Legal Issues and Traps for Startups

Startups are fantastic, exciting, disruptive places to work. However, by their very nature they’re often run by young and inexperienced people, especially within the legal area, which admittedly can be a minefield. They also deal with often complicated ideas where legal issues can be difficult, so if you’re in this situation here are some things to look out for.

Business Vehicle

In general – the best type of company to establish is a Private Limited Company. There are some basic requirements for this type of company, like needing at least one director. You also need to report to companies house details of shareholders, annual returns and such.

The problem with a LTD is the directors duties. These are owed to the company, not the shareholders. The main being: ‘to act in the best interest of the company’, ‘to act with care’ and ‘not to be under a conflict of interest’. Breach of duties at an early stage can come back to haunt you if you sell a company. The buyer of a company might (for instance) argue that you have a conflict of interest and pursue you for liabilities. This means it is usually best to form new companies rather than merging companies when you take a break from one to work on another. The worrying part is that this obligation can be perused retrospectively against the directors after a sale. This point was something new to me and worth remembering as a company director.

Raising Capital

One of the first things you need to know about when you are founding a startup is that as a founder you can invest your cash into your startup as a loan. This has a number of tax benefits. This is was a mistake that I personally made. Not only does it mean you can take your cash back out of the company later on, without paying tax, you can also expect to earn modest interest! As almost every founder ends up floating a company with personal cash, this is probably relevant to anyone starting a company.

As with ‘high net worth’ individuals, you can also raise cash from friends and family under the SEIS program – which offers significant tax incentives to the investor. The incentives under SEIS make it a no brainer. Raising capital from angels can make a big difference but usually comes with significant contractual obligations. Some angels have been known to require majority control. I have personally heard from a number of founders that have been asked to vest their own shares – leaving the investor as the controlling shareholder. Obviously, it does depend on the ‘angel’, but it can be some of the most expensive money you can raise.

Company Articles and Shareholders Agreement

As part of your company setup you need to create the company articles which set out the limitations of powers of directors, rules for meetings and voting rights. This document is publicly available and probably the best place to lay out any exceptional items. The tricky thing with the company articles is that you set them out before you really know what you may need to include.

Another important document is the shareholders agreement. You may have to have one due to the requirements of an investor. For simple cases though, you can state share transfer rights in your articles without needing a shareholder’s agreement. Some other things you might include in your shareholders agreement are exit cases for death, voting restrictions, deadlock resolution and requirements for consent. One of the really important parts of the shareholders agreement is the model for payment of dividends and retained working capital requirements.

There are a number of other clauses like the right to maintain a certain percentage under dilution – you usually don’t want them unless an angel forces them to be included (think Facebook); note that they have to buy the shares at the same rate as the investor; drag rights offer majority shareholders the option to force them to sell; tag rights are for a minority shareholder to participate in the sale. Drag rights are vital if you want to be able to sell otherwise a minority shareholder could block the acquisition of the company.

Patents, Trademark and Copyright

Patents – an old favourite of mine – cover the protection of practical aspects of an invention. For software projects it is possible to get around this, but it can be very hard for a software or process. At an early stage, investing large amounts of time on patenting could mean you spend a lot of time only doing patenting, in some cases before you have even confirmed whether your invention is valuable. For me this is the key weakness of a patent – it won’t protect you from someone innovating on top of your work to create something which is significantly different – and by significantly different we don’t just mean a simple VBA process built on top, or a ‘spit and polish’, but something almost totally different to the original. Ok, your patent will protect the original, but someone can take that as a base and build and improve on it as much as they want. As many startups don’t know what their ultimate product will look like it is hard to anticipate even your own innovation. Obviously, you could spend all of your time patenting ideas as you go; but this doesn’t sound like the primary focus of a startup to me. Isn’t the point supposed to be to spend your time improving your product and finding a market as rapidly as possible?

Patents are easier to obtain in the US. The bottom line though is that even if you get a patent granted you still need to be able to defend it. Obviously for a startup this could be a real problem. My personal take on this is that if you are innovating fast enough as a startup (if you are not then are you really a startup?) that copycats can’t keep up.

Trade Marks are a lot more useful as they allow you to protect your brand. In the UK this will cost you a couple of hundred pounds. The IPO government web site lets you search for prior art trademarks. Your trade mark has to be distinctive and not be too similar to trade marks that are already registered.

Copyright is automatically applied when you create a new creative work. It doesn’t take much to be unique. It can’t protect a concept or idea though, only the textual content. Crucially this also applies to computer code.

One interesting point to be aware of is that if you employ contractors, unless otherwise agreed, the contractor owns the rights on the content they produce. As the payer of the contractor you have a licence to use their works only in the way that was intended. This means if you use their work for a new purpose you need to get the permission of the contractor. This could be an issue when a startup creates something that is re-used in a different way. Conversely, this means your contractors could potentially sell anything they create to a competitor.