On day one, startups need to make some crucial decisions. A very crucial one, which is quite often overlooked, is to hire a lawyer. A lawyer will assist in taking the seven important legal decisions that can make or break a startup.
When startups commence their journey, revenue is quite literally, top of the line. In a frenzy to hit the road, startups spend an enormous amount of time thinking about the long haul with their co-founders, dodge idea stealers and junk assumptions of their business nearly every two weeks.
All of this requires a tremendous sense of energy. However, in this article, I will urge startups to ensure they stretch the last vestiges of energy to realize the need for a lawyer and hire one.
Very few startups think of this as important for a variety of reasons, but, mostly because they have already hired Google as in-house counsel that is prompt by being present on the founders’ homepage. I am usually asked to elaborate on the following by startups not necessarily on day one, but, at some point and sometimes it is too late. So, let me get to it right away.
When to incorporate?
There is no definite answer to this question. If your first revenue generating client is on board, then do it pronto. Co-founders need to be on the same page on several aspects – how soon will the startup hire, how soon it will require intellectual property protection, will it be seeking outside capital, will it be granting stock as an incentive, will it be signing contracts, does it need protection from liabilities on day one and so on.
No lawyer possesses a stock answer to the question of incorporation, but, a lawyer usually asks a lot more questions to understand if the founders are aligned in their interests. If the answers to majority of these questions are yes you should incorporate. Incorporations in India can cost anywhere between Rs.10,000 and Rs.1,00,000 in legal fees. Be sure to ask your lawyer the services that you will receive for the fee that is quoted and set realistic timelines.
Choice of entities
The vast amount of legal options for setting up shop in India need not all be tested and tried. The complete range of choices include limited liability partnership (LLP), partnership, companies, unincorporated bodies such as Association of Persons (AoP), Body of Individuals (BoI), For profit Trusts, the obvious choice is a company that caters to the likes of the founders who prefer limited liability and investors prefer the reporting requirements that the company structure requires companies to comply with.
You get the chance to select a life partner. This is for the long haul, no mistakes about that. Why would you jeopardise something so precious by not making sure the parties to this haul are on the same page? The importance of a founder’s agreement cannot be over emphasised. This document should deal with all the uncomfortable questions you would rather not ask like how much should one get paid and why and of course, the big question- who owns the startup idea?
Invariably the co-founder is a friend, colleague, sibling and sometimes a spouse. Fifty per cent of the time, dilution in a startup is not from an investor but from the co-founder. One day one the co founder holds sometimes 50 per cent of the equity and that’s the first round of dilution the startup witnesses. Make sure the terms for such a stake is clearly understood by the founders and that you have it written. Oral understandings, as they say, are not worth the paper they are written on.
Stock option pool
The Stock option pool is the amount of stock that co-founders can distribute to best performers in the company, outside consultants and themselves. The option pool is created for unlisted companies in compliance with the Unlisted Public Companies (Preferential Allotment) Rules, 2003. Stock options are normally vested over a period of time, rather than given all at once. Options are not really yours until they are vested. They are no doubt attractive, but, random distribution to several people makes the investor value the startup stock less. Your attorney will assist in drafting the typical documents once you have made the decision to issue options and this will usually comprise the ESOP scheme, Trust Deed, (in case a Trust is going to administer the ESOP), Grant Agreement, Option Certificates and the relevant Board & Shareholders’ resolutions. The tax and accounting treatment of the options deserves equal attention and make sure you understand what the tax professional advises. Also, do remember that typically with each round of financing the option pool gets re-negotiated.
When a startup’s business idea is stolen by an employee or co-founder who has spun himself a new outfit, the idea owner is confused, angry and hurt or all of these emotions. The only thing that outpaces the rate of startup ideas being churned is the birth of new markets everyday. The fact that on day one a startup idea is worthless unless there is more than an idea is proven by the fact that there is no market for the startup idea on day one. Yes, a non disclosure agreement (NDA) is a founder favourite, but, think about why a venture capitalist for example, would sign one? He hopes to make similar investments in similar markets and make his money, there is no way he would open himself up to all kinds of potential litigation. The only advice here is selective disclosure, the one true weapon you have.
Complex structures equals loss of peace
The best team of accountants and lawyers will not help your startup take off if the structure is complex – say ten shareholders, the ever-helpful family of the founder, being allotted preference at one price, founders being issued equity at another price, three angel investors being issued convertible stock and so on. This will mean a liaison exercise that will consume enough hours to hire a full time in-house counsel should a VC even barely glance in your direction and with this structure a VC will ensure he does not. Keep it simple, my preference is convertible stock since there is no hard stop line on the valuations at the time of issue.
Armour of legal documents you must have and where to get them
The armour consists of
(a) Shareholder/Founder Agreements
(b) IP Assignment agreements
(c) Share Subscription/Purchase Agreements
(d) Employment Agreements
(e) Charter documents and by laws of the Company.
Stock options are normally vested over a period of time, rather than given all at once. Options are not really yours until they are vested. They are no doubt attractive, but, random distribution to several people makes the investor value the startup stock less.
Startups are always ingenious when it comes to cost cutting, but, one thing they must remember is auditors and lawyers are trained in different skills and there is a reason why they organise themselves differently. One cannot substitute the other. Having said that and after having found many expensive lawyers who will not lower their per-hour billing rate, do not give up. Find a lawyer who will work on a flat fee basis, speak to other startups he has worked with and do not be afraid to ask questions on how he will help you with these must-have agreements. A lawyer’s assistance in spotting, analysing, strategy building and execution are the skills you should be hiring him for.
This article first appeared in the SmartCEO and was authored by Aarthi Sivanandh.