Corporate

Timely legal advice for startups key to avoiding pitfalls

By AdvocateDaily.com Staff

For new business owners, seeking legal advice at the outset on everything from shareholders’ agreements to intellectual property rights can be a crucial step in order to avoid headaches and disputes later on, says Toronto corporate lawyer Sammy Redlick.

Legal advice and the agreements put in place can differ depending on the scenario a new business aims to follow — whether more of a traditional model, funded using the owner’s money until profitable, or a startup path, where entrepreneurs will seek to raise capital, says Redlick, partner with Torkin Manes LLP.

For most, the first step, he tells AdvocateDaily.com, is to establish the company itself, taking into account the founders’ vision for the business, how they plan to fund it, who the shareholders are and what their contributions will be.

“Establishing the corporation and helping them work through how to set up the initial capitalization of the company is an important step. And in doing that, we always strongly recommend a shareholders’ agreement, and we work very closely with our clients to work through the shareholders’ agreement and all of the considerations there,” Redlick says.

“Whether it is a more a traditional model where we think there’s an operating business that’s not going to have new shareholders all the time, versus a startup that’s going to have several rounds of investments and eventually venture capital investors, that will make a huge difference in the approach that we take at the outset with the shareholders’ agreement,” adds Redlick.

For example, he says, often startups are ‘bootstrapping’ their business and making difficult decisions on where to allocate funds.

Although it is preferable to have a shareholders’ agreement drafted as close to the startup as possible, Redlick explains that in these cases, if the business chooses not to, it’s not the end of the world until they have something worthwhile to protect.

“It’s not unusual sometimes for startups to either do a very short form shareholders’ agreement or no shareholders’ agreement at all and then when they are ready to raise capital, we say, ‘Now let’s do a shareholders’ agreement’ because you’re taking real money from outside investors and at this stage, you really have to have something,” he says.

At the same time, Redlick cautions, there is a narrow window in which to have this discussion. “If the company is just starting and has no money and they want to wait until both people feel committed that the business is actually going to be something, that’s fine, but if you wait until it’s a successful business, it’s hard.”

For businesses in either stream, Redlick says it is essential to work with legal counsel early on in order to have employment contracts in place when you are bringing new hires on board. This, he says, is crucial when it comes to controlling severance costs as well as protecting confidential information and avoiding solicitation of customers and employees.

In addition, new companies should be sure to address the issue of assigning intellectual property rights in the early stages.

“This is something that applies, not only in employment agreements but is also critical in any independent contractor agreement. If you outsource technology development to a third party who is not an employee of the company, you need to make sure that they sign something assigning their interest in whatever they develop to the company. If you don’t do that then they’re going to own what they develop for you, even though you paid for it, and that’s not a good outcome,” says Redlick.

For those entrepreneurs who overlook this step, the pitfalls can be significant.

“In the future when you want to sell the company, or you want to raise capital with a venture capital fund and the primary asset that everyone is investing in is an invention or a technology — the first thing that legal due diligence is going to check is that chain of title to make sure that everyone involved in the development of that invention or technology actually assigned their interest to the company,” says Redlick.

“When you don’t have that, and that person doesn’t work for you anymore, and in particular they may have not left on the best of terms, good luck getting them to sign it in the future. We’ve had that scenario a number of times where you’re at that person’s whim. Sometimes you have to pay something in addition to the fees you paid them to actually develop it, just to get them to sign something,” he adds.

Founders can also find themselves getting into difficulty when they start out by promising equity or options to third parties via documents they draft themselves.

When these documents are prepared without the input of counsel, says Redlick, they can lead to undesirable results down the road.

“They’ll sign a document that they draft themselves or pull off the internet and think ‘I’m going to have a group of advisers and I want to give them all options.’ But it doesn’t speak to what the commitment of the adviser is, and what if the adviser is not meeting that commitment.”

This, says Redlick, can become a problem when the company looks to raise capital, or questions arise about the percentage of equity allocated to the adviser group, and nothing can be done about it.

“Not only do founders end up diluting themselves in ways that they can’t really backtrack out of, but they’re also hurting their opportunity to raise capital in the future, especially because if you’re starting a business that is a true startup with the intention of raising multiple rounds of financing, you always need to be thinking — what are the next group of investors going to want to see? And not just the next group, but further down the road.

“So, you want to have that mentality and get the proper legal advice so that you’re not doing something today that’s going to materially hinder your opportunity to raise capital in the future,” he says.

In addition, says Redlick, many founders of more traditional businesses often don’t appreciate that, if structured correctly, any of their own money that they put into the company can be treated as a secured loan.

“It works in a scenario where you’re starting a more traditional operating business. You can actually protect your investment and the capital you put into your company if you document it correctly as a loan and you register security. You will effectively have the same rights as if you are the bank,” he says.

As such, Redlick says, “In the worst-case scenario, if there is ever a bankruptcy or liquidation and the business doesn’t turn out well, the shareholder can actually be the most protected and in a first-place position from a creditor perspective."

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