12 Common legal mistakes new startups makes

Starting a new business involves making quick decisions. Mistakes are common, but legal mistakes are usually harder to fix and can have serious and long-term consequences. They can cost your business money, drain time and resources, trigger disputes, and harm your reputation.

Many common legal mistakes are preventable. They often arise when agreements are not recorded in writing, records are kept poorly, or legal requirements are ignored. Contracts, share ownership records, and intellectual property protection may not seem urgent at first, but early mistakes in these areas can later lead to problems, including investor concerns, legal penalties, or court actions. Prioritising a strong legal foundation can help you avoid mistakes from the outset.

This guide explores 12 startup legal pitfalls UK businesses face, why they matter, and legal tips for startups to avoid risk.

• How to start a business in the UK
• Questions to ask before starting a business: Are you ready?
• Company shares for startups

1. Relying on verbal agreements instead of written contracts

Relying on verbal agreements instead of written contracts is a common legal pitfall for cost-conscious UK startups.

Although verbal agreements can be legally binding in the UK, they are harder to prove and enforce. Verbal agreements can lead to disputes about what was agreed – such as payment terms or whether you fulfilled your obligations. Sometimes, written terms are legally mandatory – such as when you need specific terms to comply with data protection laws.

Your financial risk may increase without written contracts. You may miss key protections, such as clauses that limit your financial liability for breaching a contract, leaving you potentially exposed to uncapped liability if a dispute arises.

Written contracts also bring clarity and show professionalism at the startup stage, showing customers, suppliers, and investors that your business is well-managed and credible.

To reduce risk:

• Use clear, written contract terms when working with customers, suppliers, or partners
• Use written contracts for both small and large projects
• Make sure your contracts are correctly tailored, include key legal protections, and mitigate the risks you face

2. Choosing the wrong business structure

Choosing the wrong business structure is a common mistake. Your business structure can affect your tax position, liability, administrative duties, public perception, and ability to raise investment. Founders might choose the easiest route to trading, rather than what’s right for their long-term needs.

In the UK, business options include a sole trader, general partnership, limited company, and limited liability partnership (LLP). Each works differently with pros and cons. For example, as a sole trader, you may be personally responsible for business debts. In a general partnership, you could also be liable for the debts of another partner. A limited company or LLP has a separate legal personality from its owners, but comes with more legal duties and filing requirements. Different structures are also taxed in separate ways, which can affect how profits are handled.

The structure you choose can affect credibility and funding. Investors and lenders often prefer limited companies, as ownership and control are clearer and investment is easier to structure.

Don’t choose a structure just because it’s quick to set up. Consider liability, tax, compliance duties, investment plans and long-term ownership considerations when making your decision.

A limited company is the UK’s most commonly used business vehicle, which provides limited liability protection, broadens access to investment opportunities, and can enhance your business credibility. 1st Formations offers company formation services to support startups with the company formation process and related compliance duties, offering expert support to get your company up and running with ease.

3. Bringing on a co-founder without clear agreements

Starting a business with a co-founder without agreeing on key terms in writing is a big mistake. It can leave business ownership, control, and money issues unclear as the business grows. Startup founders often rely on trust and overlook these agreements, particularly with friends and family.

Without clear written terms, disputes can arise over voting rights, equity, profit shares, decision-making, and exit rights. In serious cases, disagreements can cause deadlocks, hinder investment, or damage the business.

Make sure you agree on key terms with your co-founders in writing before any money changes hands, or the business begins to grow.

Your written agreement should cover:

• Ownership
• Vesting of shares
• Voting rights
• Responsibilities
• Time commitments
• Major decisions
• What happens if a founder leaves, becomes seriously ill or dies
• Co-founder disagreements
• What happens if a founder wants to sell their stake.

For companies, these issues are often addressed in a founders’ agreement and later a shareholders’ agreement. For partnerships and LLPs, you can use a partnership or LLP agreement.

Freddie-Nicolle Brace, Head of Legal at 1st Formations, says:

A well-drafted, written founders’ agreement can act as a strong framework for the running of your business, planning ahead and preventing disagreements. By documenting clear rules, co-founders can stay aligned and avoid disputes if things don’t go as planned.

4. Not understanding how shares work

A common mistake is issuing shares to investors, advisers, or team members without understanding how this affects ownership of the company, voting rights, and future fundraising.

Issuing shares means creating and allocating new shares in the company. Founders often do this because they want investment or to incentivise early team members but may not understand the impact.

Dilution is the key risk. When new shares are issued, existing shareholders usually keep the same number of shares but end up owning a smaller percentage of the company. For example, if a founder brings on an investor, gaining new shares, the founder’s percentage stake, dividend entitlement, and voting influence may be reduced, even though their number of shares doesn’t change.

Dilution isn’t the only consideration. Different voting, dividend, or capital rights attached to share classes can affect who controls key decisions, and whether future investors are comfortable with the company’s structure.

Getting this wrong can lead to:

• Tax issues
• Shareholder disputes
• Ownership uncertainty
• Loss of founder control
• A share structure that risks future investment

Before issuing shares, founders should take legal advice and check the share dilution and fundraising impact.

5. Confusing share transfers with share issuances

A common startup mistake is treating a ‘share transfer’ and a ‘share issue’ as the same thing. Founders might see both as giving someone shares, but the legal and financial outcome is very different.

This matters when bringing in investors, as the route chosen impacts who receives money and whether existing shareholders are diluted.

A share issue creates new shares in the company. The investor pays for those shares, and that money usually goes into the business. This is a key tool for raising investment but alters a company’s ownership structure and can dilute existing shareholders.

A share transfer moves ownership of shares which already exist from one person to another, often in return for money. This can allow an existing shareholder to sell their shares and exit the business. The company does not create any new shares, and its share capital doesn’t increase, but there can be potential tax implications.

It’s important to consider the correct route, depending on your business objectives and structure.

The legal steps to carry out share issues and transfers are also different. Before agreeing to any share transaction, founders should take appropriate legal and tax advice to understand the implications and prevent any risks.

6. Neglecting intellectual property protection

Neglecting intellectual property (IP) protection is a risky mistake, as IP can be one of a startup’s most valuable assets.

IP rights can exist in your brand name, logo, slogans, website content, software, product designs, images, and written materials.

Common mistakes include:

• Not registering key trade marks early.
• Choosing a name or logo that’s too similar to someone else’s registered trade mark.
• Failing to make sure your company owns work created by non-employees.

A trade mark problem can lead to disputes, legal costs, or an expensive forced rebrand.

Your company will generally own certain IP created by an employee in the course of their employment. In contrast, paying a freelancer, contractor or external supplier doesn’t mean the company owns the IP they create. They’ll usually keep ownership of the IP they create, unless they sign a written agreement that transfers relevant IP rights they’ve created to your business. IP created by founders may also still belong to them personally if they created it before the company existed or outside of their employment.

Founders should carefully audit IP from the start, check who created each IP asset, and make sure contracts clearly transfer ownership of work created to the company.

7. Getting employment law wrong when hiring

Hiring fast without considering employment law rules is a common startup mistake.

Before your first staff hire or contractor engagement, check employment status. This means checking whether the individual working for your business should be treated as an employee, worker or self-employed contractor.

Status matters because it determines the individual’s rights, your responsibilities, and the level of risk.

Broadly, employees have the most employment law rights, work under your control and are usually heavily integrated into your business.

Workers have some rights, but self-employed contractors have minimal rights and operate as independent businesses (either delivering services as sole traders or through a company). An individual may be an employee, worker, or self-employed contractor – but their contract label won’t determine their status. The actual working relationship matters. HMRC and employment tribunals can look beyond contract wording and labels and consider what happens in practice to prevent “disguised employment” (where someone is treated as self-employed although the relationship is really one of employment).

To check someone’s employment status, you’ll need to look at factors including:

• Who decides when, where and how they work?
• Can they say no to work and work for other clients?
• Can a substitute do their work, or do they have to deliver it themselves?
• Will you manage them and treat them as a part of your team?

Misclassifying someone with the wrong employment status can be a serious and costly mistake. You may face claims for holiday pay, sick pay, minimum wage, tax, National Insurance, penalties, or tribunal claims.

If a contractor works through an intermediary (such as a personal service company), you also need to consider tax rules known as the “IR35” rules). The purpose of these rules is to prevent the avoidance or reduction of tax and National Insurance Contributions by having a contractor use an intermediary (i.e. a company) between them and the client (your business). If the contractor arrangements are found to operate “inside IR35”, that contractor needs to be taxed as if they were an employee.

Remember: Before employing someone, check their right to work in the UK and keep evidence.

• Employees and workers must receive a written statement of employment particulars. This is a document which summarises the key terms of employment (including working hours and pay) and must be provided on or before the first day of work. Employers usually meet this requirement by providing these details within an employment contract.
• If you become an employer, you will usually need Employers’ Liability insurance and will need to operate PAYE.

To reduce risk, make sure you take legal or HR advice on your employment law position and obligations if you’re unsure.

8. Overlooking ongoing company compliance obligations

Compliance rules carry on after a limited company is set up, but many startups underestimate or neglect their duties. Directors stay responsible for preparing and sending mandatory company documents on time.

Every UK limited company must file annual accounts and a Confirmation Statement with Companies House. It must also let Companies House know when important details change, including directors, company officers or their details, the registered office, share capital, or person with significant control (PSC) information.

There are also tax duties, which include registering for Corporation Tax where required, filing Company Tax Returns, and paying tax on time.

Companies must also keep an accurate internal register of members.

If you neglect these duties, your company may face:

• Penalties
• Rejected filings
• Strike-off
• Fines
• Criminal liability

Poor filing compliance can also make it harder to raise investment.

Rules can change, so founders should keep on top of their duties and take legal advice if they’re unsure. In particular, the Economic Crime and Corporate Transparency Act 2023 has given Companies House stronger powers to query or reject company filings and has introduced identity verification requirements for directors and PSCs.

9. Issuing shares with too high share capital

Another common startup mistake is creating more share capital than needed (particularly where shares have a very high nominal value and are not fully paid).

In a UK company limited by shares, a shareholder’s liability is generally limited to the amount unpaid on the shares they hold.

Every share has a nominal value. If a shareholder hasn’t paid for their shares in full, they may later be required to pay the outstanding amount. For instance, a shareholder with 100 unpaid £1 shares may later be required to pay £100.

If a company creates more share capital than it needs by issuing shares with a very high nominal value (and leaves those shares unpaid or partly paid) the shareholders might inadvertently expose themselves to much greater liability than they intended.

This is because although a limited company provides protection against personal liability for the company’s debts, shareholders may still need to pay the amount left unpaid on their shares.

In practice, this means that an unnecessarily large amount of unpaid share capital can reduce the practical benefit of limited liability, by increasing the amount shareholders may be required to pay and creating financial exposure they might not expect.

To avoid this risk, founders should be careful when deciding on the value of the shares they issue and take legal and tax advice as needed.

10. Poor record-keeping

Poor record-keeping is a common mistake where founders are time-poor and neglect their paperwork. However, the consequences can be serious.

Missing or inaccurate records can make it unclear who owns the shares in a company, what business decisions were made, and if those decisions were properly approved. Poor records can also lead to disputes, HMRC enquiries, and compliance risks. They can create problems when raising investment, too, as investors will often review the company’s records as part of due diligence in funding rounds. Missing key information can delay a deal, reduce investor confidence, or result in less favourable investment terms.

To avoid this, put strong record-keeping systems in place from the start.

Keep the following documents:

• Financial records
• Employee contracts
• Records of right to work checks for employees
• A register of members
• Company formation documents
• Contracts, board minutes
• Resolutions
• Up-to-date Companies House filings.

Make sure your records are well organised and easy to find and allocate internal responsibility for recordkeeping.

Good record-keeping can help your business run smoothly, support better decision-making, and make the company appear more credible, investment-ready and easier to scale.

11. Ignoring data protection rules

Ignoring data protection rules is a common legal mistake businesses make who collect personal data from individuals such as customers, staff, or website users. Many founders may not understand their duties, but data protection law applies as soon as you start using common personal information like names, email addresses, or telephone numbers.

Failing to comply can lead to complaints, regulatory investigations, penalties, including fines, and loss of trust.

It can also cause problems during investor due diligence, as data privacy is increasingly important and treated as a risk factor when assessing a business for investment.

Data protection affects day-to-day operations, and poor data management can also lead to greater risks of cyber or data breaches, which can be heavily time-consuming and expensive to fix.

To reduce risk, be clear about what personal data you collect, why you collect it, where it is stored, who can access it, and how long you keep it. Regularly review your use of personal information and take legal advice on your data protection compliance obligations, as legal duties are not one-size-fits-all and depend on how you use personal data in practice. Remember that if you’re a data controller (i.e. your business controls the personal data you use), you’ll also need to register with the ICO (the UK’s data protection regulator) and pay an annual data protection fee, unless very limited exemptions apply. You can be fined if you fail to do this where required.

12. Using AI or DIY legal documents carelessly

In the age of AI, many startups now rely on AI-generated or DIY legal documents without properly checking them or their accuracy. Though AI tools and free templates can save time and money, their outputs are often generic and unlikely to reflect how your business operates or delivers its services.

Critical legal terms may be missing, wrong or poorly drafted, including payment terms, liability clauses, and intellectual property ownership terms. These issues may not become clear until a dispute arises, an investor reviews the business or a regulatory risk emerges.

AI tools also bring extra risks. For instance, content may be inaccurate or out of date. It could also closely resemble existing material, which can create copyright concerns and potential reputational damage.

You may also use AI terms that don’t reflect your commercial arrangements or comply with legal requirements relevant to your business.

To reduce risk, ensure your legal documents are properly drafted and tailored. If you do use AI or templates, review them carefully and take legal advice to check if they’re accurate, suitable and legally correct. Our legally reviewed Business Document Template Library offers access to a range of valuable startup documents, including an NDA, Cookie Policy and Consultant Agreement.

Starting your business with a strong legal foundation

Many of the legal mistakes startups make are avoidable. Investing early in strong legal foundations can help you reduce risk, support scalable growth, and make your business more trustworthy and attractive to customers, investors, lenders, and commercial partners. Explore our Hassle-Free Compliance Service to start your business journey on the right track.

Disclaimer

The information in this article is provided for general information. The law and guidance may change. If you’re unsure, you should obtain advice on your specific circumstances from a suitably qualified solicitor.