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Posted: April 18, 2011

Top 10 tips to avoid legal nightmares

No. 1: Never do business on a handshake!

Joanna Kitto

Our clients often joke, a little bitterly, that they are not "savvy" as a business person until they've gone through a litigation. Philosophical joking aside, you will certainly be more savvy about litigation, but you will also have emptier pockets and misplaced resources.

Many of our clients tell us they resent the lost time as much as the legal bills, where they had to spend time on document location and review, depositions, meetings and review of pleadings instead of spending time to grow or manage their business.

In my observation, new or emerging business owners can be a little cavalier with their contracting practices, but businesses that last take their contracts seriously. A good way to think about contracts is that contracts are preventative legal care for your business. Like preventative medical care, preventative legal care is well worth the time and effort.

My favorite anecdote regarding the "penny wise, pound foolish" approach to preventative legal care is the client who paid our firm about $2,000 to review a proposed real estate transaction. The client received a deal analysis and due diligence letter but refused to spend another hour or so to have counsel attend the closing.

That decision meant that, at the closing, money and signatures changed hands before due diligence was received and reviewed. Communications took place that resulted in our client being sued. In attempting to avoid less than $500 in preventative legal care, that client spent approximately $150,000 over the next two years in costs, experts and attorneys' fees to defend his life's assets from exposure in a shareholder and fraud dispute that was easily avoidable.

A good contract can prevent disagreements or control the cost of a dispute, because the contract provides certainty to all parties involved and minimizes the costs of disputes. Below are the top 10 things any business owner, but particularly new business owners, should keep in mind:

1. Don't do business on handshakes. Ever. My best and most profitable litigation clients are those that went into business with another party based on blind trust and a handshake. Later, when there was lots of money to fight about, or very little, the client belatedly tried to nail down the terms of a shareholder or member agreement.

In the very worst cases, I have seen the business partner who controls the bank account or brick and mortar space simply lock out the non-controlling party. There was nothing in writing to prove the ownership interest of the locked-out party other than circumstantial evidence. Unless you are ready to spend five or six figures seeking an injunction to get back into the business or force an accounting, don't put your time or money in until you have a written agreement that discusses management, percentage of ownership, voting rights, and how the relationship will end, among other things.

2. Understand your contracts! Are you ecstatic because your biggest client just handed you a contract to do more volume of work than you dreamed? Don't sign blindly! Make sure you understand and agree on work scope, timetables for deliverables, payment terms, limitations of liability and jurisdiction and other key terms, even if there is a disparity in bargaining power.

Many very smart business-owners are remiss in ensuring they really understand the "gotcha" provisions in a contract. Review the contract to make sure you know what the key issues are. If you don't understand the legalese, get help to understand it. You may enter into the contract anyway, or you may negotiate a few issues, or in some cases, you may walk away if the contractual burden is too onerous. But do so knowingly.

3. Detailed work scopes. One of the most commonly litigated disputes is often about what was within the scope of a contract, or not. When you fail to detail the work scope upfront, or to state what you need from your customer to do your job, or ignore the written change order process, you are asking for "he said/she said" disputes about what the expectations of the parties were. The important of a good work scope is equally applicable, whether to a consulting, services, construction or licensing transaction.

4. Your first lease (or second or tenth) is important. We are asked to review a lot of leases upfront, and quite a few after a dispute has arisen. It is much more affordable to understand your lease upfront, and further, a lease for a growing or new business can make or break the business.

What happens if your business falls off? What are your rights for sub-contracting? Are you a restaurant that will invest in building your business in a specific location for the next five years, but have no renewal rights? Did you agree to pay all costs of upgrades to your space, but now the City is requiring, while the walls are opened, $100,000 of unanticipated upgrades to the entire building, and you are required to pay that?

How about the reverse? You are a landlord and your tenant opens up walls, and the lease says you have to pay for the unanticipated upgrades. What does your lease say about assignment rights? As a landlord, have you thought about how you will feel if your tenant decides to assign their lease to someone you don't know or with a business model to which you object? Wouldn't you rather contractually retain approval over such issues. Lease terms can simply be critical to either a commercial landlord or tenant.
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5. Have contracts with commissioned employees. Some emerging business owners are hiring sales staff so quickly that there is no time, they believe, for written contracts. Or they grab some work product better suited for a different business, or that is 10 years old. That can be a mistake - as one of the most common and expensive disputes for your business is commissions, especially for employees or contractors who leave before the commission is fully earned or collected.

Silence in the contract or lack of detail as to what happens to such commissions is fodder for an expensive dispute. The Colorado Wage Claim Act may allow your commissioned employee to collect attorneys' fees from you, which can be significant, even if the amount involved is de minimus. If your contract has enough detail, your sales force knows what to expect and disputes about commissions will be resolved quickly and affordably.

6. Have contracts with employees to protect your company/trade secrets/clients! Another common area of dispute is how sensitive information to which an employee or contractor has been exposed while at your company, or non-compete agreements. How will you feel if your star employee leaves to go to a competitor or start their own business using information in which YOU invested?

Certainly, you do not want your competitors to know about your customer lists, business methods or sensitive marketing or pricing plans. A contract can contain protections that result in post-employment obligations for your employees and protect your business' trade secret information. Further, certain, limited non-compete provisions can be enforceable against various levels of employees, if properly drafted. Be sure to inform prospective employees of such requirements at the time of offer, and convey the agreement then.

The Colorado Supreme Court has recently held that an employer who asks employees to sign agreements mid-employment may not have a valid contract, if there was no additional consideration for such agreement. Continued employment is no longer viewed as sufficient consideration.

7. Have contracts with outside contractors to protect your intellectual property. Does your business, whether in the arts or technology space, depend on commercializing your intellectual property? Did you that if you are a film-maker and you hire various outside contractors to assist you in making your critically-acclaimed film, absent a contract, those contractors can later claim ownership of your film?

Did you know that your failure to contractually nail down IP ownership might later lead to refusals of other parties to distribute your project, no matter how commercially viable it is? Protect your IP with a contract that specifies work for hire arrangements!

8. A good contract can limit your liability. Did you just agree to provide services for $10,000? Would you like to be later sued for millions of dollars in consequential damages if there is a breach of contract suit, even though you only earned a fraction of that amount? A good contract can operate to prevent claims for consequential damages or limit liability to amount of services received. Conversely, if your contract has extreme consequences, the right drafting can ensure that all damages may be claimed or that time is of the essence clauses are incorporated.

9. Dispute Resolution Mechanisms. Did you just sign an agreement agreeing to arbitrate any disputes? Do you know what that may mean if you need to assert a claim to collect $100,000 from a customer? That means, you just agreed to pay an arbiter hundreds of dollars per hour, and to pay room charges, and costs for the next several years.

You may have just agreed to a cost structure that is incredibly cost-prohibitive except in the event of multi-million dollar disputes. Alternative dispute resolution can be very good and can reduce costs in the right situation. However, for some businesses or transactions, free access to our court system, with a few filing fees, is critical.

10. Out of State Customers and Disputes. So you just landed a great client in Dallas, and you scrawled your signature across the contract sent because the work scope looked fine. Did you just agree to be governed by Texas law and subject to the Texas court's jurisdiction if you have a dispute? Are you prepared to retain Texas counsel and fly to Dallas numerous times for court hearings and depositions if the client does not pay?

Businesses of all sizes increasingly do all kinds of work across state borders. If that is the case for your business, make sure you nail down that you want disputes heard in Colorado and or what law controls. Unless the other state has more favorable laws for some reason, or your business has the resources to collect debts in other states, you do not want to be in the business of litigating disputes in other states.

In conclusion, smart business owners that last don't denigrate contracts; they endeavor to learn about contracts and how to use good contracting practices as a tool in their business. Savvy business owners educate themselves and their sales force to issue-spot, so they understand the transaction at hand and to get help if they do not. Such preventative legal care is critical to the long-term success of your business.
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Joanna Kitto is an attorney and partner in the business law firm of Ambroziak Kitto, LLC. More information can be obtained at www.ambroziak-kitto.com or from her at jo@ambroziak-kitto.com.

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Readers Respond

Joanna, Excellent, thorough and well written [except for the slam on arbitration]. Great job. By Doug Foote on 2011 04 18

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