3 Legal Decisions Every Founder Must Face
Guest post by Nick McNamara - Paralegal at Lehman Walsh Lawyers
The recent example of Snapchat, along with countless others, demonstrate why professional legal advice is imperative for all startups. All founders are faced with crucial legal decisions that can be implemented with the assistance of a legal profession. Some of the decisions include when they should form a company, how they should allocate equity and how can they protect themselves and their product.
Forming a Company
Forming a company has the benefit of limiting the liability of the shareholders. Australian law views a company as a separate legal entity that can own and dispose of property, enter contracts and sue or be sued. It is distinct from the owners, managers, operators, employees and agents and thus protects their personal assets. Formation of a company should occur early in a startup's life to safeguard the members from any liabilities that may arise in the future. Limiting a founder's liability is critical as startups require a significant investment of time and money and have a high failure rate.
One of the greatest challenges for a startup is raising and maintaining sufficient capital to continue the endeavour. Investors find companies as the most appealing business structure as equity can be provided for their investment. Options such as convertible notes can be used before an accurate valuation of the company is made, allowing for startups to generate capital in their earlier stages. Companies also have the benefit of a flat tax rate of 30 percent and startups may qualify for additional tax relief or financial aid via grants from the Australian Government.
Two decisions should be made about allocating equity. The first is how the equity will be allocated among the founders, other key members and investors. The second is when the equity will be vested.
Founders must determine how the equity will be allocated among the current members; this should be completed with a view of what roles each member will undertake in the future. A shareholder agreement should be drafted to set out the rights, obligations and share allocations of each shareholder and provide a guide to how the company will be operated. Startups are often innovative, and the value of original ideas, sustained effort and varying tasks can be clouded over time. Therefore it is best to determine this early in the startup's life. Snapchat's recent lawsuit by former founder Reggie Brown is an example of why recording each member's involvement from inception is crucial. Other examples include uBeam and Facebook, where disagreements between the founding members have resulted in lawsuits.
When equity vests in each member are as important as allocating. Vesting Clauses dictate when each shareholder will receive their share. A share subscription agreement can be drafted to determine the process of vesting the shares. Usually, this will occur over a four-year period, with the shareholder receiving 25% of their share after each year. This provides an additional incentive for members to remain with the startup, reducing the risk of losing key resources to complete the startup's goals.
Protecting the Founders and their Product
Scaling a startup's team to operate within the confines of the law is essential. While limited liability is a benefit for forming a company, there are instances where this is not afforded to certain individuals within the organisation. In Australia, some examples of where limited liability will not apply include when a company knowingly trades while insolvent, where a director acts outside their authority and commits a wrongful act and where a director enters into an agreement to prevent employees from recovering their entitlements. There are many scenarios where limited liability will become unlimited; this is a contentious area of law so it is important for members of startups to be aware of how the law is changing and what actions could make them personally liable.
A startup's key asset is its product; therefore, the founding members should ensure that the product is adequately protected from the startup's inception. Active protection of the company's intangible assets should be a priority with all employees entering into a non-disclosure agreement and assigning intellectual property to the company via an intellectual property assignment agreement. This is particularly important in the early stages of the startup when intellectual property is owned by individual members and not the company. Once the company is established, intellectual property that is created by an employee of the company during their employment will be owned by the company. However, if the company uses an independent contractor instead of an employee, then the intellectual property will likely be owned by the contractor. It can be difficult at times to determine if a company has hired an employee or enlisted an independent contractor. Features such as control over work, if the tax is deducted from remuneration and whether tools and equipment were provided are used to determine if the company has hired an employee or an independent contractor. For this reason, it is paramount that the employee/employer relationship is defined in the employment contracts and that the contract dictates who owns any intellectual property created.
The examples of Snapchat, Facebook and uBeam demonstrate the necessity of professional legal advice at the foundation. Startups are vulnerable in their initial stages, consulting a lawyer early on will assist in protecting their product, reducing their liability and remove ambiguity in any future disagreements.