Top 8 Legal Areas Every Start-up Must Cover
February 24, 2020880 views0 comments
By Afolake Lawal
We have the privilege of regularly advising start-ups, small and medium enterprises (SMEs) on business decisions and corporate actions, and in the course of these engagements we are presented with varying challenges, data and numbers that paint a picture of the prospects of a company – whether for the good or bad. Oftentimes, these challenges do not capture the underlying issues a business faces, as it is taken for granted that you can all but cure business ills by waivers. At other times, there is just little understanding on what to do next in a way that makes it difficult to sustain the health of the business.
As a result, we have compiled a list of frequently occurring business issues that require utmost attention by start-ups, SMEs and those affiliated with them. A number of businesses may already be aware of these issues, but there is a difference between consciousness and action. Ultimately, the impact of these issues is business-specific, and there is no telling when an entity will be brought to its knees by not proactively mitigating its challenges. For the mindful investor, business manager and employee, the preservation of wealth and value is enough to compel progressive action.
Partners or founders: A common occurrence in most startups and SMEs with one or more founders is the absence of clearly defined roles and responsibilities, such as whether a founder is merely a business partner as opposed to a founder/promoter of the company – a distinction that is lost to most businesses. This lack of clarity regarding roles and responsibilities plays out in different ways, from day-to-day operations, to decision-making process, dispute resolution, ownership stakes, and exit process; and is generally traceable to the flexibility and freedom culture that is inherent in most startups’ work environment. While that free-spirited attitude to business can provide a boost to morale, it is often the cause of so much clash and resentment between founders, with attendant negative effects like overlapping responsibilities, non-recognizable chain of command, shirking of responsibilities, as well as uncertainty amongst employees.
It is typical for the business to turn a blind eye to most transgressions under the guise of friendship until large cracks form that can prove fatal to the harmonious functioning of the business.
Controls and governance: Allied to the lack of clarity is the tendency for startups and MSMEs to have little to no controls or governance processes, often resorting to actions “on the fly”. Amongst the myriad of reasons adduced, the need to stifle bureaucracy and time pressure to institute essential governance features stand out. While the former motivation is laudable, the latter is primarily a recipe for disaster, as it merely heightens the effect of existing risks in the business; and since the absence of controls and governance means the absence of accountability or reporting structures, businesses end up in dire straits. Where, for example, key-man risk exists in a business, it means all corporate decisions are routed through one individual, who invariably builds a personality cult, and coupled with the absence of governance processes, it means the key individual in the organization can take actions without appropriate checks regulating those actions.
What to do:
• Formalize existing relationship between the founders
• Agree on and write out each founder’s role and responsibilities
• Create a mechanism for resolving disputes between founders
• Create a mechanism for founder exits
• Build out minimum governance and controls processes
2. Human capital:
Employee relations/status: Human resource and employee relations are a thorny issue for business owners and employees alike. The one class seeks a higher return on human capital vis a vis the cost of acquisition, while the other seeks commensurate remuneration for services rendered; and unless incentives are properly aligned, the price of a wrong match can outweigh the benefits of an employment. Employee relations are purely contractual relationships, and apart from compliance with minimum wage laws, pension contributions and other statutory levies on employers, parties can contract freely.
In certain situations, companies may utilize the services of independent contractors or interns instead of engaging full-time workers, and here the motivation is the reduction of staff overheads. At other times, the use of an outsourcing agency to perform non-core business functions may become expedient. In all cases, a number of companies fail to properly document these relationships, and simply rely on email communications or text messages as the basis of a contract. Needless to say, when issues surface, they are mostly undocumented conditions or obligations, such as where an employer decides to unilaterally change the nature of independent contractor’s engagement on account of “changing business needs”.
Human resource policies are sometimes an afterthought in most companies, and this can be attributable to the reality that most startups primarily focus on revenue generating activities. Yet human resources policies set the tone for work culture, expected conduct and productivity. At the least, startups and MSMEs should have in place minimum policies that govern business ethic, disciplinary process, health and safety, workplace misconduct and harassments, compensation and benefits, learning and development, company leave, suspension, redundancy or termination of employment.
What to do:
• Provide employment contracts for employees
• Classify independent contractors and unpaid interns properly
• Formalize relationship with independent contractors or staffing agencies
• Put in place minimum human resource policies and standards
3. Business Structure:
Partnership vs Corporation: When deciding on a business entity structure, the choice is frequently between a partnership versus a corporation. As with all things, this choice will have important implications for both the legal and tax risks of the business, as well as the ownership structure. The key difference between the partnership structure and a corporation is in relation to liability for the debts of the business entity: so that under a partnership structure, the debts and outstanding obligations are personal to the promoters of the partnership; but in a corporation, they remain the debts and obligations of the corporation. For start-ups, the general rule should be to minimize any exposure to personal liability of the founders/promoters and ensure that all business activities are performed by the business entity, and not by an individual founder.
From the outset, the choice of business structure should primarily be guided by the entity that best supports the founders and business’ goals from a legal, tax, growth and capital standpoint. This will also serve as a buffer in the event of a future change in business structure. Thus, while it may be prudent to establish a partnership if the business is one to be carried out on a small scale with little capital; a business with far-reaching goals will be best served by being established as a company.
What to do:
• Avoid exposure of founders to personal liability
• Perform a business formation assessment
4. Business Assets:
Protection of intellectual property: Very few start-ups set out to build a business which in a few years will be brought low on account of challenges pertaining to intellectual property (IP), yet this is a familiar tale in start-up wonderland. Tales of woe regarding IP theft, sale, exposure or disclosure of IP, trade secret and customer data to competitors or third parties, non-registration or renewal of rights in IP, non-assignment or license or IP rights make for a founder’s nightmare. The implications are numerous: lawsuits, loss of revenue, loss of reputation, loss of customers, business dilution, distrust, and even bankruptcy. A recent example involved a client whose director was registering and transferring company IP to his personal name, effectively using company IP as a bargaining chip to demand higher salary.
When scenarios like the above occur, they are often the result of the business’ failure to account and plan for the remoteness of such operational and strategic risks. Where a start-up develops a unique product, technology, or service, appropriate steps to protect the exploitation of the IP must be taken. In the same vein, the business has a similar responsibility to avoid infringing on the intellectual property rights of third parties by regularly auditing its IP portfolio and its engineering/product development processes. The common protective measures undertaken by start-ups will typically include patents, copyrights, trademarks and the utilization of IP contracts such as licensing agreements, assignment agreements, non-disclosure and non-compete agreements. Due to the technicality of this field, businesses are best served by working with expert advisers in order to secure their competitive edge.
What to do:
• Develop a comprehensive IP strategy
• Execute non-compete contracts with employees
• Execute IP assignment and license contracts with employees and founders
• Maintain a database of IP assets & register IP
• Audit product development processes
• Obtain clearances and rights to third party IP
As one of our partners who recently completed a due diligence exercise on a N200million seed funding investment for a client observes, this is more or less a health check at the hospital. Check weight, height, sight, hearing, internals, reflex and then compare to previous report cards to make sure things are all right before you plunge deeper. Finally, great businesses make educated, balanced decisions founded on sound corporate governance structures. Such structures can only stem from a repository of sound legal and business knowledge.
In part one above, we shared some essential tips for business decision-makers to use in addressing issues that usually surround start-ups and SMEs. These tips are not just about quick fixes or short-term improvements, but they go to the core of wealth creation, preservation and sustainability of any business entity. So, with thanks to our web audience who gave their valuable feedback on our previous post, here are other issues that we equally consider important to you and your business and some suggestions for you to handle them.
Outside investors: Do you opt for outside investors or friends and family? The importance of capital to the existence and subsistence of any business endeavor cannot be overstated. However, in the bid to raise capital, a founder’s relatively limited experience can lead to misjudgment about what amounts to an appropriate funding mechanism, and at what stage in the lifecycle of the company, a certain type of investor is required. In general, identification of product-market fit is a good estimate of when to approach outside investors.
Outside investors for startups fall into 3 main categories: angel investors, venture capitalists and strategic investors. Regardless of the legal nomenclature, they provide capital to cover a runway period of about 18 months in return for a seat at the table and the guarantee of a liquidity event for their capital.
The challenge for founders arises from the inability to navigate the terms and demands of this category of investors, which terms predominantly revolve around minimizing loss of capital and control by the investor. Viewed from a different light, the investors’ demands counterbalance the founder’s natural instincts for free rein and autonomy.
It is not unusual for founders to be shocked by investor demands like board seat, voting rights, transfer restrictions, preemptive rights and other investor rights and negative covenants. This often leads to disagreements and power tussles to the point that pre-agreed terms either fall apart or deals are negotiated that put the founder at a serious disadvantage. In many cases, these negotiations commenced or concluded without the engagement of experienced advisers by the founders in question.
What to do:
• Determine the source of capital for the company
• Engage experienced advisers in negotiations with outside investors
• Scrutinize investor term sheets and transaction documents
• Don’t be afraid to ask for clarification
2. Business Relationships & Transactions:
Documentation: Is an oral agreement with a business partner a cost effective (and time-efficient) alternative to the documentation of a business transaction? This question represents the primary consideration for founders and managers of startups in contracting for the supply of services or the acquisition of new customers. Commonly, this consideration is based on some assumptions, the first being that the business relationship or transaction is of little economic consequence and future relevance that it is not worth “sweating the small stuff!” With this and other assumptions relating to contract timing, performance, contract deliverables, risk allocation, dispute resolution and escalation and, the nature of the business relationship, the tendency is to pursue “handshake agreements” over email or phone, and without subsequent documentation.
Again, in the quest for speed and minimalism, founders and business managers waive or set aside business terms or requirements on the belief that closing a deal is more important than risk allocation and mitigation. However, in more than one instance, founders and their respective companies have been caught in an embarrassing position where they omitted protection under certain contractual obligations even though the risk was foreseen. This is typically the case with tech startups that omit disclaimers and limitation of liability provisions from their contracts under the guise of being accommodating. In this case, as in most other situations, the aphorism remains valid: whatever is not being negotiated is a risk a party is willing to bear.
What to do:
• Document even the most basic business relationships and commercial transactions
• Create a risk register for the company’s business transactions
• Maintain a portfolio of standard business contracts and terms
Lawyers not needed: Startups and SMEs are usually concerned about expenses, and this concern is demonstrably apparent in the non-utilization of legal counsel for business dealings. Here, the thinking is that the value of experienced counsel is not commensurate with the cost of engagement. At other times, operating on a shoestring budget means that startups may not possess the flexibility to utilize the services of legal counsel; or they may develop lofty estimation of their capabilities and dispense with the need for legal counsel entirely. In any of these three scenarios, the do-it-yourself approach becomes the de facto operating mode, and is readily recommended in some startups and founder groups.
The challenge with this approach is the fragmentation of legal resources and assets of the company, since it is unlikely that the company possesses an organized legal documentation system to aid easy access to and retrieval of documentation or information. Beyond that, the risks take on a commercial flavor such as the inability to adequately assess and mitigate the risks in a business dealing, the loss of time occasioned by this inability and the obliviousness to a foreign clause in an agreement that may impose liabilities on the company. These cascade into over-paying for the benefit of a transaction, the unavoidable discontent at being on the wrong end of a deal, and then the desire to pull out from a bad deal which could readily escalate into a legal dispute.
Scenarios like these could be avoided by simply recognizing the nature of legal counsel as a guide in taking corporate actions and a risk assessor/manager in the mitigation of remote and real risks. In most cases, the fear of accruing high expenses for legal services is unfounded as legal advisers can work out flexible billing arrangements to accommodate the needs of the company.
What to do:
• Engage experienced legal counsel, either on retainers or ad-hoc basis
• Create an in-house legal documentation system
How often: For most startups, the mention of compliance strikes fear in the heart. However, most compliance obligations are simply about keeping the company in good-standing with regulations and laws. The fear for most startups arises from their perceived inadequacy in dealing with these types of activities due to the remote connectedness with the core business operations and, in some instances, the proliferation of government agencies to deal with.