Due diligence: an inevitable destination on any start-up’s yellow brick road to investment success

Due diligence: an inevitable destination on any start-up’s yellow brick road to investment success

In the age old classic, The Wizard of Oz, Dorothy is advised to follow the yellow brick road through the surreal and unfamiliar world of Oz until she reaches the Emerald City. Red boots and all, she, together with her travel companions, set out on this journey, facing some unnerving scenarios along the way. Sound familiar?

Although not written with start-ups in mind, this story can easily serve as a metaphor to illustrate the fascinating world start-up entrepreneurs must navigate on the “yellow brick road” to their next “Emerald City” destination – be it funding rounds, impossible deadlines, incubator pitches or that big exit – this journey has it all. One of the most important, however, not-so-often-discussed, destinations on this “yellow brick road” are due diligence investigations. This article explains why start-ups (or investors) should always keep this often-forgotten destination, and its potential impact on future investment success in mind.

What is a due diligence investigation (commonly referred to as a “DD”)?

Startuplawyer.com defines a due diligence as “an investigatory process performed by potential investors or acquirers to assess the viability of an investment or acquisition and the accuracy of the information provided by the target corporation (or start-up)”.

As such, although a due diligence is usually done by the investors, any start-up would be well-advised to consider the due diligence implications of all their actions leading up to that point. Simply put, this starts by ensuring that internal processes are in place to accurately and continuously record, save and timeously update documentation from the get go. More specifically, documentation and official company records, items relating to internal governance procedures, stakeholders’ communications and company information (i.e. organisation information, market size, team structure), key and material agreements, financial management and annual statements, asset valuation, regulatory approvals, product development and proof of intellectual property (IP) protection are all important for the start-up to keep on record. Furthermore, saving these documents in an orderly and easily accessible folder system eases the process of any due diligence investigation, which in turn, speeds up negotiations and valuations, potentially staving off weeks on an investment timeframe.

Why is it important?

Any sensible investor likes to determine beforehand exactly what it is that they are investing into and in doing so, considers various factors, including: compliance with the potential investor’s investment model, the financial position and investment viability of the start-up, material risks related to its business model, management structure, founders’ commitment, company valuation, legal standing and regulatory compliance. In short, investors are eager to get an all-inclusive and well-rounded snapshot of the start-up to encourage them to provide the necessary funding and to see if the two parties fit. Therefore, if a start-up can provide this information accurately and timeously, it may well contribute to investment negotiations being concluded far more easily than anticipated. Both parties are advised to note that due diligences generally take longer than anticipated, but by being adequately prepared and organised many a pitfall can be avoided.

Does a due diligence benefit the start-up at all?

Yes, regardless of whether the investment proceeds, the preceding due diligence is a good trial by fire for any start-up. Usually, by way of the investor providing a due diligence report, concerns or queries are highlighted in detail, providing an objective and holistic view of all the facets contributing to the start-up’s business. This can greatly assist the start-up in determining further strengths, weaknesses, opportunities or threats. Start-ups are, however, advised to not be duped into a due diligence too easily. Especially during early stage negotiations, a commitment from investors (usually in the form of a term sheet) is important to ensure mutual benefits are derived from the due diligence investigation.

Concluding remarks

Although a due diligence is a high level and intense review of the start-up’s business, it need not be a daunting experience. It is important to remember that both the investor and the start-up should benefit from this process – the start-up showing off its true colours, and the investor justifying its investment. As such, communicating honestly to avoid any confusion, disappointment or time wastage is well advised before any due diligence and subsequent negotiations commence. Considering the above, if a start-up is aware and is pro-actively engaging this inevitable destination from the get-go, the due diligence need only be a brief stopover on your “yellow brick road” to the next Emerald City destination.

Website terms – purpose, importance and consequences

Website terms – purpose, importance and consequences

Nowadays, websites almost always contain policies and terms that govern your use of the site. Sometimes these policies will appear as banners on the site (which you have to “agree” to in order to make them disappear), links in the page footer (like we have on our website) or as a statement along with a tick box saying that you have “read and agree with” the terms (usually when transacting online).

The questions on peoples’ minds are firstly, why do I need all these different sets of terms and, secondly, are these policies binding.

Why do we need all of these terms?

The website terms which we feel are important are browser terms, privacy policies and commercial/transactional terms. Each one of these deals with specific aspects of the website’s use, including, for example, the collection of personal information, social media integration, payment methods and your rights as a user of the website. Below we discuss each policy and its importance. These policies also protect your rights and interests in your website and can allow for you to have a claim in law against people who infringe your rights.

Browser terms

Although browser terms are not a legal requirement, they are useful to ensure that the “web surfer” understands and agrees to certain key points. Browser terms should be used to inform the surfer that:

  1. you, as the website owner, owe them no responsibilities;
  2. they get no rights to any services or IP merely by browsing;
  3. they are required to respect your website and the content thereof; and
  4. you comply with all necessary legal disclosure requirements.

Browser terms are “agreed” to through the surfer continuing to browse the website. These types of agreements are called “web-wrap” agreements. More on this below.

Privacy policies

Privacy policies are essential whenever the website collects or makes use of personal information. Personal information is often collected through cookies as well as when browsers become users of a website by creating an account or by integrating their social media accounts with the website.

The Protection of Personal Information Act 4 of 2013 (“POPI”) sets conditions for the lawful processing of personal information. Included in POPI’s ambit will be the mere storage of personal information when it is collected by cookies. POPI also requires that companies make certain information available to users when they collect their personal information. This can be achieved through a privacy policy. Privacy policies therefore also assist the website owner to comply with legal requirements

Privacy policies usually include the following important aspects:

  1. the use of cookies to collect certain information;
  2. the purposes for the processing of the personal information;
  3. the sharing of personal information by the website owner with certain select third parties;
  4. the storage of personal information, including the security measures taken and whether cross-border storage will occur; and
  5. the user’s rights in relation to his/her personal information and the recourse that he/she has.

Privacy policies are, like browser terms, usually agreed to by browsing, however, a recent trend has been to display the fact that cookies are used as a banner on a website requiring a “click-wrap” agreement to be entered into in order to remove the banner.

Commercial/transactional terms

As the name suggests, the commercial terms become applicable where the website enables users to transact with the website owner through the website. These terms serve as the terms of the contract which you conclude with the user when the user becomes a customer. The important aspects that this policy should govern includes:

  1. a general explanation of the service or product being offered by the website;
  2. the fees that are payable, which may be a once off purchase price or a subscription fee, as well as the fees relating to delivery costs, insurance and VAT;
  3. the terms applicable to returns;
  4. limitation of liability, which will be subject to the Consumer Protection Act 68 of 2008 (if it applies);
  5. the applicability of promotional codes and vouchers; and
  6. acceptable use policies, however, this is more applicable where the website offers a service and not a product.

The Electronic Communications and Transactions Act 25 of 2002 (“ECTA“) requires certain disclosures in terms of section 43 by the website owner when goods or services are offered for sale or hire through an electronic transaction. Some of the disclosures required include:

  1. company name, registration number and contact number;
  2. addresses, including physical, website and e-mail;
  3. a description of the main characteristics of the goods/services offered (which fulfils the requirement of informed consent;
  4. the full price of the goods, including transport costs, taxes and any other and all costs;
  5. the manners of payment accepted, such as EFT, cash on delivery or credit card, as well as alternative manners of payment such as loyalty points;
  6. the time within which delivery will take place;
  7. any terms of agreement, including guarantees, that will apply to the transaction and how those terms may be accessed, stored and reproduced electronically by consumers;
  8. all security procedures and privacy policy in respect of payment, payment information and personal information; and
  9. the rights of the consumer in terms of section 44 of ECTA.

ECTA also requires that the customer must have an opportunity to review the transaction, correct any mistakes and withdraw from the transaction without penalty before finally concluding the transaction. ECTA non-compliance gives the consumer the opportunity to cancel the order and demand a full refund.

Additional requirements are placed on suppliers transacting online regarding payment systems. The payment system used must be sufficiently secure in terms of current accepted technological standards. Failure to comply with these security standards can render the website owner liable for any damages suffered due to the payment system not being adequately secure.

Are these policies binding?

Essentially, yes, website terms will be binding based on the principles of contract law. Website users must be made aware of the terms that apply to their use of the website and you should always ensure that you include wording to the effect that by anyone continuing to use the website they agree to the terms.

To this effect, web-wrap and click-wrap agreements come into play.

Web-wrap agreements

Web-wrap agreements (also referred to as browse-wrap agreements) are used to acknowledge the terms of use of a website by continuing to use the website. The user indicates acceptance of the terms by using the website and does not expressly indicate acceptance of the terms. Such agreements are usually used in browser terms and privacy policies.

Click-wrap agreements

Click-wrap agreements require the user of a website to indicate their agreement with the terms through positive action – usually by clicking “I accept” before proceeding with their activity on the website. These agreements are usually used for more important agreements, such as when installing new software on your computer or when entering into online transactions.

Conclusion

Even though all of these policies may seem excessive, they are worth having. Yes, copying and pasting clauses from other policies will get the job done, but you may leave yourself vulnerable to certain consequences that you haven’t thought about. These consequences may be even worse when it comes to commercial terms. Contact us for a free quote and ensure that your online business is fully protected!

Potential oversights of entrepreneurs – protection of intellectual property

Potential oversights of entrepreneurs – protection of intellectual property

Running a business is a tough ask of anyone – between maintaining cash flows, keeping customers happy, managing your employees and looking for potential investors (or dealing with current investors), there is a lot that can fall through the cracks. One of the things that is very easy to forget about, especially with the more modern, technology-heavy businesses, is the protection of your intellectual property (IP).

In the technology sphere, copyright law governs the development of computer software, which is much of what the entrepreneur of today is dealing with. As an entrepreneur, you may come up with a great idea that is going to be the next “Google”. So you call your business partner up and spend countless hours in the office and cups of coffee developing this new idea, whilst running your business at the same time. You come to the end of this, completely overworked, and you have produced the holy grail of products that is going to revolutionise the industry, and you own it, right…? Well, when considering this a little further, that may not be the case.

If your business is a company, you may be in for a surprise – it is probably the company that owns the product that you have just developed and not you personally. If that previous comment made you break out into a cold sweat, not to worry. Below are some factors that you should consider when developing a new idea as a director of or shareholder in a company:

• Did you use the company’s property or time to develop the product? As an example, did you use a company laptop and normal working hours to develop your new product?

• Is the product that you developed substantially similar to other products developed by the company or did you use the company’s software code to make your new product? As an example, if your company develops an app that is involved in data collection in agriculture and you develop an app that collects data in retail, it is likely that because of the common data collection thread, the products are substantially similar. It may also be likely that you “borrowed” some of the code from the previous app to make your new app.

If your answer to both or one of the above is “yes”, then your company probably owns the product that you just developed. This also should not be too much of a problem though. If you and your business partner (if you have one) are the only shareholders in the company, then both of you can just agree to transfer the product out of the company. The only difficulty comes in where you have investors looking for an opportunity to get a return on their investment.

It is not uncommon for investors to factor in protection against the company disposing of any property (including IP) without their consent, as they will almost always want a good return on their investment. You could be stuck in a situation where you have to share the fruits of your labour with the other shareholders in your company, which is not ideal.

A good way of avoiding this is, as soon as you are in the process of obtaining your first round of funding from your first investor(s), introduce a “pay-to-play” option into your company’s shareholders’ agreement. This will essentially provide that any new intellectual property that you are thinking about developing will be offered first to the company and then to any investor, provided that if they want a share in it, they must put some capital into the project, which project can, and should, be placed into a new company.

There are many more layers to this issue, but the long and the short of it is that you should always be wary of losing all your hard work due to a simple legal slip up.

Introducing the SAFE document as a vehicle to raise capital in early-stage South African companies

Our regular involvement in funding transactions for startups in the South African tech space often requires us to implement US-style investment terms and instruments to ensure that we are as relevant as the market needs us to be. In recent months the SAFE document (being an acronym for ‘Simple Agreement for Future Equity’) was introduced in the US venture capital scene and made its way to South Africa fairly quickly, where it has now become a popular method for early stage financing.

The essential terms of this document are that the investor purchases the right to subscribe for preferred shares in the investee company upon the next round of equity funding in the investee company. The most common method of calculating the number of shares to be subscribed for by a SAFE-holder is by applying an agreed valuation cap to the investee company upon issuing the SAFE document to the investor. By way of example, if US$1 million is invested at a valuation cap of US$3 million and the valuation of the company grows to US$5 million by the time the next round of equity funding is done, the SAFE-holder’s US$1 million investment will buy more shares than that of an equity subscriber also investing US$1 million at a later stage.

An alternative to the valuation cap, is to apply a discount rate to the investee company’s valuation upon the next round of equity funding and issuing preferred shares to the SAFE-holder based on the reduced valuation. This discount rate is specified in the SAFE document issued to the investor and has a similar effect to the valuation cap, but is calculated differently. If a 20% discount rate is applied in the scenario above, that means that the investee company’s actual valuation on the next equity round (US$5 million) is reduced by 20% to calculate the preferred shares to be issued to the SAFE-holder. In this case that would mean that the SAFE-holder subscribes at a valuation of US$4 million.

The SAFE document can also include both a valuation cap and a discount rate, in which case the document will state that the method of calculation which results in the greater number of shares issued to the SAFE-holder will be applied. By way of example, based on the scenario above, if a valuation cap of US$3 million and a discount rate of 20% is provided for in the SAFE document, the valuation cap (and not the discount rate) would be applied, as that will result in more shares for the investor.

If the company’s valuation drops to below the valuation cap by the time the next equity round is implemented, the valuation cap is merely disregarded and the SAFE-holder subscribes for preferred shares at the same valuation as the other subscribers.

One of the reasons why SAFE documents were developed is to limit transaction fees by using a simple standardized document, cutting out significant costs, time and effort usually spent on closing equity funding rounds. This also enables the investee company to close transactions with investors (and get the funds needed in the business) one investor at a time, as each investor negotiates separate terms with the investee company. This can prevent the situation of one stubborn investor holding up a whole funding round.

Other positives are that the investee company can offer different valuation caps to different investors, depending on the timing of the investment or even the reputational or experiential value of the investor. Having flexibility in the valuation offered to different investors may be very useful when negotiating with investors who can contribute more to the business than just their monetary investment.

This may all sound very attractive to investors, especially if you consider that the flexible valuation may be a very effective way to reward the risk of very early stage investment with a higher return. However, the picture becomes slightly less exciting if you consider the SAFE-holder’s position in more detail.

Here are some of the obvious areas of concern from an investor’s perspective:

  • The SAFE-holder only subscribes for preferred shares in the investee company upon the occurrence of specified trigger events. These are usually an initial public offering (‘IPO’), the next round of equity funding, any other change of control or the dissolution of the investee company. In the interim period (unlike holders of convertible debt), the SAFE-holder is not a creditor, as the SAFE -document is not a debt instrument (there is no obligation on the investee company to repay the investor, no interest and no security). This means that the investor will have no recourse or further rights unless a trigger event occurs, which can be very problematic if, for instance, the investee company keeps on raising capital by issuing more SAFE documents to third party investors.
  • Unlike convertible loan notes, the SAFE document does not create an option in the hands of the SAFE-holder, as the subscription will happen automatically upon the occurrence of a trigger event. The only exception to this is where an IPO (the SAFE-holder has the option to subscribe for ordinary shares) or other liquidation event (the SAFE-holder has the option to have its investment returned) occurs. This means that a convertible loan note holder will be in a better position than a SAFE-holder, as the convertible loan note creates a debt with a defined payment obligation and an option for the holder to remain a creditor or subscribe for shares in the investee company.
  • Once the SAFE-holder subscribes for preferred shares in the investee company, its preferred shares will have a liquidation preference (like other preferred shareholders). However, if the SAFE-holder subscribed for shares at a lower valuation than that of the other preferred shareholders, the SAFE-holder’s liquidation preference is calculated on the lower valuation (i.e. on a lower ‘per share’ liquidation preference than that of other preferred shareholders).
  • When signing the SAFE document, the SAFE-holder does not know what the terms of its shareholding with the investee company will be. It knows that they will be materially similar to those of the other preferred shareholders, but that may not always be favourable for the SAFE-holder. If, for instance, other preferred shareholders are related to the founders of the investee company in some way, the rights attached to the preferred shares may be structured with slightly ‘lighter’ protective mechanisms (like vesting of founders’ shares, restraints, preferred distribution rights) compared to terms usually included in early stage funding transactions.

When we advise investors on SAFE documents, we aim to mitigate some of the risks highlighted above, by including certain restrictive measures not included in the standard SAFE document. These may include a restriction on the investee company to only source a limited amount of funding through the issuing of SAFE documents. This will ensure that the investee company does not delay the equity subscription with endless issuing of SAFE documents. In addition to this, we would also suggest to investors that there should be a time limit to the SAFE document, which triggers repayment (in real terms) or equity subscription (at the SAFE-holder’s option) if an equity funding round (or other trigger event) does not occur by a certain date.

Considering the above, it is clear that the SAFE document may hold certain advantages for both the investor and the investee company. However, it remains to be seen whether investors are willing to accept the risks associated with the SAFE document in its standardized form.

Moral Rights In The Context Of Copyright Law In South Africa

INTRODUCTION

In simple terms, a “copyright” is a form of intellectual property right that grants the creator of an original work (“the author“), the legal and exclusive right to the use and distribution of the work (in return for compensation for the author’s intellectual efforts). In this sense, a copyright can be said to be an economic right.

A “moral right” in the context of copyright law, on the other hand, is rather a personal right which attaches to the author, allowing the author to receive the appropriate credit when his/her work is used and it also dictates, to an extent, the way in which an author’s work is treated by others.

In South Africa, copyright law is regulated in terms of the Copyright Act, No. 98 of 1978 (as amended) (“the Act“), and is administered by the Companies and Intellectual Property Commission, as a branch of the Department of Trade and Industry. In terms of the Act, nine classes of works are eligible for copyright protection and they include literary works, musical works, artistic works, cinematograph films, sound recordings, programme-carrying signals, broadcasts, published editions and computer programs.

 

THE CONCEPT OF MORAL RIGHTS

Section 20 of the Act creates a legal obligation to give credit to works of an author and not to treat it in a derogatory way, and further defines a moral right as a protected right that applies to literary, musical and artistic works, cinematograph films and computer programmes (but excludes sound recordings, broadcasts and published editions) (“work/s”). At its heart, a moral right consists of the right to paternity and the right to integrity of the author’s work. The right to paternity allows the author to claim authorship of the work, whereas the right to integrity allows the author to object to any distortion, mutilation or modification of the author’s work to the extent that any such distortion, mutilation or modification would be prejudicial to the author’s honour or reputation. In other words, if the author reasonably feels that making certain changes in or to his/her works would undermine his/her creative intent or “vision” embodied in those works, he/she can prevent that change from being made, regardless of any economic rights that another person may own in that same work by virtue of a license or copyright.

An author’s moral rights to his/her works are, however, qualified by the economic interests which a copyright seeks to protect, and section 20 of the Act further provides that an author may not object to modifications to his/her works which are absolutely necessary for the commercial exploitation of those works.

It is important to bear in mind that a moral right can only subsist in the above works if such works enjoy copyright in South Africa in the first place.

 

WAIVER AND TRANSFERABILITY OF MORAL RIGHTS

Just like many personal rights, moral rights can be waived by the author and the author can choose not to enforce them. No formalities are prescribed in the Act for the waiver of moral rights, although good practice dictates that any waivers of moral rights be reduced to writing.

Whereas copyrights are freely transferrable, a moral right attaches to the author throughout the author’s lifetime and terminates upon his/her death (or in the case of an author which is a corporate entity, the dissolution of that entity) and cannot be transferred. What is interesting in this regard is that an assignment of copyright leaves the author’s moral rights unaffected and in many instances, the holder of the copyright will still be required to obtain the necessary waivers from the author. In other words, no matter who gets to exploit the economic rights being the subject matter of the copyright, the author will still have the right to be named and given recognition for his/her work (unless he/she waives such right).

 

INFRINGEMENT, ENFORCEMENT AND REMEDIES

A moral right could be infringed by, for example, not properly attributing the work of the author, or treating it in such a manner so as to lower the reputation or dignity of the author. Given the closely related nature of copyright and the moral rights that subsist in the copyright, the statutory remedies which apply to an infringement of copyright would also apply to an infringement of an author’s moral rights. The Act provides for a claim for damages or the imposition of an interdict. These statutory remedies are complemented by common law remedies to the extent that any conduct that violates the dignity and reputation of the author can give rise to a similar claim for damages or an interdict to curtail the infringement.

 

CONCLUSION

Authors in South Africa enjoy a reasonable measure of protection regarding the intellectual products of their labours. South Africans have, however, been slow to enforce these rights and to date, there have been very few reported cases dealing with this area of law. Perhaps the reason why moral rights are so rarely asserted are, firstly, it is a fairly unknown concept in South Africa, and secondly, many commercial agreements governing the use of intellectual property will often include a waiver of the moral rights of the author.

Should you have any queries concerning your business and its use of its own intellectual property and that of others, please feel free to contact us – we would be glad to assist you.

Insights Into Restraints Of Trade

It is a well-known commercial practice for employers to include restraint of trade provisions in their employment agreements despite prevailing uncertainty as to when and how (as well as to what extent) these restraint of trade provisions would be enforceable.

A restraint of trade is essentially an agreement in terms of which one party agrees to some form of limitation to their freedom to carry on their trade, profession or business. Restraint of trade provisions are most frequently encountered in employment contracts, where the employee undertakes not to compete with his or her employer during and/or after termination of his or her services to the employer. There are also other forms of agreements in which these provisions can be encountered, for example, in a sale of business, where the seller agrees with the purchaser not to carry on a similar business in competition with the purchaser within a reasonable proximity of the business premises and for a prescribed period of time. Partnership agreements may also include similar provisions in terms whereof each of the partners undertakes not to compete with the business of the partnership during and/or after leaving the partnership.

In terms of the well-known and oft-cited Appellate Division judgment in Magna Alloys and Research (SA) (PTY) Ltd v Ellis [1984] 2 All SA 583 (A),it was held that restraint of trade provisions are valid and lawful unless the party wishing to escape the provisions of the agreement in question can prove that they are contrary to public policy and therefore unenforceable.

The Magna Alloys precedent necessitates an enquiry as to when restraints of trade will be deemed contrary to public policy (which is by nature a vague concept). Fortunately in the later judgment in Basson v Chilwan and Others [1993] 2 All SA 373 (A) the court laid out several guidelines with which to determine whether or not a restraint of trade agreement is contrary to public policy, as follows:

  • Does the restraining party have an interest deserving of protection, during or after termination of the relevant contract (a “Protectable Interest”)?
  • If so, would that Protectable Interest be prejudiced by the restrained party’s freedom not being limited by the restraint?
  • If the above can be answered in the affirmative, then it furthermore needs to be decided whether the Protectable Interest of the restraining party (seeking to uphold the restraint agreement) qualitatively and quantitatively outweigh the interest of the restrained party to be economically active and productive?
  • Are there any other aspects to be considered to determine whether or not to uphold or reject the restraint?
  • Does the restraint go further than reasonably necessary to protect the interests of the restraining party seeking to enforce the restraint in question?

Generally speaking, according to the Basson judgment, if the answers to the first three questions above are in the affirmative, and the answer to the last question is in the negative, then the restraint of trade is reasonable and consequently not contrary to public policy, therefore making it enforceable against the restrained party. However, if the answers to the first three questions are in the negative and the answer to the last question is in the affirmative, then such restraint of trade would be contrary to public policy and therefore unenforceable. In some instances the court may find that a restraint of trade provision has gone further than is necessary to protect the interest of the restraining party but doesn’t go so far as to render it contrary to public policy. The court may then order that the restraint be partially enforced. By partially enforcing a restraint, the court would restrict its limitation to either a narrower proximity than the one that was initially included in the restraint of trade, or for a lesser period of time than the period that was initially agreed.

In order to determine whether a restraint would be reasonable, the concept of a Protectable Interest must be considered further, as either parties’ assertion or defence would primarily be dependent on whether there is any Protectable Interest that the restraining party could argue he is entitled to protect. A court would normally only entertain a restraint of trade dispute if it is satisfied that there is indeed a Protectable Interest. There’s no exhaustive list of what constitutes a Protectable Interest, although the judgment in Advtech Resourcing (Pty) Ltd t/a The Communicate Personnel Group v Kuhn and another [2007] 4 All SA 1368 (C), provides the following insights:

  • A Protectable Interest includes the restraining party’s ‘trade secrets’ (meaning any information that is capable of application in trade or industry provided that such information is only known to a certain number of people but not to the public and is of economic value). By way of example, technical processes, chemical formulae, computer software, price lists, credit records and business conversation, constitute trade secrets.
  • However, the mere fact that an employer had provided an employee with training and skill development does not mean that he or she owns the skill provided to an employee. This is illustrated by the following excerpt: “An employee who, in the main, uses his own expertise, knowledge, skill and experience [after leaving employment] cannot be restrained [from doing so]”.
  • Confidential information constitutes a protectable interest.
  • Customer goodwill or trade connections constitute a protectable interest.

Another question that needs to be considered is that of who bears the onus of poof in restraint cases. Most past judgments follow the approach that was laid down in Magna Alloys, in which it was held that the party alleging that the restraint is contrary to public policy, bears the onus of proving the unreasonableness of such restraint. In the new Constitutional dispensation, however, every person has a constitutionally enshrined right to choose and carry on his/her chosen trade, profession or business. With that background, some more recent commentaries have held that the restraint enforcer should bear the onus of proof. Some commentators remark that it does not matter who bears the onus of proof because the guidelines that were laid down in the Basson judgment are decisive.

In conclusion, restraint of trade provisions in agreements are lawful, valid and enforceable provided they are reasonable and not contrary to public policy, and the enquiry into public policy will often centre on a consideration of the Protectable Interest that a restraining party would wish to protect. Beyond this, although restraints of trade are very common in practice, it is notoriously difficult to predict whether a court would determine a particular restraint to be fair and reasonable in the circumstances. We recommend that any party to a restraint carefully consider its terms and limitations, and attempt to negotiate on these limitations if you foresee a time when this restraint may be detrimental to your ability to carry on your chosen trade or business.

The effect of Section 12J of the Income Tax Act on the South African venture capital regime

Section 12J of the Income Tax Act has been the talk of the town in many South African venture capital circles in the last few years, but ironically there has been a lot less action in the market than the government expected when implementing this tax incentive in 2009. This incentive seems very promising on face value, but at the moment there are still less than 10 approved Section 12J venture capital companies in the country. This is an exceptionally low number if we consider how popular a similar venture capital incentive in the United Kingdom has been over the years, which beckons us to take a closer look at the incentive to determine the reason for the market’s reluctance to explore this.

The rationale behind the incentive is quite simply to address the fact that one of the main challenges to the economic growth of small and medium-sized businesses in South Africa, is the inability of these businesses to secure equity finance to fund their growth.

In terms of Section 12J, any South African tax resident that invests in a venture capital company (VCC), approved and registered in terms of Section 12J, can claim income tax deductions in respect of the expenditure actually incurred to acquire shares in such VCCs, subject to certain conditions.

Section 12J VCCs are therefore intended to be a marketing vehicle that will attract retail investors to invest in VCC’s, whereas the VCC makes money by investing in smaller trading companies. These are entities which the VCC’s fund managers deem as having prospects of producing a favourable return on investment. These companies are generally referred to in this context as qualifying investee companies.

However, before a venture capital company can start trading as a Section 12J VCC, it has to apply to SARS to be registered as such, for the purpose of which the company must meet certain preliminary requirements. To meet these requirements, the company must:

  • be a South African tax resident and its tax affairs must be in order;
  • have as its sole object, the management of investments in qualifying investee companies;
  • not control (whether directly or through a related entity) any qualifying investee company in which it holds shares; and
  • be licensed as a financial services provider in terms of section 7 of the Financial Advisory and Intermediary Services Act, 2002.

The major risk for a Section 12J VCC and its investors alike, is that SARS can withdraw the approved VCC status if, during any year of assessment, the company fails to comply with the preliminary approval requirements as listed above. SARS may also withdraw the company’s VCC status, if the preliminary requirements are met but the company fails to satisfy the following additional requirements after the expiry of 36 months from the date of SARS approving the company’s Section 12J VCC status:

  • a minimum of 80% of the expenditure incurred by the VCC to acquire assets must be for shares in qualifying investee companies, and each investee company must, immediately after the issuing of the qualifying shares to the VCC, hold assets with a book value not exceeding R300 million in the case of a junior mining company or R20 million in the case of any other qualifying company; and
  • the expenditure incurred by the VCC to acquire qualifying shares in any one qualifying investee company may not exceed 20% of its total expenditure to acquire qualifying shares, which basically means that the VCC must have at least 5 investee companies in its portfolio.

What happens when a Section 12J VCC loses its status as such? Well, SARS can include in the VCC’s income in the year of assessment during which the status was withdrawn, an amount equal to 125% of expenses incurred to issue shares.

If you consider the fact that venture capital investments are generally regarded as high-risk, relatively illiquid investments, the picture seems even less rosy for investors if the drastic consequences of non-compliance looms as an additional risk to their investments.

However, in the 2014 National Budget Review, the government announced that it will propose one or more of the following amendments to the VCC regime:

  • making tax deductions permanent if investments in the VCC are held for a certain period of time;
  • allowing transferability of tax benefits when investors dispose of their VCC equity investments in VCC’s;
  • increasing the total asset limit for qualifying investee companies from R20 million to R50 million, and that of mining companies from R300 million to R500 million; and
  • waiving capital gains tax on the disposal of assets by the VCC.

These new changes are to be welcomed and have certainly sparked renewed interest in the market, which is still wide open for those that are willing to enter this relatively untapped opportunity. Whether the proposed reforms are substantial enough to give this incentive the required momentum to ignite the South African venture capital industry as intended by the government remains to be seen.

Buying a Distressed Company – Bargain or Burden?

Things you need to know before buying a distressed company

Every now and then an opportunity comes along that looks very hard to resist. If you’re a seasoned entrepreneur, this might come in the form of a company that, although in such distress that the shareholders want out, still has genuinely valuable assets or a viable business model.

Buying the company at a discount and then selling off its assets is one way to turn a profit from such a situation. Another option is to buy the company and turn it around. This can be especially tempting when the company has liabilities that may prevent it from showing a profit for some time, which can translate into a considerable tax advantage.

Deals like this are not for the inexperienced or fainthearted – or for those who tend to get carried away by their own enthusiasm. Unfortunately, this perfectly describes most entrepreneurs – seeing the upside and getting swept up in your own enthusiasm is practically part of the job description. This is why you need a team of lawyers, accountants and other advisers on your side to provide a reality check.

The first rule of buying a company in distress is: Never, ever go soft on due diligence. Hire the most paranoid team you can find and have them tear the place apart. There are bound to be skeletons in various closets, and you want to shine clear, cold daylight on all of them.

The primary objective of the due diligence is to make sure there are no liabilities in the business that you’re unaware of, and no unquantifiable risks. It’s always the stuff you don’t know about that will trip you up, so do whatever is possible to ensure you know everything.

We usually ensure that a Purchaser has recourse to the amount paid to the Sellers (such as by retaining all or a portion of the purchase price, or placing it on escrow).  The big thing to beware of is any material risk that could expose you to a liability greater than the price you’re paying for the company. You can always ask for warranties from the sellers that they haven’t withheld any relevant information – but the warranty indemnity probably won’t be more than the purchase price.

You also need to beware of any evidence that the previous management has not been running the company properly in the past. If there is any suggestion that they’ve been playing fast and loose, SARS can re-open tax assessments from previous years – and then the entire basis for your purchase could be undermined.

Which brings us to the second rule of buying a company in distress: Get the best tax advice you can afford. The really interesting structures often have tax advantages – and if your goal in buying the company is to enjoy the tax advantage, you had better be sure it really exists.

If the due diligence confirms there is no SARS debt or other debt you can’t compromise, and that you have identified all the risks –then there is a chance you have a real opportunity on your hands. If you are confident that you can turn the company around and make it work, the rest is up to you.

Director’s Duties – 5 things you need to know

There has been a lot of media coverage in the past couple of years devoted to directors’ duties under the new Companies Act of 2008, and the fact that directors can be held personally liable if they breach those duties. The effect can be fear and uncertainty – but the basic principles are easy to understand and live by.  There are five things every director should know:

1.     What exactly is a “fiduciary duty” anyway?

Fiduciary” comes from the same Latin word for faith and trust that’s given us “fidelity” and “confidence” (it’s also why there’s a tradition of calling dogs Fido). Basically, if someone places their faith and trust in you – for example by giving you their money to invest or their company to manage – you have a duty not to betray that trust. You have to be loyal and act in their best interests, not your own. It’s really that simple. The moment you find yourself thinking in terms of what’s best for you personally, take a deep breath and a long cold drink of water and think again.

2.     What is a “duty of skill and care”?

As a director, you don’t only have to act in good faith – you have to know what you’re doing. The expectation is not that you should be an expert, or never make a mistake – but you should have the skills that can reasonably be expected of someone in your position, and apply those skills. You can’t, for example, approve a deal because it feels right in your gut or the other person is in your church and you’re sure you can trust them. You need to do all the due diligence required to make sure it will benefit the company.

3.     It doesn’t matter how big or small the company is

 These duties apply equally to directors of small companies, large listed companies and non-profits. It gets more scary and complicated the more of other people’s money is at stake, but your basic duties and responsibilities to your shareholders remain the same.

4.     It doesn’t matter what it says on your business card

 You don’t have to carry the name of Director to bear these responsibilities. The law puts it in more complicated terms, but basically: If it looks like a duck, and walks like a duck, and quacks like a duck, it’s a duck. So if you attend board meetings, make important decisions, sign off on deals and do other things that directors do, the law will regard you as a director. You can’t avoid the responsibility by steering clear of the name.

5.     When in doubt, always opt for more transparency

The law is absolutely clear that you may not use your position to make any kind of secret profit, whether the company loses out or not. If you set up your own new company to take advantage of a major opportunity offered by a client, that’s a clear breach of your duties. But things that seem more innocuous can also be breaches: What if a major supplier offers you a discount when you renovate your house? Even if there’s no expectation of reward, this could still breach your duties. Honesty, as always, is the best policy: Tell the board and let them decide.

In many ways, the Companies Act just codifies in law what most people regard as basic ethics and common sense. If your habit is to act in good faith and care, you’re unlikely to have any problems. But anytime you’re in doubt, seek advice – – it’s always better to know what you’re getting into.

How to Kick Off Investor Negotiations

Dommisse Attorneys
July 2013

It can take months of pitching before you find the right investor for your business, but finalising the deal can be tricky. Corporate Finance attorney Adrian Dommisse of Dommisse Attorneys shares his tips to avoiding the pitfalls you may encounter during the negotiation.

Finding an investor can be a difficult and time-consuming process and once you’ve found one with the right strategy and values, you may be tempted to rush through negotiations to access the promised cash injection. However, there can be serious ramifications if the details of the deal are not negotiated on level playing fields.

Here are some issues for you to consider:

• Ask for a term sheet early

A term sheet is simply a summary of the deal in a few pages. It exposes the bare bones of the fundamental commercial terms of the investment and because it is so concise, you are less likely to miss some essential detail, as you tend to do when faced with pages and pages of legal documents. The term sheet can be an invaluable document because each board member or founder can get to grips with it quickly, and give input from their unique perspectives.

• Compare deals

Always compare the terms on which different investors would invest. Don’t be tempted (or persuaded) to commit to one investor unless they offer a genuinely better deal. Often an entrepreneur is focused on the valuation of the company, hoping for a higher valuation and therefore a higher investment. But don’t forget other important points – there may be a significant “negative” value such as founder restrictions, share claw backs, rights of investors to sell (their shares and yours!) and other terms that come along with a higher valuation.

• Determine which terms are binding

Before you put pen to paper on the term sheet, be sure to understand which parts are binding. Although the terms of a cash injection will not be binding until set out in comprehensive documentation, the investor may require you to commit to an exclusivity period, in terms of which you undertake not to negotiate with anyone else for a set period.

• Always check the fees

Once the investors instruct their attorneys to draft the investment documents, they will expect those fees to be for your account – usually deductable from the investment amount when it is advanced to you. However, what if there is a genuine disagreement on a fundamental term of the investment? Who pays those fees if the investment never closes? Make sure that you hash out all the details prior to signing and make sure that the legal fees are capped so that they won’t drain your investment funds.

• Determine if there are “arranging costs” involved

“Arranging” costs can be significant. If you are negotiating directly with the investor, this fee may not apply. You could argue that the investor’s profit will be from their investment (exit profit or distribution of profit), not from the company’s balance sheet at the commencement of the relationship. Having said that, it is not uncommon for investors to take a fee from the proceeds of the investment. There can be valid reasons for this, such as where a complex deal requires unique, expert skills to arrange. But you should investigate any such term in discussion with the investor to understand why they would rather do that than invest those funds with you. Check to see if this is common practice – again, by comparing deals.

Following the above process will help avoid disappointment, or even avert a failed deal later down the line, at your cost.