Legal Issues Faced by Startups
Andrew Farquhar and Anoop Joshi
Director of Legal and Legal Counsel at Skyscanner
Throughout Skyscanner's journey from start up to scale up, we've come up against all manner of legal, regulatory and compliance issues ranging from contract, IP and employment issues to competition law, mergers and acquisition. When you're moving fast there's plenty of scope for error and mistakes and based on our experience, we've prepared a list of the key legal pitfalls we believe anyone starting out should be aware of.
Pitfall 1 – not putting in place the right corporate structure
It's essential to formalise a corporate structure for your business as early as possible - making your business a 'legal person' in its own right. The most common legal form for start-up businesses is a private limited company as members have limited liability. However, there are other structures including partnerships and LLPs.
Failing to do so could result in:
the founders being held fully liable for the wrongdoings or failings of the business;
an increased tax liability/double taxing;
difficulties in obtaining investment; or
ownership and control disputes between founders and other stakeholders.
Pitfall 2 – not making the deal clear with co-founders
When starting up a business with others, it is critical to make sure that rights and responsibilities of the respective founders are agreed and clearly documented at the outset.
Put in place written agreements (shareholders' agreement and articles) which clearly document:
Who owns what
What the roles and responsibilities of the founders are
What happens if a founder leaves
How key decisions are made
What happens if the founders disagree
What happens on a future funding round (do founders have anti-dilution rights?)
Legal input on such documents is recommended, but if you can't or won't pay a lawyer, having anything in place (in writing) is better than nothing.
Pitfall 3 – not having restrictive covenants in place
Restrictive Covenants are contractual terms which protect a business by preventing competition (non-compete or non-solicitation clauses); infringement of IP (assignment of IP clauses); and disclosure of confidential information (confidentiality clauses). They can be used in shareholder agreements; consultancy agreements; non-disclosure agreements; and employment contracts.
Pitfall 4 – not owning your IP
Intellectual property rights are one of the most important assets of your business.
Principle forms of IP to be aware of:
Copyright – protects original works of authorship and gives the owner exclusive rights to make copies of the work. If your business writes software code, then copyright will probably be the key IP for you.
Patents – protect inventions by giving the inventor the right to prevent others from making or using the invention it describes.
Trade marks – protect the value of a word or logo used to identify a specific good or service as belonging to the trade mark owner.
Design rights – protect the shape and configuration of 3D objects and enable the owner to stop others from copying that design.
It is critical to ensure that you actually own the IP that is being generated by your business.
Avoid the situation where you have a deal set-up for the sale of your business or for a major investor to come onboard, only to discover during the diligence process that you don't actually own the IP that you thought you did…
Best case scenario: you feel embarrassed and look unprofessional, but the issue is eventually resolved and the sale/investment proceeds anyway.
Worst case scenario: the ownership issue cannot be fixed, the value of the business is reduced as a result and the deal is significantly reduced or even called off.
Who owns IP?
Employees: IP that is generated by company employees will automatically vest in the company, unless their contracts of employment say otherwise.
Contractors: ownership of IP that is generated by third party developers, consultants or contractors will automatically vest in those third parties unless your contract with them contains a clear IP assignment clause.
Avoid the IP ownership pitfall by making sure that every contract you enter with a developer or other third party contains a clear IP assignment clause! Where there is any critical IP in your business that you don't own (e.g. a third party software platform on top of which you have developed your product), make sure that you have a clear, perpetual and irrevocable licence to use it as required.
Pitfall 5 – using OSS without having checked the licence terms
Very useful and very prevalent in start-ups and tech businesses in general, provides a free source of high-quality source code.
Is still subject to licences, so make sure you have checked the relevant licences applicable to the OSS before you use it to ensure there is no unintended 'contamination' effect on your proprietary code.
There's a risk that if you build OSS into your proprietary code, the terms of the original OSS licence may require you to make that amended source code (i.e. the OSS and your proprietary code) freely available.
For example, 'copyleft' licenses such as GPL requires licensees to submit the code of the combined software they developed as derivative works from the original licensed OSS back to open source community (i.e. giving access to your proprietary source code to competitors).
Pitfall 6 – choosing a brand that infringes someone else's rights
When picking a company name, brand and domain name…
Pick one that is as distinctive and unique as possible – a distinctive and unique brand is stronger than a descriptive one and will increases your ability protect by way of trademark.
Search the IPO website and the EUIPO website, companies house, domain registries (i.e. godaddy.com) and Google to make sure your great idea is not already trademarked or being used by another business.
If your great idea is taken, better to realise that at the outset than to find out three years later when your big marketing push results in you receiving a 'cease and desist' letter from an existing trade mark owner. Disputes and litigation are costly and can be a major distraction which can be avoided by taking the right steps at the outset.
Pitfall 7 – ignoring the implications of data protection /privacy laws
If your business collects or processes user personal data, you must comply data protection/privacy laws to avoid regulatory fines and potentially irreparable damage to brand and reputation.
Key steps to ensuring compliance:
Understand the obligations which are imposed on you under the UK Data Protection Act and the GDPR.
Ensure that you put in place terms of use, privacy policy and cookie policy documents that clearly explain to users how you are collecting and using their data. If you use third party data processors to handle personal data, are your contracts GDPR compliant? These terms need to be genuinely considered and reflective of what your business is doing, not just copied from other sites!
Make sure the above policies are available to your users via all of your websites and apps.
Pitfall 8 – failing to put in place written contracts when doing business
When you're busy getting your business off the ground, its easy to think of contracts as a hindrance rather than a help:
Another hurdle to jump before work can get started;
I have a good relationship with these guys – if there's a problem we can just work it out later;
Cheaper and faster to just sign whatever contract the partner has presented me with rather than negotiate the terms;
Incomprehensible legalese;
However, taking the time to put in place written contracts which clearly set out the rights and responsibilities of both parties, is actually of real benefit to your business. For example….
Provide clarity and certainty over each party's rights and obligations, for example, payment terms, what happens after termination of a contract, any exclusivity arrangements.
Provide you with the certainty over IP ownership.
Prove the underlying value of a company – upon sale of or investment in your business, one of first things the potential buyer/investor will want to see are written contracts evidencing the commercial deals you claim to have in place.
Protect your confidential information – never disclose confidential information without a signed NDA in place!
Make it easier and less expensive to resolve issues/disputes later.
Recommendation – invest in a template form NDA, commercial contract and development contract early on. Many law firms will give you a good deal on pulling some basic templates together in the hope of further work from you.
Pitfall 9 – not putting in place adequate employee incentivisation arrangements
Start-ups have a tendency to give away too much equity (shares) in the early days to bring in high calibre management/employees. There are few fundamental problems with this:
It is not tax efficient
Employees/management who have shares straight away may lack motivation
The employees/managers will be shareholders and are likely to have voting rights and rights to dividends.
A better solution is to grant options to employees/management via a tax efficient incentivisation scheme. Such as:
Enterprise Management Incentive scheme (EMI) – granting options to subscribe for shares at a future date. The options could be linked to performance or an exit, motivating employees. Options granted at market value (i.e. likely to be negligible in a start up) give rise to no tax or NI. Entrepreneurs relief if also available on any sale, reducing capital gains tax to 10%.
Employee Shareholder Status - shares are issued to employees, who are given a special employee shareholder status in return for giving up certain employment rights (unfair dismissal). No capital gains tax is payable on the first £50,000 of gain.
These are the key legal pitfalls we most commonly encounter when speaking to start-ups. If you've got a question or would like to chat about any general legal issues (we're not your lawyers but can give you general guidance or pointers before you seek legal advice) we'll be running legal clinics at RookieOven – keep an eye out for the dates on the RookieOven mailing list.
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