Common Errors made by Start-Ups

Abraham Lincoln was quoted as saying “ Give me six hours to chop down a tree and I will spend the first four sharpening the ax.” An ax is a strength multiplier. You can be the strongest lumberjack in the world, but with a dull axe, you are in trouble!

Through experience, I have come across various scenarios where start-ups land into trouble due to making certain common mistakes, which could easily have been avoided. These mistakes are made frequently at the nascent stage of the business.

I have picked out the most common ones and briefly stated how they can be rectified. 

Error # 1. Not knowing which legal entity to opt for

This is usually one of the very first decisions and one of the most important ones - what legal form to adopt to operate the business. Founders generally do not consult lawyers and act whimsically when choosing the legal entity as they do not think it will have a great impact. However, they can incur higher taxes and become subject to significant liabilities that could have been avoided if they had structured the business as a corporation or a limited liability company (“LLC”). But again depending purely on the type of business involved the legal structure has to be decided upon.

Keep in mind that, prior to forming an appropriate legal entity, the founders have personal liability for the debts of the business.

Error # 2. Get it right amongst yourselves as Founders

Typically, what happens is that a start-up is usually formed with friends or acquaintances. Since trust is high in these relationships, people generally ignore to think about any worse case scenarios and do not jot down crucial points that are paramount to serve if and when things turn sour. Think of the founder agreement as a form of “prenuptial agreement.”

Previously, when I asked a disgruntled founder, who was in a deep mess because his friend, who was his co-founder, had ditched him taking away half of the company shares, that why didn’t he pen these points in their Co-Founders Agreement? His reply did not surprise me which was that the co-founder was his best friend and they could not even imagine things taking this turn and that too so soon. 

I urge all start-ups to have this difficult yet crucial conversation early on and get it clear – demarcation of roles and responsibilities of the different founders, allocation of equity, who is going to have what sort of title in the business, how key decisions shall be made, the financial picture of the contribution of cash, sharing of profit/loss, vesting shares, exit mechanism, termination, assignment of intellectual property etc. 

We all are familiar with the Winklevoss brothers vs Mark Zuckerberg scenario, one Agreement between them would have altered the course of history – it’s that important!

Get it all penned down in writing, have a difficult conversation now as opposed to later. Consider seriously subjecting all of the founder's equity divesting to avoid situations where a founder leaves after a short period of time with all their equity free and clear.

Error # 3. Not Maintaining Proper Corporate and HR Documentation

I recently came across a case where a start-up had landed itself into a boggling mess as they had misplaced a very important document. Being new to the business they are often sloppy in maintaining proper corporate and employee/HR-related documentation. This can become problematic as it piles up over time and when the company seeks investors, or is involved in an M&A activity, or even gets embroiled in claims or litigation with an employee or regulatory agency, then their position becomes synonymous to a drowning man trying to catch onto straws. Here is a compendium of the types of documentation the company should consider maintaining carefully:

·      Board and shareholder resolutions and minutes

·      Signed contracts 

·      Stock and option records 

·      Employment agreements

·      Employee related documentation

·      Finance related documentation

·      Confidentiality and invention assignment agreements

Error # 4. Taking Intellectual Property casually 

This is another crucial area that demands attention right from the start. Be careful about protecting your intellectual property!

A typical scenario that I see with budding companies is that they hire people to develop some sort of intellectual property for their company and assume that it will automatically belong to the company – Wrong! That individual can go rogue and profess ownership over the intellectual property that he has developed and you will only be able to claim it back after a long legal haul and till then a lot of damage may have accrued. 

Imagine the value left of a Tech Startup which does not own its intellectual property? Probably not much. Time and time again we hear stories of offshore developers writing business critical code without the necessary legal documents to assign the code to the entity which engaged them. Moreover, an investor will not be willing to put money in such a company where the intellectual property hangs in a balance. 

Make sure you have a proper mechanism to own every bit of intellectual property being developed for the company, or at least have the right license to use it.

Error # 5. Not requiring relevant people to sign a Confidentiality Agreement

Imagine you in all your enthusiasm discuss your idea with a prospective investor, just to impress him, only to find later it gets leaked to another party and they avail it. You may hire people to come up with ideas, work product, and inventions that may be useful to the business. Employees have access to a good deal of their company’s confidential information, which can be very valuable, especially in technology companies.

One basic way to protect proprietary company information is through the use of a confidentiality and invention assignment agreement. This should be the first step and not a “I will send you our NDA to sign later”. It could be with employees, investors, vendors, board members, suppliers and manufacturers or anyone who has to be exposed to sensitive company information. 

Error # 6. Termination and Exit issues

Termination clauses must be clearly drafted.

Some common situations where the contract may be terminated i.e obligations of the parties will come to an end and they will no longer be bound by the contract are: 

i)) on expiry of the Term; 

ii) at will or for convenience; 

ii) due to change of control;  

iii)due to death or disability; 

v) due to insolvency; 

vi) for cause (this gets triggered in the event of breach); or 

vii) force majeure (something which is beyond your reasonable control)

Terminating an employee can entail legal risk if not properly handled and documented. Similarly, exit strategies should be clearly laid out in various agreements, including the Founder’s Agreement. A good legal counsel can direct you rightly so your company can avoid all the legal drama that can be initiated which will not just drain the company’s pockets but can also affect its goodwill too. 

Error # 7.  Having weak EULA, Terms of Use/ Service and Privacy Policy for your Website

The market for software and applications designed for personal computers, mobiles and cloud-based applications has increased significantly with several new businesses emerging in this space. For these businesses, since software or related services form a critical revenue stream, it is important that the software is not used in an unintended manner or in a way that prejudices their commercial interest. For their end customers, the objective is to ensure that such applications fulfill their purpose on a reliable basis. 

A Terms of Use Agreement sets forth the terms and conditions for people using your website. Your privacy policy is a legal statement on your website setting forth what you will do with the personal data collected from users and customers of the site, and how such data may be used, sold, or released to third parties.

Having these agreements properly written is extremely important. Some of the more prominent clauses that these agreements must have are:

1.    What is the software that is being licensed? 

2.    What is the nature of the license granted to the user? 

3.    What are the limits imposed on the manner in which the software is used?

4.    Can the software be used for a commercial purpose, or can it be rented or sub-licensed by users? 

5.    What is the term of the license? 

6.    How to terminate the agreement? 

7.    What are the provisions for support?

8.    Are there any warranties accompanying the software? 

9.    Is the software fit for its intended use? 

10. What is the liability of the software manufacturer in case of malfunction?

There is a temptation to copy privacy policies of similar websites and use them as your own, however, that is a bad idea and can easily lure you in a ditch. 

Having a privacy policy is not just a formality but a legal requirement now.

A good policy would essentially answer the following questions: 

1.    What data is being collected?

2.    How is data collected? 

3.    How is the collected data used by the organisation? 

4.    Is there any usage of cookies or web beacons? 

5.    Is there any usage of third-party plugins and the collection of data by third parties? 

6.    Will the data be shared or used by third parties?

7.    Is there any way to opt out of the data collection process? 

8.    Is there any way to delete or remove collected data? 

9.    Will the data be transferred to other jurisdictions? 

10. Whom to contact for any grievances?

Error # 8.  Not having the Right Legal Counsel

In a misguided effort to save on expenses, startup businesses often hire inexperienced legal counsel, including lawyers who are friends or relatives, or those who offer steep fee discounts. Maybe your Aunt Sally, who is a family lawyer, generously volunteers to help you draft contracts and you get excited as you get to save money and get free counsel. However, they should include a caveat as in doing so, the founders may be inviting trouble and soon find themselves enmeshed in substantial legal problems. I implore Founders to think smart and consider taking counsel from a lawyer who is most apt for their area of interest. The right choice at the right time is an elixir that guarantees success – no exception!

Conclusion

Startups that manage to avoid these legal pitfalls and missteps have a better shot at success than do those companies that fail to anticipate and plan for them from the beginning. Invest in planning and obtaining expert advice now to avoid major problems later.

These issues faced by early-stage companies are common, and although each legal situation is unique and requires all the facts to be examined before concrete advice can be rendered, they can generally be navigated easily with a straightforward approach and attention to market standards and trends.

A piece of GOOD NEWS for startups:

We at the British Legal Centre have recently uploaded an extremely beneficial course specifically for startups. You might not even need a lawyer after this course, there is so much good resource and advise for you in it. 

This course has 7 intensive modules which teach participants to understand the kinds of legal agreements needed to protect themselves and their clients. Major phases of startup and financing are taught, telling you what you can expect and how to make informed decisions. We even provide your own templates to work with.

This is an MBA level class taught by an experienced MBA/Law professor Marjorie Sudrow.

Whether you’re a buyer, seller, investor, B2B or B2C, tech developer, designer, inventor, or lawyer who wants to learn about the law, financing and documentation of High-tech company start-ups, these modules will be the best spent time of your startup career.

The author is the legal representative of the British Legal Centre for the GCC states and also a Legal Manager. 

If anyone is interested in the Start-up course do contact me for a special discount.