TOP 4 LEGAL AREAS EVERY STARTUP MUST COVER

We have the privilege of regularly advising start-ups, small and medium enterprises (SMEs) on business decisions and corporate actions, and in the course of these engagements we are presented with varying challenges, data and numbers that paint a picture of the prospects of a company – whether for the good or bad. Oftentimes, these challenges do not capture the underlying issues a business faces, as it is taken for granted that you can all but cure business ills by waivers. At other times, there is just little understanding on what to do next in a way that makes it difficult to sustain the health of the business.

As a result, we have compiled a list of frequently occurring business issues that require utmost attention by start-ups, SMEs and those affiliated with them. A number of businesses may already be aware of these issues, but there is a difference between consciousness and action. Ultimately, the impact of these issues is business-specific, and there is no telling when an entity will be brought to its knees by not proactively mitigating its challenges. For the mindful investor, business manager and employee, the preservation of wealth and value is enough to compel progressive action.

1. Founders:
Partners or founders: A common occurrence in most startups and SMEs with one or more founders is the absence of clearly defined roles and responsibilities, such as whether a founder is merely a business partner as opposed to a founder/promoter of the company – a distinction that is lost to most businesses. This lack of clarity regarding roles and responsibilities plays out in different ways, from day-to-day operations, to decision-making process, dispute resolution, ownership stakes, and exit process; and is generally traceable to the flexibility and freedom culture that is inherent in most startups’ work environment. While that free-spirited attitude to business can provide a boost to morale, it is often the cause of so much clash and resentment between founders, with attendant negative effects like overlapping responsibilities, non-recognizable chain of command, shirking of responsibilities, as well as uncertainty amongst employees.

It is typical for the business to turn a blind eye to most transgressions under the guise of friendship until large cracks form that can prove fatal to the harmonious functioning of the business.

Controls and governance: Allied to the lack of clarity is the tendency for startups and MSMEs to have little to no controls or governance processes, often resorting to actions “on the fly”. Amongst the myriad of reasons adduced, the need to stifle bureaucracy and time pressure to institute essential governance features stand out. While the former motivation is laudable, the latter is primarily a recipe for disaster, as it merely heightens the effect of existing risks in the business; and since the absence of controls and governance means the absence of accountability or reporting structures, businesses end up in dire straits. Where, for example, key-man risk exists in a business, it means all corporate decisions are routed through one individual, who invariably builds a personality cult, and coupled with the absence of governance processes, it means the key individual in the organization can take actions without appropriate checks regulating those actions.

What to do:
Formalize existing relationship between the founders
Agree on and write out each founder’s role and responsibilities
Create a mechanism for resolving disputes between founders
Create a mechanism for founder exits
Build out minimum governance and controls processes

2. Human capital:
Employee relations/status: Human resource and employee relations are a thorny issue for business owners and employees alike. The one class seeks a higher return on human capital vis a vis the cost of acquisition, while the other seeks commensurate remuneration for services rendered; and unless incentives are properly aligned, the price of a wrong match can outweigh the benefits of an employment. Employee relations are purely contractual relationships, and apart from compliance with minimum wage laws, pension contributions and other statutory levies on employers, parties can contract freely.

In certain situations, companies may utilize the services of independent contractors or interns instead of engaging full-time workers, and here the motivation is the reduction of staff overheads. At other times, the use of an outsourcing agency to perform non-core business functions may become expedient. In all cases, a number of companies fail to properly document these relationships, and simply rely on email communications or text messages as the basis of a contract. Needless to say, when issues surface, they are mostly undocumented conditions or obligations, such as where an employer decides to unilaterally change the nature of independent contractor’s engagement on account of “changing business needs”.

Human resource policies are sometimes an afterthought in most companies, and this can be attributable to the reality that most startups primarily focus on revenue generating activities. Yet human resources policies set the tone for work culture, expected conduct and productivity. At the least, startups and MSMEs should have in place minimum policies that govern business ethic, disciplinary process, health and safety, workplace misconduct and harassments, compensation and benefits, learning and development, company leave, suspension, redundancy or termination of employment.

What to do:
Provide employment contracts for employees
Classify independent contractors and unpaid interns properly
Formalize relationship with independent contractors or staffing agencies
Put in place minimum human resource policies and standards

3. Business Structure:
Partnership vs Corporation: When deciding on a business entity structure, the choice is frequently between a partnership versus a corporation. As with all things, this choice will have important implications for both the legal and tax risks of the business, as well as the ownership structure. The key difference between the partnership structure and a corporation is in relation to liability for the debts of the business entity: so that under a partnership structure, the debts and outstanding obligations are personal to the promoters of the partnership; but in a corporation, they remain the debts and obligations of the corporation. For start-ups, the general rule should be to minimize any exposure to personal liability of the founders/promoters and ensure that all business activities are performed by the business entity, and not by an individual founder.

From the outset, the choice of business structure should primarily be guided by the entity that best supports the founders and business’ goals from a legal, tax, growth and capital standpoint. This will also serve as a buffer in the event of a future change in business structure. Thus, while it may be prudent to establish a partnership if the business is one to be carried out on a small scale with little capital; a business with far-reaching goals will be best served by being established as a company.

What to do:
Avoid exposure of founders to personal liability
Perform a business formation assessment

4. Business Assets:
Protection of intellectual property: Very few start-ups set out to build a business which in a few years will be brought low on account of challenges pertaining to intellectual property (IP), yet this is a familiar tale in start-up wonderland. Tales of woe regarding IP theft, sale, exposure or disclosure of IP, trade secret and customer data to competitors or third parties, non-registration or renewal of rights in IP, non-assignment or license or IP rights make for a founder’s nightmare. The implications are numerous: lawsuits, loss of revenue, loss of reputation, loss of customers, business dilution, distrust, and even bankruptcy. A recent example involved a client whose director was registering and transferring company IP to his personal name, effectively using company IP as a bargaining chip to demand higher salary.

When scenarios like the above occur, they are often the result of the business’ failure to account and plan for the remoteness of such operational and strategic risks. Where a start-up develops a unique product, technology, or service, appropriate steps to protect the exploitation of the IP must be taken. In the same vein, the business has a similar responsibility to avoid infringing on the intellectual property rights of third parties by regularly auditing its IP portfolio and its engineering/product development processes. The common protective measures undertaken by start-ups will typically include patents, copyrights, trademarks and the utilization of IP contracts such as licensing agreements, assignment agreements, non-disclosure and non-compete agreements. Due to the technicality of this field, businesses are best served by working with expert advisers in order to secure their competitive edge.

What to do:
Develop a comprehensive IP strategy
Execute non-compete contracts with employees
Execute IP assignment and license contracts with employees and founders
Maintain a database of IP assets & register IP
Audit product development processes
Obtain clearances and rights to third party IP

As one of our partners who recently completed a due diligence exercise on a N200million seed funding investment for a client observes, this is more or less a health check at the hospital. Check weight, height, sight, hearing, internals, reflex and then compare to previous report cards to make sure things are all right before you plunge deeper. Finally, great businesses make educated, balanced decisions founded on sound corporate governance structures. Such structures can only stem from a repository of sound legal and business knowledge.

For further questions or enquiry, please contact:

Moyo Maku (Associate Counsel, Imperial Law Office)

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