All businesses start in exactly the same way: someone has an idea, then that person (and others) add money, resources, considerable effort and more ideas to refine the idea, create value and hopefully turn R1 into R2.
We were recently requested to address the participants at the 2015 Net Prophet Sparkup! event, as to the most fundamental legal challenges faced by start-up entrepreneurs. As the event is an exciting entry for some into the world of investor-entrepreneur relations, we spent some time discussing the manner in which investors measure the prospects of a start-up company.
We all know that in the real world, all great ideas are not created or developed equally well. Two entrepreneurs might have very similar business ideas, but the one’s name eventually shines brightly in Forbes magazine, while the other ends up among the sequestration notices in the local newspaper (with apologies to Henry Ford, Donald Trump, Walt Disney and the many more who played in both teams).
At Dommisse Attorneys, we have a passion for assisting our entrepreneurial clients in turning their sharp ideas into tangible value. On the other side of things, we also strive to see our investor clients adding real value to investment opportunities…the right opportunities! In light of this, we are in the perfect position to provide entrepreneurs with a very realistic overview of the things that make one company more attractive to investors than the next.
Although this article is certainly not the alpha and omega on this topic, we thought it well to pen down our thoughts on some of the most important legal factors that investors usually consider before taking the leap.
- Intellectual property
The number of tech startups that have emerged in recent years highlights the importance of intellectual property (IP) as an asset from investors’ perspectives. Most importantly, investors will want to know what measures have been taken to protect a startup company’s IP. While the company can patent certain aspects of its IP (if the IP is new, a result of an inventive step taken and useful in commerce), there might be more effective ways to protect IP. If the company has IP that is not in the public domain, which the company can keep secret even while using the IP in the market, then it might be more appropriate to protect the IP as a trade secret by imposing certain protective measures. This does not require a formal registration process and might be a very cost-effective strategy to apply. If you want to explore the option of patenting an idea, it is very important that you do not to start using IP in the market before submitting your patent application, as the idea will then lose its novelty and no longer be patentable.
In most cases it will also be important to determine how the company is planning to commercialise its IP, for example, by means of licenses or franchise agreements. It is therefore fundamentally important to have a clear idea of what your company’s essential IP is and how it will be protected, developed and commercialised.
- Capital structure
The manner in which the ownership of a company is structured, is often referred to as its “capital structure”. While investors are likely to require you to simply rectify anything they don’t like, it is important to think carefully about the shareholding proportions when issuing shares to founders. This may be extremely difficult early on in the company’s growth cycle. Be careful when issuing shares to some shareholders for cash contributed, while issuing shares to others for services rendered to the company. While both are acceptable, the net effect can be quite surprising if you don’t consider the tax implications (i.e. that shares issued for services rendered are subject to revenue tax) or have an inaccurate view of the company’s valuation. Further to this, a company is not allowed to issue shares upfront for any deferred performance, as things can then become messy when that performance is not measurable and the parties dispute whether performance was completed or not. For this reason shares that are issued in return for any deferred contribution should be held in escrow until performance is completed. Investors do not want to be dragged into future disputes regarding the founders’ shareholding and frankly, this is the crux of a founder’s hope to get monetary returns for hard work, so make sure that the initial subscription process and terms are handled correctly.
- Liability
There are a million and one ways in which any company can be held liable for the loss or damages incurred by others. This may be as a result of defective products, injury caused to end users, sub-standard performance, technology glitches, etcetera. While there is no point in lying awake at night panicking about this, we understand that it can be very concerning and there are ways in which to curb a company’s risk from a legal perspective. Investors will be more comfortable investing in a company that knows exactly what its risks are and has found ways in which to carefully protect itself against exposure in this regard.
This may mean simply taking careful aim when determining the company’s “terms and conditions” with customers, but also to implement other measures like holding all the company’s assets in one entity and using a second entity as the “operational company”. This sounds fancy, but can be a very effective way to make sure that the essential business assets are not exposed to potential claims of creditors. Another option, especially for companies with more than one unrelated technology or product offering, is to hold each of these in a separate entity. This is beneficial to ring-fence each entity’s risk, but also gives prospective investors the opportunity to only invest in one technology or product offering. This level of flexibility might be very attractive for investors, especially the clever ones that insist on investing only in products that they understand.
- Funding
The company’s funding history is quite important and can be detrimental for chances of sourcing investment in the future. If the company has obtained too much debt funding or funding on risky terms in the past, investors will flag this as a massive risk and for that reason be reluctant to invest in the company regardless of how promising the business looks otherwise. For this reason it is important for founders to not only maintain a healthy debt : equity ratio, but also to make sure they understand the effect and terms of funding obtained.
- Continuity
Investors will also want to know that the founders will be prevented from exiting the company prematurely, especially if founders have essential skills required to grow the company to the next level. In terms of the company’s constitutional documents founders are often bound to vesting provisions, which determine that founders’ shares vest in the founders gradually over the first few years of the company’s growth cycle. This means that founders are prevented from selling their shares in the company before the lock-in period expires. In addition to that, founders can often be expected to “earn out” when they sell their shares in the company. This enables the company to replace the exiting founder with a new person in that role and complete the required handover process. The investor therefore knows that a founder’s exit will not derail the company. It is important to implement these protective mechanisms sooner than later in the company’s life cycle. Even if a first round of investors do not require it, the experienced investor most certainly will, but if the new round of investors see that there is already a vesting period implemented, they are unlikely to request that the vesting period be extended.
- Key management
Inexperienced entrepreneurs often struggle to differentiate between ownership and management of a company. The ownership is one element, which is covered in the constitutional documents of the company, but it is crucial to also understand the importance of regulating the founders’ roles as directors of the company. Founders and other key employees should have adequate agreements with the company, in terms of which they are restrained from competing with the company when they resign, assign all IP rights (to inventions made while working for the company) to the company and other terms to determine the performance measures to be applied to the person’s services to the company. These agreements should be seen in a positive light, as they clearly define what the company expects from each executive, even before investors come aboard.
In the same light, it is also important to consider incentivizing key employees in the company by, for example, implementing an employee share option pool (ESOP), which is basically a scheme that rewards key employees for their hard work by giving them the option to buy shares in the company. A manner in which to do this is by giving employees the option to subscribe for shares in the company at a fixed strike price, even if the valuation of the company increases. This is a very effective way to inspire employees to apply their best efforts to ensure that the company succeeds. Investors love to see an ESOP in place even before they invest, because that means the key employees are more committed to the cause. Another more obvious reason, is that if a limited amount of shares have already been allotted to an ESOP, the investor will not be diluted when it eventually happens.
While there are many more aspects to consider when getting your company in shape for investors, the ones mentioned above are some of the most crucial ones, at least from a legal perspective.
We are currently working on a Startup Legal Playbook, which we will soon make available on our website as a free document to guide entrepreneurs through the early years with more details on the above, as well as other challenges in this regard. In the meantime, please feel free to contact us should you have any queries, or require our assistance.
