Running a start-up comes with several challenges, be it spotting the right opportunity, executing a bright idea or raising the capital to do so. Something that rarely gets discussed—at start-up forums or venture capital (VC) seminars—is the legal aspect of starting and scaling a company. A start-up may be on to the next big thing, but if its founders cannot protect it legally, it could lead to a lot of time and money wasted on litigation.
Such risk could emerge in the form of a dispute between founders, legal manholes at the time of funding or even simple but critical regulatory approvals. In the past, Mint has written on what VCs look for in start-ups and how to find the right VC for your business. This time, we draw up a check-list of 10 legal points a start-up should keep in mind.
1) Whose IP is it anyway?
Legalities could creep in even before you begin. When you quit that job to start something on your own, make sure the IP (short for intellectual property) belongs to you. If you have worked on the idea at your previous employer’s office using its resources, or utilized parts of an office project to build your own plan, you could leave yourself open to questions later. Companies have been sued for “idea theft” before. Social networking site Facebook Inc.’s founder Mark Zuckerberg was sued by ConnectU Llc. in 2004. ConnectU’s founders alleged Zuckerberg had stolen their idea and code to start Facebook when he briefly worked with them as a consultant in 2003. The case was dismissed last year, but ConnectU has filed again and the case continues. Generally, such charges don’t stick but time and money on litigation can dilute your focus on your business.
2) Start right
How and where you register your company could make a lot of difference. In India, you could register a company as a private limited, proprietorship or partnership. The last two, however, are not fundable models. VCs want stock in a company, which cannot be given under a proprietorship or partnership. Vendor and customer companies also prefer dealing with a company that has limited stock. In a proprietorship, the sole owner is personally liable for risks the company takes. Registering a proprietorship is quicker and inexpensive, while a limited stock registration could take up to six weeks and cost between Rs12,000 and Rs20,000 for a company with Rs1-1.5 lakh paid-up capital. For this reason, many start out as a proprietorship but change later. A Bangalore-based Internet start-up, which did not want to be named, has operated as a proprietorship for more than a year and plans to change before being funded.
Several start-ups also go for a US incorporation. If the product or service is global in nature, and a potential exit—through initial public offering or acquisition—lies in the US, this makes sense. It is costlier than an Indian registration, but takes just two-three days to incorporate in Delaware state. “Most ramifications of a wrong incorporation relate to tax. You have to evaluate where you want to list, and choose accordingly,” saysAmitabh Nagpal, founder, Studyplaces Inc., an education start-up that chose a US incorporation.
3) Friendship is fine, but put things on paper
Decide ownership of company and course of action in case of potential conflicts at the earliest stage possible. Put down everything on paper, legally. If one of the founders in a start-up decides to quit at a later stage, it is difficult to resolve the issue unless a framework is already in place. Last June, local search firm Burrp.com got into controversy as a former college mate of its founders accused them on a blog of not giving equity to three others involved at the beginning. “The (allegation) is baseless. We signed on a law firm very early, which helped us get documentation in place for ownership and other issues,” says Deap Ubhi, CEO and co-founder, Burrp Software Pvt. Ltd, adding it is key to institutionalize capital structure.
4) Term sheet is only an expression of intent
At a recent conference, a representative from a small business in the power sector was confused. His company had received a term sheet from an investor and in the belief that money would follow, the founders borrowed money from other sources in advance. Six months later, the deal still had not been sewn up. When a VC offers a term sheet to a start-up expressing interest in funding, it is just that. It is not legally binding on the VC. All it guarantees is confidentiality and exclusivity (for the VC) when due diligence is done. Typically, it takes less than six weeks from signing the term sheet to close funding, but it can drag on.
5) Start-ups foot most legal bills
During the funding process, legal counsel is usually hired by both the VC and the start-up to negotiate the details. When it was getting funded by Helion Venture Partners, mobile payment start-up JiGrahak Mobility Solutions Ltd decided to bring in a lawyer towards the end. “Talking to the investors is peer-to-peer, but talking to their lawyers got too complex, and it takes up too much time,” says Sourabh Jain, CEO, JiGrahak. Legal counsel is expensive, and the start-up typically bears the charges for both the VC’s lawyers as well as its own. The lawyers’ fee depends on complexity and size of the deal. Typically, the firm could charge 1-2% of the investment amount. If the VC offers to share legal representation during funding, you have to sign a document waiving off conflict.
6) Founder stakes are tied with employment
Just like funding is often tied to business milestones, the founders’ personal stake too comes with conditions. “At early stage, VCs invest in the team, so often there is an employment agreement tied in with the founders’ stake,” says Shantanu Surpure, managing advocate and attorney at law, Sand Hill India Advisors, which specializes in legal counselling for start-ups and early stage venture capitalists.
7) Founders can be replaced
Once you have investors, you have to report to a board of directors. Read the fine print. For example, a clause could state the board comprises one representative for the investor, one for the start-up founder and one CEO. And, a founder need not always be CEO post-funding, and can be replaced. Case in point, online travel company Cleartrip Travel Services Pvt. Ltd. After KPCB Ventures and Sherpalo Ventures funded the company, Sherpalo partner Sandeep Murthy took over as CEO and co-founder Hrush Bhatt became director (product and strategy). Murthy says the decision was an amicable one— it need not always be.
8) Use it right, get rights to use
When you are developing a product or service, check that you have the right to use all external technology that is part of your offering. For example, if you are building a product on an existing platform, ensure you have permission to use it. Open source is not a free lunch, it is freedom to access and modify. An open source software can be given away freely or sold, and the source code should be included or made available.
9) Outsource the work, but keep the IP in
Just as you ensure you cannot be sued, make sure the IP for the work you outsource rests with you. This means when you hire contract employees, external coders or companies that could execute part of your technology, make sure they cannot misuse your IP for their own use or share the information with others. Sign a master services agreement covering confidentiality and ownership terms.
10) The rest
Your check list should also include business partnership agreements, provident fund registrations for your employees, tax registrations and lease agreement for office space. There will be other compliances specific to the start-up. For example, online travel company Makemytrip India Pvt. Ltd needed two separate approvals from the department of telecommunication, as it operated an international call centre and a domestic one for customer queries. “These are not just things that are nice to have, they are mandatory. Without them, you cannot operate,” says Rajesh Magow, chief financial officer, Makemytrip.