Startup Law 101 Series – Mistakes Founders Make – Misusing Form Contracts

Ours is an era in which legal forms proliferate and many entrepreneurs are tempted to use them without much thought given to customizing them for the specifics of their deal.

This is a mistake.

The unthinking use of legal templates assumes that the law is a mechanical process, as capable of simplification as is the process of selling widgets. The thinking goes something like this: You find a widget on the web. You buy it for a cheap price. You use it. Hence, no need for those middlemen lawyers who charge a lot for pulling the identical widget out of their drawer and handing it to you with their bill.

There are some partial truths here. Some contract situations are utterly routine. And lawyers sometimes have abused entrepreneurs by keeping them in the dark while running up billings in simple situations. It does not follow, however, that contracts are merely widget-like and interchangeable units that anybody can use in plug-and-play fashion.

In reality, the law is a slippery beast, one that seems to defy simplification. David Dudley Field made a famous effort to simplify California’s laws in the 1870s. The most educated men of that era consciously set about to take all of California’s laws and make them so simple that even the least educated person could understand them. The result — a world-class belly flop. The judges took the simplified new layer of laws embodied in the Field Codes, wove them into a complex system of legal interpretation, and — voila! — California emerged with the most complex set of laws in the nation.

Why does this happen? Why does law so stubbornly defy being reduced to a system of unthinking application that is easy to understand and administer?

Because, like it or not, law is designed to regulate human affairs that are themselves complex. And it cannot do this effectively unless it is customized to the situations at hand. This is why judges decide issues case by case. It is why law has so many localized variations. It is why a canned contract, beautifully drafted though it may be, will ill serve the parties who adopt it without thinking through its implications.

Again, like it or not, business and corporate law is complicated. So too is intellectual property law. And tax law. And securities law. And licensing law. And distribution law. And property law. And all other forms of contract and commercial law. Have you ever tried to deal with an unsecured debenture? Or a revisionary interest? Or with any other of thousands of bizarre-sounding legal concepts that seem to float in and about the law that surrounds businesses and corporations? Yes, you may be familiar, from your practical experience, with what FOB means as a commercial shipping term. Or with what an “implied warranty of merchantability” means. But take such terms, multiply them by the thousands, put them in an unfamiliar context, and what do you get? You get a web of legal terms of art, each of which has a specific meaning only when understood within a complex legal context.

This is much more than the case of a lawyer trying to spread so-called “fear, uncertainty, and doubt” in an illegitimate manner. This is the reality of law trying to comprehend and regulate complex affairs that do not lend themselves to simplification when considered as a whole.

Therefore, contract and commercial law is highly complicated and does not lend itself to thoughtless application. If it were only a matter of filling in the names, for example, on a partnership agreement, then anyone starting a business could go to a stationery store (the old way) or go to a forms download site (the new), buy a canned partnership agreement, fill in the names, and be done with it. This is normally an unwise way to form a company. Such a boilerplate form may have nothing to do with the nature of the business being set up by the parties. It may have language in it that has no bearing on their deal and that will only confuse them and everyone else concerning what was intended by their deal. Worse, it will not expressly set forth the nature of their deal to make clear what they intend in their contract. Such a contract is an open invitation to litigation should anything go wrong in the deal between such parties. Perhaps tens or even hundreds of thousands of dollars will be spent hashing and re-hashing ad nauseam what they intended when they “agreed” to badly-worded boilerplate. If you have ever had the misfortune to suffer this fate, you will never again resort to such corner-cutting in documenting the affairs of your startup business or small business.

All but the simplest of contracts need to be reviewed carefully by someone with a discerning eye and also need to be understood in their full legal context. A contract review, of course, can be done by a smart lay person using self-help resources. And some people are inclined to invest time and effort for that purpose in a way that helps them manage their legal budgets more carefully because they pick up a lot of the burden themselves. But it is a burden, and it has a cost attached to it – there is always a cost-benefit component to any such effort. What is worse, many people do not do a good job of thinking through the issues and wind up cutting corners. A contract in their hands can be like a loaded gun in the hands of a six-year old — wildly unpredictable and sometimes dangerous results can follow.

Moreover, context is critical. What seems placid on the surface can hide legal turbulence beneath. Sell stock to investors with a simple purchase agreement. Fine. I sell. You buy. Then, later, you find you did not comply with securities laws. Or that your buyer gets a large taxable gain for having contributed intangible assets for his stock. Or that your deal violated someone else’s rights in the company that restricted such sales. Yes, lawyers can and do sometimes spin such issues out needlessly. But such issues can and do exist in many cases. When you use a boilerplate form, you need to see beyond its apparently simple boundaries to understand how it functions legally in its broader context. Otherwise, you might step into trouble without having the slightest idea that you are doing so.

So, can you as an entrepreneur use boilerplate forms with impunity without fully understanding them and without understanding their context? In some cases, yes. You need a simple promissory note, and the generic one fits your needs without too many risks of getting legally blind-sided in a simple transaction. You need a canned nda for your employees and you have a form you had used in a prior company — the type of form that has remained pretty constant over many years of use. This can work for you and, even when there are potential technical problems with the documents you are using, the problems may never arise in your particular situation.

For every case where entrepreneurs either can or do get away with it, though, there are all too many situations in which their attempts to do so prove ill-advised. Flying blind does have its limits, after all.

Bad business lawyers are lawyers that simply take forms and switch the names without giving thought to the nature of the deal before them. Bad as this may be, at least such lawyers have a modicum of legal education and experience to be able to spot some of the legal issues and some of the potential traps.

The same cannot be said for an entrepreneur trying to do the same thing but without the benefit of a legal education or legal training. This then is the worst of all cases. Don’t put yourself in this situation.

The issue gets confused when the entrepreneur will have had significant exposure to certain types of legal documentation, as for example in the case of one who managed the contracts of a large company in an executive capacity while working under the guidance of skilled lawyers. In such cases, someone who has had a lot of practical experience with a particular class of contracts is often far more aware of their ins and outs than are non-specialist lawyers who have not dealt much with such contracts.

This is true as well of the seasoned entrepreneur who has developed such a strong working knowledge of business deals as to be able to run rings around certainly any green business lawyer who attempts to work on such deals.

While all this is true, it simply means that law has a practical side as well as a theoretical one, and any smart person who has worked through complex legal deals often enough will come away from that experience with some excellent skills applicable to such deals. Serial entrepreneurs, contract managers, and others with like experience fit this mold.

This only confirms, however, why it is ill-advised for an entrepreneur to try to do business by using legal forms unthinkingly. The seasoned entrepreneur, the skilled contract manager, etc. may not be business lawyers but do have the vast experience to be able to think their way carefully through a complex contract. Even then, such persons will attest that they ultimately need their deals reviewed by a skilled business attorney. Though they may be able to drive a deal more efficiently owing to their experience, they themselves know this is no substitute for using the services of a lawyer who is an expert in their field.

The operative word is “think.” A good business lawyer will think carefully about any given deal and will customize any contract for the commercial situation at hand. A seasoned entrepreneur will do the same within the limits of a layman’s knowledge in a technical field. An entrepreneur using good legal self-help resources will similarly think through the issues carefully within the limits that such resources enable.

It is the unthinking use of boilerplate forms that does not cut it. Use of boilerplate forms without the requisite training, experience, and education does not give an entrepreneur any basis for thinking through a deal to spot the issues and potential trouble spots. Don’t use boilerplate forms mindlessly. In the end, it may cost you dearly.