How To Launch a Startup and Avoid Ending-up in Jail

by Scott Edward Walker on June 23rd, 2011



I love working with startups and trying to protect founders (and watch their backs).  Not only are there key contractual issues that must be buttoned-down (like vesting and IP assignment), but also there is a minefield of laws and regulations that must be complied with.  Indeed, in a world of easy access to online documents and web sites like LegalZoom, it is often this legal compliance which is overlooked by founders, as they attempt to stay “lean” and “scrappy.”  As discussed below, however, non-compliance with certain laws and regulations could lead to founders’ criminal liability.

Potential Criminal Violations

Employment Laws.  The most common employment violations are (i) misclassifying an employee as an independent contractor and/or (ii) failing to pay an employee the minimum wage.  Both violations could lead to the same result: criminal liability for the failure to properly pay wages.

The key issue with respect to classification is control – the more control and supervision the startup exercises over the worker, the more likely he or she will be deemed an employee; for example, if a worker is required to show-up to the company offices at a certain time and work a certain number of hours every day under the supervision of the same company manager, it is unlikely the worker is an independent contractor.  And simply calling a worker a “consultant” or “independent contractor” in an agreement is irrelevant.

As I discussed in my recent post “How To Hire a Superstar Engineer for Your Startup,” startups may not give employees “sweat equity” in lieu of any ongoing cash payment/salary; nor may startups defer wages and other compensation.  In short, employees must be paid at least the applicable minimum wage (and typically, at least semi-monthly).

Moreover, as Chris Dixon reminded me, it is also unlawful for companies to hire illegal immigrants.  This is sometimes an overlooked issue for Web/tech startups — particularly those hiring engineers who are attending (or recently graduated from) a U.S. university.  Founders must insist on proper documentation prior to hiring foreigners (which is typically addressed in the offer letter).  And be forewarned: governmental audits of small businesses are clearly on the rise.

Privacy Laws.  It is imperative that startups have proper privacy policies in place and carefully adhere to them.  Needless to say, privacy has become a huge issue internationally and at the federal and state levels, and numerous hearings have been held in the U.S. Congress.  Indeed, Pandora disclosed in its recent IPO filing that it received a criminal subpoena in April “in connection with a federal grand jury…convened to investigate the information sharing processes of certain popular [smartphone] applications….”

Last year, three Google executives were held criminally liable in Italy for an online video of an autistic teenager being bullied – and they were given six-month suspended sentences.

Moreover, certain states have criminal libel laws for web defamation, which generally means posting false information about someone that defames them (such as marital infidelity, criminal activity, etc.)  Colorado state law, for example, makes criminal libel a felony carrying up to 18 months in prison and a fine up to $100,000 for the first offense.

Tax Laws.  One of the most common violations of tax laws by startups that could lead to the criminal liability of a founder is the willful failure to “pay over” payroll taxes withheld from employees.  For example, in January 2010, the U.S. Court of Appeals for the 10th Circuit affirmed the conviction and 37-month prison sentence of a business owner who failed to deposit withheld payroll taxes with the IRS.

Similarly, if a startup collects sales taxes from its customers and then fails to remit it to the applicable state taxing authority, founders could be charged with theft of state funds.

Obviously, the failure to pay applicable federal and/or state income taxes could lead to criminal liability.

Securities Laws.  Finally, a violation of applicable securities laws could result in criminal liability.  Some of the most common securities laws violations by startups are (i) making materially false or misleading statements in connection with the offer or sale of securities; (ii) retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) that offer and/or sell securities on a startup’s behalf for a commission; (iii) advertising, or improperly soliciting investors in connection with, the offer or sale of securities, including via email, Twitter or Facebook; and (iv) improperly offering and/or selling securities to “friends and family” who are not “accredited investors.”


This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat.  If you have any questions, feel free to call me directly at  415-979-9998 (San Francisco) or 310-288-6667 (Los Angeles).  Cheers, Scott


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