Five legal things to get in order when you start a business
In a start-up environment entrepreneurs find themselves in the position of taking on many different roles that are required to establish a business. A founder may have one or two co-founders to share the burden with, but often founders will find themselves in the position of taking on the role of CEO / finance director / marketing manager / HR director / IT director / office manger / general trouble-shooter. That’s quite a combination before taking into account the time required to focus on developing the product (whatever it may be) and winning clients or customers to sell it to.
Amongst all these pressures it is not surprising that some other important aspects of the business tend to be overlooked as they move down priority lists. Some of these, although they may fall into the ‘I’ll deal with that later’ category, can have a material impact on the value of the business and cause significant issues if left until later. They are often much easier (and cheaper) to address at the outset rather than to rectify later. These include the following:
1. Correct choice of Legal Structure
The choice of legal structure can have an impact on several different areas but the choice will impact on tax, the control a founder may have, how profits are extracted and the potential liability if a loss is incurred or a claim is brought by a third party. In most cases a private limited company will be the corporate vehicle of choice, especially if external funding is anticipated at any stage during the business life-cycle.
2. Ownership of business assets (especially Intellectual Property)
It is crucial in protecting the value of the business that any assets are held by the company. This may seem obvious but very often assets that are material to the business are not held by the company itself, a fact that is uncovered during the due diligence process undertaken in relation to any fundraising or exit.
The most common example of this is in relation to intellectual property. Founders should ensure that anyone who creates any IP for a company is engaged on terms that assign such IP to the company. This includes the founders themselves, any employees and any third party contractors. It is much easier to address this point when engaging contractors than trying to rectify it once they have done the work and have strong bargaining power. For tech companies this is particularly important and would include domain names, the source code and any patents supporting the product.
The other common example is when the business has been trading prior to incorporation of the company but has not been formally transferred into the company making it very unclear as to where ownership of the assets sits.
In both cases this can be particularly hard to rectify if individuals have moved on from the relevant organisations or a fee is demanded by any third parties to transfer assets that the company thought it already owned.
3. Shareholding Structure and Agreements
When incorporating a new company and shortly afterwards it is extremely easy to ensure that any shareholdings are set out in the correct proportions with the correct shareholders. However, as soon as the company has any assets or has undertaken any trading this becomes harder with tax implications on any transfer of shares for the shareholders. The longer this goes on for, the more of an issue it becomes.
An agreement with any other shareholders should be put in place, especially other founders. The most important point that this will cover is when shareholders are expected to sell their shares and who can decide on when an exit can take place. Without an agreement, a shareholder has the ability to stop working for the business but hold onto his shares leaving any co-founders or other shareholders having to split any profits or exit proceeds with the leaving shareholder.
4. Employment Agreements and Incentives
It is a legal requirement that all employees have a written statement of employment particulars and the best way of ensuring compliance with this is through a contract of employment. In addition a written employment contract gives the company protection with regards to other areas in the event that an employee resigns such as confidentiality obligations to protect the trade secrets of the company. Where appropriate, founders should consider restrictive covenants in the agreement that protect against a leaving employee poaching, customers, suppliers or other staff members. These restrictions must be reasonable so advice should be sought to ensure they are enforceable.
The other point to consider is how to incentivise employees. One of the best ways of doing this is through an employee share option scheme. These can be drafted in many different ways but can include that employees only receive shares on an exit if certain criteria are reached. In addition, schemes such as an EMI scheme can have tax benefits for both the employee and the company.
5. Written Agreements with Customers and Material Suppliers
It is sensible to have standard terms and conditions upon which the company does business and these will vary depending on the nature of the business. Where there is a material customer that provides a large proportion of the company’s revenue the terms with that customer should be documented preferably with as long a term as can be commercially agreed.
Each of the points set out above have their various nuances and can be extremely complex or relatively simple to put in place. The key point is that founders are aware of them and seek to address them as soon as possible, having sought advice before doing so.
Richard Pull is a partner in the corporate team at Goodman Derrick LLP, the law firm.