TOP 10 LEGAL MISTAKES OF EARLY STAGE COMPANIES

Presentation by Andrew Arnold - Partner of Deacons at the TiE Angel Forum





Recently, an article written by James T Greenberger concerning the top 10 legal mistakes of US early stage companies was brought to my attention. I thought that it would be worthwhile to produce an Australian version of the top 10 legal mistakes of early stage companies. This article focuses in particular on issues that emerging companies should bear in mind when dealing with proposed venture investors.
1. Intellectual Property Searches
An early stage company should obtain adequate trademark and business name searches before commencing to trade under its chosen name. Registering an exciting or catchy domain name will not provide sufficient protection if there is an existing business conducted under the same name, or a substantially similar name. The last thing an emerging business needs is to establish goodwill under a proposed new name only to find out that the name must be changed in order to avoid threatened action from an existing user of the name. Potential consequences of commencing trading under someone else’s name include threatened actions for passing off and trademark infringement.
2. Failing to adequately secure intellectual property rights
Uncertainties concerning ownership of key intellectual property can kill a proposed investment. Any significant problems in this area must be identified at an early stage. The following are examples of commonly encountered intellectual property issues.
(1) Ownership of Intellectual Property versus Licence
Where intellectual property is a key asset of a new business, then the ownership rights in that intellectual property must be clear. Key documentation concerning ownership of intellectual property should be in place from the outset. If the company does not own key intellectual property, but merely licences that intellectual property from the founders, then this may be a problem for some venture investors. We have also seen instances where intellectual property rights are claimed via a complicated series of licences and sub‑licences, in some cases involving overseas entities, and in other cases involving documentation in foreign languages.
(2) Registrations
To the extent that a company has key intellectual property assets that can be registered such as trademarks, business names and domain names, cost effective registrations should be undertaken at the outset. In addition, if the investee owns patentable intellectual property, then it may be necessary to consider patent applications within Australia, or on a worldwide basis.
3. Inadequate contracts with employees and contractors
An early stage business should critically analyse the proposed form of employment contract or engagement letter to be used with key employees. It should be determined whether the contract adequately deals with issues of confidentiality and ownership of intellectual property. For example, the employment contract should specifically state that all intellectual property rights concerning inventions and ideas developed during the course of employment are assigned to the company. The ideas and contributions of key employees are fundamental intellectual property assets of the company. It is also important to attempt to sign up key employees for a specific agreed term, for example 2 to 3 years.
4. Treating Shares and Options as a Substitute for Cash
There is a temptation for early stage companies to offer consultants and other third parties shares or options in the company in lieu of cash payments. This has the advantage of reducing the demands on the limited cashflow of an emerging business, however it can also create a number of problems. Venture investors prefer to deal with a small number of shareholders, rather than facing the prospect of negotiating with a large body of shareholders. Therefore, the temptation to issue shares to a large number of family members at the outset should be resisted. Similarly, to the extent possible, shares should not be issued to contractors and other third parties as a substitute for cash. This can also create problems under the applicable securities laws, and is discussed under heading 6 below.
5. Failure to adopt a clear policy for employee shares and employee options
Two structures that are commonly used by companies wishing to issue shares or options to employees as part of an incentive package are as follows:
(1) Shares could be issued to the employees at market value and the company could lend funds to the employees to assist in the acquisition of the shares. In that circumstance, the employees potentially have access to a 50% CGT discount if they hold the shares for at least 12 months.
(2) An employee option scheme could be adopted. One benefit of options is that they are ideally suited to the concept of incentivising senior employees and directors. Options can be tied to performance milestones so that they only become exercisable in stages upon the achievement of those milestones. One disadvantage of options is that the establishment of an employee option scheme is more costly and time consuming.
In addition, whenever shares or options in the company are being issued, great care must be taken to ensure that there is no breach of the prospectus provisions of the Corporations Act 2001, as discussed in section 6 below.
6. Compliance with Securities Laws
A fundamental aspect of the professional management of the company is ensuring compliance with the law. An early stage company must take clear advice concerning the securities laws in the jurisdictions where it will raise money. Strict compliance with those securities laws must occur in order to avoid future problems.
Offers of securities can only be made pursuant to a prospectus that has been lodged with ASIC unless a specific exception applies. Most of the exceptions are found in section 708 of the Corporations Act 2001. Early stage and emerging companies issuing shares to angels and venture investors in Australia rely entirely on exceptions of the type found in section 708. Strict compliance with these exceptions is required.
7. Company Documentation
It goes without saying that in order to attract venture investors, a company must be able to demonstrate that it has a sound business, good quality management and clearly articulated plans for the future.
The managers of early stage companies must deal with many competing demands on their time and resources. One matter that is often given insufficient attention is putting in place the key documentation and legal structures that will ensure that the company is continuously “investor ready”.
Most emerging companies will focus on one key type of product or service. The core dealings of the company with both suppliers and customers should be conducted using appropriately drafted terms and conditions from the outset. This will minimise potential “leakage” of key rights, such as intellectual property rights in core software supplied to customers during the early stages of the company’s trading.
8. Legal Structures
In many jurisdictions, the choice of legal entity is a key issue for new businesses. In Australia, the entity of choice is usually an Australian proprietary company limited by shares. However, in some circumstances, there are other entities that may be appropriate. The choice of entity must be governed not only by the founders’ taxation considerations, but also with the view to the company’s future investment audience, ie, a structure must be put in place that is both very familiar to venture investors and can easily accommodate the issue of securities to new investors.
If a short term objective is to move into international markets, then the proposed structuring for such expansions should be considered at the outset. The founders’ taxation circumstances and the needs of future venture investors are paramount considerations. For example, incorporating in the British Virgin Islands may be attractive for some founders, however, it may make a business less attractive to future investors who are unfamiliar with that jurisdiction.
9. Shareholders Agreement
Many companies do not have a shareholders agreement until their first round of venture funding. I recommend that most early stage companies should have a simple shareholders’ agreement between the founders long before the company starts talking to venture investors. This shareholders’ agreement will identify the founders’ expectations and the rights of shareholders. In particular, it is important to place restrictions on the transfer of shares by existing shareholders and the issue of new shares. This will help to avoid difficult negotiations where circumstances change, for example, where one of the founders departs or a new key manager joins the company. If there is already a shareholders’ agreement in place at the time that the company begins talking to venture investors, then this will minimise the need for parallel negotiations between the founders at the same time as negotiations take place with potential venture investors.
10. Selecting a Venture Capitalist
The process of finding a venture capitalist does not simply involve looking for someone with money to invest, rather it is a process of selecting a trusted business partner who will add value to the company above and beyond a cash investment. The founders should thoroughly investigate potential venture investors, including their other investments in similar companies, the venture capitalist’s exit strategy and time horizon, whether or not the venture capitalist is willing and able to participate in future rounds of financing and the outcome of any previous disputes between the venture capitalist and management of other companies.
The company should be continuously aware that each potential investor has its own needs and expectations. Failure to adequately respond to the particular needs of a proposed investor may cause the company to miss an investment opportunity.
This article is intended as a general summary only and should not be relied on as a substitute for legal advice.