be in place at the same time. That's why you want to have sort of template agreements built from the start. It's a service business, you want to have your template scope of service drafted and your service agreements drafted that not only protect you, but also build that value for the long term.

SPEAKER_00 29:04

Yes. And as a financial advisor, I just have to say if you haven't listened to my episode about building your financial fortress, it is super important to make sure that you have built up enough savings outside of your 401k and home equity to replace your current income until your business starts becoming not only profitable, but producing the level of income that your household depends on.

SPEAKER_01 29:31

Yeah, look, it certainly happens. And I certainly have clients who have some idea and can hit the ground running with a list of customers, with a product that can be manufactured and monetized immediately. That happens. It does tend to be, I think, the less common approach. And much more commonly, there is a lag time. And businesses take time to build and to become more mature. And you're in that sort of startup phase where maybe you're in the red for a while. That's the other reason why you need that year or so time period, not just to plan for the future on paper, but also to plan for the future in terms of building your war chest and building your, uh, I like the way you put it, the financial fortress.

SPEAKER_00 30:15

Yeah. And then, Jordan, I guess just sort of what is your final overall takeaway for listeners, especially because I'm sure there's so many people that are thinking, I just don't want to spend the money on an attorney because I want to put all of my money into my new business. And what can an attorney really do for me? So, what would be your message to our listeners on that?

SPEAKER_01 30:39

Think of a legal fee for a startup like an insurance policy. No one likes paying an insurance premium. But if something goes wrong, you're usually pretty glad you did. By the same token, legal planning is not just about lawsuits. It's not just about avoiding lawsuits, it's not just about handling lawsuits. It's about creating your options and protecting your downside risk right from the start. It's true, and I've said a couple of times during this conversation, nothing kills a business like a lawsuit. But the other piece of this, the other important part of this is you want to be able to build something the right way. It doesn't help you to build a business to spend years building a business only to find out you have no real value that you can transfer to another person. So having a lawyer on the front end creates that kind of value. And certainly for some types of advantages, for some types of business programs or things like I mentioned QSBS earlier. There's no way that anyone without legal training will can set that up for you appropriately. You got to think of a lot of those things as sort of traps for the unwary. If you don't do it exactly right, you lose huge benefits. And, you know, having a lawyer on the front end will protect those benefits for you. That's why it's a lot like an insurance policy. You have to think of that as a necessary cost. And you build that into your legal planning and you build it into your business planning. What you're creating affects your legal rights and affects the things that are that you're going to get. And having a lawyer to help navigate those waters is super important.

SPEAKER_00 32:08

Yeah. Thank you so much, Jordan. This was really helpful information again on all the stuff that people kind of don't really think about. They think about all of the other more exciting stuff about starting their own business. So really important advice here. Thank you so much for joining us.

SPEAKER_01 32:26

The the legal aspect is exciting to me, but freely admit I'm a giant nerd.

unknown 32:33

Okay.

SPEAKER_00 32:33

Thank you. Thank you, Jordan.