Major legal issues faced by early-stage innovative businesses
What kind of legal issues inexperienced undertakers may face during the early stage of business ideas in today’s world of informational technology?
During one of my last interviews, I was asked if the role of a Chief Legal Officer (CLO) is essential for a startup and what are the main actions I take for the one I participate in. The straightforward answer was: “Everything — from internal legal structure — to covering all touchpoints with partners and clients.” In general, the CLO — the most annoying team member who constantly reminds everyone that every significant action of the company has to be documented or otherwise legally protected. Sometimes early-stage entrepreneurs find it difficult to differentiate between the notion of a business and a company. Many founders are not exactly familiar with this crucial detail, which may well cost them the future existence and development of their enterprises. The assumption that if the business goes well, everything with the company is in line might be pretty wrong. For this reason, it is advisable to take into account all frequently encountered legal issues that may arise and prioritize the prevention of the latter. This article aims to introduce some of the risks that may come to the surface at different stages of the innovative undertaking and help you find out if you have it all covered.
1. Undefined Business Structure
It is not necessary to have a company from the start. You may decide to operate the undertaking without any formalities up to a certain point. However, when you, your co-founders and partners start creating significant value (having an increasing number of customers, generating substantial intellectual property or partnerships), you need to start thinking about company incorporation. Defining the company’s structure is the foundation of all future work and policies you will put in place for your innovative business. It also affects your tax responsibilities and the extent of personal liability in the event of a lawsuit. Thus, the first decision revolves around where and what type of legal entity to register. The most important things to consider are:
- Favourable tax regime;
- Flexibility for equity distribution and vesting schemes;
- Options for using diverse ways to raise money (including issuing financial instruments);
- Maintenance expenses (legal, accounting, employees’ insurance, etc.);
- Difficulties for bank account opening;
- Possibilities to remotely operate with the legal entity.
2. Missing essential provisions in the Articles of Association and Shareholders Agreement
Usually, the local legislation imposes some limitations on the shareholder’s ability to include everything they agreed to in the Articles of Association (“AAs”). This document governs the shareholders’ relations and their rights and obligations related to the company as a structure. Accordingly, the AAs determine the voting rights for important decisions such as accepting new shareholders, purchasing real estate, appointing managers and C-level executives, getting funding in any form, acquiring other companies, etc. Therefore, it has to be done from the beginning. Otherwise, it might be too late at some point.
The Shareholders Agreement (“SA”) aims to cover everything which cannot be included in the AAs. Further, the AAs are frequently publicly accessible, and the shareholders may decide to keep some of their arrangements private and confidential. Typically, the SA governs the personal involvement of the founders and other key employees in the enterprise. Here, one can easily spot the difference between the people involved in the undertaking and the company. The SA satisfies the necessity to have a clear framework of each participant’s rights and obligations. Thus, the business is correctly held while the legal entity’s underlying structure remains secure and flexible, which is the favourite setup for all investors.
3. Applicable law and Licensing
Did you know that a contract may be recognized in one country while it may be null or invalid by a court in another? Such a case is just one of the implications of the applicable law. The legal systems worldwide are not unified, and sometimes international undertakings encounter the necessity of dealing with partners and contractors worldwide. However, imagine that even if you agreed with a developer in another country to contribute to your platform, you may, in the end, find out that you don’t have all rights to the source code that he produced. This situation may happen if local law where this developer lives and works require additional deeds to be performed or more specific text to be included in the contract so that the title of ownership over intellectual property is transferred to the enterprise. Beware that although the applicable law is always at the end of the contract, it significantly impacts your relations with the counterparties.
4. The Website — Your Contract with the Public
Besides new business opportunities, your website may bring you many headaches if the legal framework behind it is not in place. Via the webpage, you interact with the end-customers who are always under the protection of their local regulators, and if somebody complains, you might be in trouble. Therefore, one of the steps you should take is to use a privacy policy compatible with the legal requirements and global standards. The privacy policy is a statement that discloses some or all the ways of gathering, using and managing the online visitor’s data. For example, the privacy policy should tell users about the information collected by the interface, the purpose behind this, and the steps taken for its protection.
On the other hand, the absence of a privacy policy or the content of very general texts that do not fully cover the innovative business can lead to severe sanctions on the company and its activities. You shouldn’t also “borrow” similar businesses’ terms and conditions. Remember that the risks related to your online platform and specific ways of doing business are not the same as those of other enterprises. A thorough article will be dedicated to this subject matter, as it requires a detailed overview. However, don’t copy — otherwise, you are risking having headaches covered by the next point.
5. Protection of Intellectual Property
Intellectual property refers to creations protected in law through patents, utility models, designs, trademarks, and copyright, enabling the creators to earn recognition and financial benefits from their creative efforts. Patents and utility models prevent others from replicating your unique hardware (in some countries software) products, chemical compounds (or processes for their production) and other objects of patentable intellectual property. Please, mind that the patent and utility model protection can be costly. Thus, entrepreneurs need to evaluate on a strategic level when and how to approach this issue in the most financially and legally sound way.
On the other hand, you don’t want to receive one of these notices that somebody “kindly requests” you to change the brand name under which you are developing your business because he has already registered a trademark. Such invitations are frequently garnished with some monetary claims for the time during which the protected name was used.
One of the most critical components of today’s innovative online undertakings is the proprietary source code on which the magic web, mobile and desktop applications are built. Unfortunately, sometimes early-stage startups forget to document the generation of such source code leading to the lack of clarity regarding the ownership over the software. For example, imagine that you have created Viber and don’t know if you have all rights to the application’s source code, leading to the investors backing off.
This article is quite far from exhaustive regarding all “dots” that need to be connected from a legal perspective when a successful enterprise is on its way up. The typical initial disregard of the above-described matters can quickly come back and cause problems at the moments when one needs them the least — negotiating with investors. It is essential for future growth to have a clear track record of all legal relations that the company is part of and protect its assets. When a startup starts to transition to a scaleup, the founders realize that having the proper legal structure underneath the project can save you much time and spend the money raised or earned for better things rather than filling in gaps. From the investors’ standpoint, it is clear that they would like to see their target scaleup grow fast and eventually reach the unicorn phase. Nevertheless, this may never happen if the company’s backbone is not built up based on the right legal foundations. We will tell you more about those critical pillars in the articles to come.
