Home / Entrepreneurship / The Legal Life-Cycle of a Startup

The Legal Life-Cycle of a Startup

Via LinkedIn : Outlining the various legal steps that a startup will have to go through and the importance of founders having a good legal advisor

Having sat on both sides of the table, first as a qualified lawyer in Eversheds and now as COO of Soundwave, I thought it might be helpful to talk through some of legal requirements that I’ve come across over the past few years. Of course every startup is slightly different to the next but from my experience, the overall legal life-cycle of a startup is quite uniform and follows a set path that can (and should) be understood by founders in advance of starting up.

Unfortunately, this often isn’t the case and I’ve been consulted by numerous founders over the past few years who have either underestimated the level of legal advice needed or undervalued how important it is to get the fundamentals right from the start. This is crazy because a good lawyer can play a critical role in getting your startup off the ground while ensuring that you avoid some pretty serious pitfalls along the way.

The aim of this post is therefore to try and give any founders (who are not yet versed in company law) an overview of the main legal touch-points they can expect to encounter throughout the life of their startup. Despite all the chaos and randomness associated with the day to day running of a business, the legal landscape can be surprisingly settled if issues are dealt with proactively instead of reactivelyduring the following stages:-

Incorporation — the startup is incorporated and the founders begin their journey to achieve their vision and to make their own dent in the universe.

Seed— as things develop, the startup begins to get some traction and is able to start bringing in customers/active users at a rate that allows them to raise some seed capital or to grow by continuing to bootstrap the business.

Maturity — the startup matures, processes become more established and the company finds its operating rhythm. Achieving product/market fit generally provides an opportunity to raise further funding at a higher valuation or to invest more profit back into the company in a virtuous growth cycle.

Realisation/Winding Up— at some stage in the future, the startup will hopefully enjoy an exit through an event of realisation (IPO, acquisition) if everything goes well. In some less fortunate cases, the startup may go out of business through an event of liquidation (voluntary or involuntary winding up).

Startups tend to be naïve about the level of legal assistance needed and how complicated the various legal issues that arise can be. This is largely understandable as 99% of founders have had little or no legal exposure before they start a company. However, this leads to a number of common legal mistakes being made which could have been avoided if the right legal advisor had been in place from the start. Prevention is always better than cure.

Did you know that Facebook was originally incorporated as an LLC in Florida?! Eventually it was reformed under company law in Delaware but as @paulg mentions in his recent lecture on How to Start a Startup:

“Mark Zuckerberg did not succeed at Facebook because he was an expert in startups, he succeeded despite being a complete noob at startups; I mean Facebook was first incorporated as a Florida LLC. Even you guys know better than that.”

When founders do start a business, legals usually become an unnecessary nuisance at first or an afterthought at best as the focus remains on building the business, securing financing or hiring staff. This doesn’t have to be the case though and the below overview outlines some of the legal requirements, costs and document that are needed when navigating through each stage.

Disclaimer: I’ve experienced the first three stages of the legal life-cycle as a founder (incorporation, seed, maturity) and have been able to advise on the last stages (exit, bankruptcy) working as a lawyer. Also, the legal life-cycle I’m describing primarily applies to high growth software startup companies that are fundraising (as opposed to SMBs or other traditional bricks and mortar businesses that are bootstrapped). Also the advice is tailored more for earlier stage starts that are governed by Irish/UK company law (because that’s my local legal jurisdiction). Finally, this guide shouldn’t be taken as legal advice and is provided for your information only (but you knew that already☺).

Seed

maturity

Incorporation Stage

When founders have decided to pursue their idea and turn in into a commercial venture, typically they will want to incorporate a company. Stemming from the Latin for corpus (body), incorporation provides founders with the ability to create a legal ‘person’ through which they can conduct their business. There are numerous reasons as to why this is the best option but the main ones are that any shareholders will have limited liability (eg you won’t be held personally liable for the debts of the company), ease of transfer of ownership in the company and tax incentives that are not available to an individual. There are other ways to run a business but for the purposes of a high growth startup, a limited liability company makes the most sense (note that every legal jurisdiction has its own peculiarities so it’s worth finding out which type of vehicle will best suit your operation going forward).

Once the company is incorporated, the founders will usually be in a position to raise some micro seed capital by giving up equity in the company. Incubators andaccelerators are very much in vogue with early stage startups and these usually represent the best way of obtaining micro seed funding. The terms vary a lot and can range from €20,000 for 10% of the company all the way up to €100k for 7% of the company. This investment will usually be for ordinary shares in the company and so it’s important to remember that this will remain on your cap sheet going forward (eg your capitalisation table which basically shows ownership in your company). The valuation will very much depend on how far along each startup is and whether they have any leverage to negotiate.

A startup needs to be mindful that these agreements are legally binding and I’ve seen a lot of companies sign them without seeking outside legal counsel. Incubators and accelerators will have all taken legal advice on these agreements and there is no such thing as a ‘standard’ agreement. Apart from the economic terms of the agreement (which you should try and negotiate anyway ) there can be some nasty terms around IP, use of investment monies, restricted transactions, non-competes, pre-emption rights and information rights. These terms can all have knock on effects when you’re fundraising in the future and anything overly prohibitive can cause issues at the due diligence stages. It’s worth having a lawyer review these types of agreements before you sign them!

Documents:

Constitutional Documents: In Irish company law, you’ll need to file a form A1 together with Memorandum and Articles of Association (which set out the Company’s internal rules). A lot of these documents can be bought off the shelf with business formation specialists. There is nothing wrong with this and it’s a good way of keeping costs down (see below), just be aware that the constitutional documents will need to be amended by a lawyer down the road and these are likely to be just an ‘off the shelf’ temporary fix. You will get a certificate of incorporation as proof of registration.

Shareholders Agreement: It’s a good idea to draw up a shareholders agreement (or founders agreement) as soon as the company is incorporated. This will usually set out the terms of how the initial shares should be split and what happens if an early founder leaves for example. It can be critical to get vesting rights or good leaver/bad leaver provisions sorted at this stage to stop an early shareholder walking away with a significant chunk of the company.

Investment Agreement: When you join your accelerator or incubator, there will usually be a short-form document that sets out terms of the programme and micro-seed investment in your startup. This may supersede the shareholder agreement if the accelerator/incubator is joining as a shareholder in your company.

Company Documents and Statutory Filings: Various company documents will be required to evidence any share transfer including stock transfer forms and Board minutes (approving the transfer). Depending on the jurisdiction, certain statutory filings will also have to be made to make these changes public and to inform the local companies registry.

Mutual NDA — it’s a good idea to have a mutual or reciprocal NDA that you can use with potential partners even at this early stage. Please don’t ask investors to sign these though until you’re at least at term stage with the investor. Your idea is not that valuable and asking for NDA’s like they’re going out of fashion is usually just a red flag that you’re a first time founder.

Activity:

The legal activity can be very minimal when incorporating. Anything more complicated such as the investment agreements or shareholders agreements should be reviewed by a qualified lawyer.

Cost:

The cost or incorporating will be low if using a business formations outfit. Usually between €300–400 (and should include all statutory books and a company seal).
Reviewing and advising on a relatively short form commercial agreement or shareholder agreement should take no more than a couple of hours so €500 — €750 would be reasonable (assuming there is minimal negotiation).

If you’re incorporating at the same time as you join an incubator or accelerator (which is surprisingly common) I’d advise engaging a lawyer who will do the incorporation, shareholders agreement and investment agreement as a package. Assuming the lawyers in question take a long term view on fees, this should cost no more than €1000 to €1500.

Sesame

Seed Stage

Assuming you’ve graduated from your incubator or accelerator, having validated a lot about your business and grown at a healthy rate during your incubation/acceleration stage, the next step will likely involve you looking for seed funding to provide much needed capital to bring in your first hires, develop or release your product and market it to the world.

There are numerous ways to raise seed capital including angel investments(money from high net worth private investors), crowd funding (money from a large collection of private investors) and VC funding (money from institutional investors typically acting on behalf of a fund). Depending on what route you go down will dictate how complex the legals will be for your seed round of funding and what type of valuation you might raise the round at.

Also it’s worth noting that seed investments can be raised using different structures — usually either priced equity or by way of convertible debt. I’ll explain the advantages/disadvantages of these in a future blog post but whatever route is chosen will dictate what legal steps need to be taken.

Assuming some seed investment is drawn down, your startup is likely to be in a fortunate position to pay contractors for any outsourced work and/or to pay salaries to any new hires. There are some standard documents discussed below that should cover a lot of the recurring legal issues that arise during this stage.

Documents:

Investment Agreement/ Loan Note Instrument— dictating the terms of the investment, this will be quite a comprehensive document with protracted legals.

An ancillary document also often required is the infamous Disclosure Letter — which is used to disclose against any of the warranties provided for in the investment agreement (e.g. if you warrant that you (or the company) own(s) all of the IP in the company, this is your chance to come clean if that is not the case and typically, any IP will need to be assigned to the company in advance of any investment in the company). Note that Investment Agreements will have penalties for breaching any warranties. A good lawyer should help you navigate around any hurdles though at this stage.

As part of the Investment Agreement — there is also likely to be certain amendments to the constitutional documents (Memorandum and Articles of Association) together with other statutory filings and company documents required to evidence the investment.

IP Assignment Agreement — this is a critical document for any startup and is used to protect the proprietary technology in the company. In short, an IP Assignment Agreement is to be signed by contractors/advisors or employees (and are usually stitched into the body of their contracts entered at the commencement of their relationship with the company) to ensure that all intellectual property is properly assigned to the business and does not leave if and when their contract finishes. This can be a a deal breaker for investors if they are concerned that the company does not own all the IP so it’s worth getting a good template which can be used as often as needed. This will be one of the most frequently used documents in your startup so take the time to get this right.

Contracts for Service (for contractors/consultants)— this document is used to form a contract with third party contractors or consultants for work that is outsourced. Some fundamental terms that are normally covered include the costs involved, whether the contractor/consultant will be paid on retainer, what the exact scope of work is and when the contract is to terminate and, most importantly, to ensure that ownership of any IP created is vested in the Company. It’s important that every contractor/consultant signs up to such an agreement both to protect the company from any future claims and to ensure that there is some form of recourse available should the work provided not meet a high enough standard.

Contracts of Service (Employment Contracts) — these contracts can be fixed (eg for a specific period of time) or permanent (perpetual until otherwise terminated), depending on the jurisdiction. These contracts should clearly set out important terms like annual salary, number of holiday days, how long the probationary period is and any other incentives (insurance, pension contributions, options etc). Senior hires and hired managers will need to sign non-compete clauses to make sure that they can’t steal clients or existing employees if and when they leave. From experience, the most important part to get right in any employment contract is the probationary period (of say 3 to 6 months depending on the particular role) as you’ll usually know very quickly if a hire is not going to work out. An extended probationary period can save a lot of employment law issues down the road as once an employee completes their probationary period, it can be harder to let them go and they may also be entitled to statutory payments.

Internship Agreements — similar to employee agreements but these documents must specify what skills an intern is going to learn while working for you and should specify certain requirements (eg that the intern works less hours then a full time employee).

Directors Employment Contracts— again, similar to employment contracts that set out the terms of appointment for director of the company. These contracts are usually driven by investors and will be more explicit around terms such as confidentiality, conflicts of interest and non-competition.

Employee Options or Restricted Share Schemes — these need to be drafted carefully and will often require specialist tax advice in each jurisdiction. Again, this is usually investor driven (in terms of vesting criteria and the pool of shares available) but it makes sense for early hires to be incentivised to help your company grow.

Activity:

If trying to raise a seed round, the level of legal activity will increase once you get a term sheet. It’s important to note that some founders will agree terms and sign a term sheet before having a lawyer review it. Although legally speaking, these are often just heads of terms (and not therefore legally binding there are typically a number provisions that are binding to include exclusivity and confidentiality), the ‘agreed’ terms in the term sheet usually dictate how the overarching Investment Agreement will drafted and so it’s worth getting a lawyer to review the terms at this stage — you may be able to nip any nasty legal issues in the bud.

Depending on the complexity of the deal, there can often be a number of months of negotiation (and investor due diligence) between the investor’s lawyers and your lawyers before it closes with quite a lot of legal engagement needed. Don’t underestimate how long fundraising can take and/or the level of legal activity required at this stage. Once the fundraising is closed, most of the legals can be reduced with good precedent documents that can be tweaked. New hires and contractors can all be covered by good standard form documents which you can work with your lawyer to produce.

Cost:

Some legal firms bill in different ways but a good rule of thumb I’ve found is that no more than 1% of the total raised should go on legals. If it’s a €1m round, €10k on legals is reasonable. If it’s €500k, something closer to €5k would be fair. It does depend on the degree of negotiation involved, but many firms will be agreeable to capped / fixed fees for this type of work and you should seek that, where possible.

For other standard form documents that can be used again and again, it would make sense to work out a fixed fee in advance also. This is worth doing so you can ensure that the operational side of your business is not blocked by legals every time you bring on a new hire or need an IP Assignment Agreement. These documents may well come as part of the seed fundraising suite and may be factored into those costs. Note that using other legal precedents (e.g. provided by other startups) is fine and pretty common. You are taking a bit of a risk if not first reviewed by a lawyer who will often have to spend just as long correcting poor drafting as they would have getting a good precedent ready (and tailored for you) in the first place.

Bean

Maturity Stage

As the business progresses, you’ll need to engage lawyers more frequently as your headcount increases. As the company moves out of seed stage and into a more mature entity, commercial considerations like securing office space start to arise. Often lawyers will be needed to review proposed partnership, licensing or distribution agreements as your customer base grows. The same day to day requirements exist with contractors, employees as identified at the seed stage — the cycles can be just a bit quicker. Some companies may bring in house legal advisors at this stage to reduce the outlay and to help speed up the operational side of the business.

Series A fundraising (and later) will also require more legal advice as these rounds will often be at valuations of at least €10m and over. Due diligence is more drawn out and the level of disclosures are higher because the business had been operating for longer and is therefore not as ‘clean’ as it was at seed stage. Overall, there should be nothing completely new from a legal perspective and it’s always impressive to see founders, who were once new to the whole game, learn and deal with relatively complex legal issues in a professional and informed manner. The only difference is that the stakes are typically higher (both the upside and downside) and so legal costs can go up as does the level of legal activity during this stage.

Documents:

General Commercial Agreements — Depending on the type of startup you run, there can be numerous requirements for licensing, distribution and partnership agreements. Although there are standard forms that deal with each of the above, your business is likely to be anything but standard at this mature stage and so it is worth having a lawyer draw up some good templates that you can keep in your legal arsenal to signup and win new customers or users.

Office Lease/Purchase Agreement —Having drawn-down seed funding (or having successfully bootstrapped the business for a while) most startups will eventually look to get their own office space that they can work from. Usually this will be by way of a letting (not many startups can afford to buy a space) and will vary in length depending on the local market. Rental prices are at an all time high right now for example so locking yourself into a long lease will need careful financial forecasting (so you can make rent) or a good break clause at the very least (allowing you to break the lease before the agreed termination date). Don’t pay over the odds for an office space and then scrimp on legal advice — that may prove costly in the long run.

Further Funding Agreements — similar approach to the above. Later rounds can sometimes be carried out by way of venture debt. Typically any convertible debt will convert at this stage and most rounds from Series A on will be carried out by way of priced equity or venture debt. The same company-wide and statutory filings will be needed for each new round of funding.

Activity:

Due to the relatively settled environment at this stage, some good standard form documents with a legally versed operations person can reduce the amount of outside legal activity during this stage. There will obviously be spikes of required legal advice during each subsequent round of funding and outside counsel will be needed during each of these peaks. It’s difficult to surmise about the level of engagement needed during this stage because there is so much commercial variance between each startup. In short, the peaks of activity will be higher and the troughs of activity might be lower if the right support structures are put in place.

Cost:

I’d argue that the same 1% (or less) rule of thumb applies for legal fees/amount raised during this stage. Much larger rounds of financing can take on a life of their own though and estimating costs gets more difficult. It’s best to have an upfront discussion with your lawyer to talk through the various complexities involved and to try and work out something in advance. Otherwise, fees can get out of hand as certain deals may require multiple lawyers with different specialities. When billing by the hour per lawyer, it’s easy to see how these fees can stack up.

Other engagements can usually be managed by fixed fee arrangements. If dealt with proactively (eg give your lawyer plenty of notice that a potential partnership is coming) then they’ll be in a better position to provide a competitive quote. If you land the deal on their desk when they have lots of other instructions to advise on, you’ll be unlikely to get a competitive quote and are likely to be billed by the hour.

Plant

Realisation/Winding Up Stage

Not every startup desires an exit (eg an event of realisation that provides for the extraction of value) and many carry on as highly profitable enterprises that extract value through payment of dividends for example. However, if you have taken on outside investment your investors will be looking to extract some upside from their investment and this is usually either achieved when the startup is acquired (in a share or asset sale), merges with another company or goes public and floats its shares on a chosen stock exchange.

It would be fair to say that except in cases of distressed sales (where investors are hoping to ‘flip’ the asset, i.e. your company), an acquisition/merger is somewhat reactive in nature and is driven by the intended purchaser. Companies get bought, they don’t sell. For this reason, a good M&A lawyer can be worth their money and more as they will have dealt with tens if not hundreds of such similar deals and will be able to strive for the very best commercial and legal terms you can get. This can be the ultimate win-win-win situation as you, as a shareholder in the company, will be rewarded by earn-outs, your investor will make a return on their investment and your lawyer will deservedly make a good profit on the legal services provided (having taken a long term view on fees at the outset!).

Equally, an IPO (initial public offering) in which a company goes public and floats its shares is usually another fruitful occasion. It should be noted that a lawyers job during an IPO is to make sure that it is basically investor ready and that all securities laws have been complied with as these deals are usually adviser driven (requiring good corporate finance advisors too).

In other cases, the end of a startup’s legal life-cycle may come about if it can no longer or chooses not to continue trading as a going concern. There is a distinction between 1) companies that are wound up and can no longer pay their debts (labelled as insolvent companies) and 2) companies that are wound up which are not insolvent.

In Irish company law, members voluntary winding up procedures are enforced when it is decided by executive management to wind up a company even thought it is still able to meet its liabilities. When a company can no longer meet its liabilities and it is wound up, voluntary creditors winding up procedures must commence. Note that there are usually quite severe civil (and often criminal) penalties for Directors who continue to trade when it is known that the company cannot pay its debts. Remember that certain investment structures such as convertible debt are basically big liabilities on your balance sheet (from an accounting perspective anyway) and so the lines between solvency and insolvency are often hard to discern. These penalties vary from jurisdiction but it you feel like your startup is not working out and you think it may be insolvent, you need to engage a good insolvency lawyer to start winding up procedures (or to work out your options at the very least).

It should also be noted that there is a difference between personal insolvency (or personal bankruptcy) and company insolvency (discussed above). Personal insolvency often arises when a Director of a company has personally guaranteed certain liabilities that cannot be paid. Again, if this is the case you will need a good insolvency lawyer to help you navigate these choppy legal waters. Assuming you have not personally guaranteed anything, the limit of your liabilities will be limited to any outstanding share capital due for the ownership of your shares in the company (which should be nil if all share capital is paid up to date).

Documents:

Share/Asset Purchase Agreement — in cases of an acquisition, your startup will usually be bought when the purchaser acquires either the majority of shares in your company (a share sale) or when they purchase certain assets in your company (an asset sale).

Merger Agreement — when your company will be merging with another company in order to form a new company together.

Supporting Documentation —In the same vein as any other investment, there will a whole host of supporting documentation that is needed in a share or asset purchase. As mentioned previously these would include disclosure letters, company documents evidencing the sale, statutory filings etc.

IPO Documentation — due to the highly regulated nature of IPOs, there are a lot of legals to be sorted out before, during and after an IPO event. Certain required documents such as an application, prospectus, verification and completion documents will all have to be washed through your lawyer.

Members Voluntary Liquidation Documents — you will typically need to sign a declaration of solvency first. Then you will hold a Board meeting to wind up the company advertising of your intention with a (specified) public notice within a given timeframe. A liquidator will then be appointed to finalise matters and you must submit the resolution to the relevant companies house.

Creditors Voluntary Liquidation Documents— A director can propose this if the company,due to fact that it cannot, by reason of its liabilities, pay its debts and continue its business. A majority of the shareholders will then usually have to vote to wind up the company. You then would appoint a liquidator, advertising in a public notice and send a resolution to the companies house within a specified time frame. In addition, you must also hold a meeting with all creditors soon after the company is wound up presenting the statement of affairs.

Activity:

Acquisition/Merger — As mentioned, companies are usually bought not sold and so the legal requirements will arise only when a suitor comes on the scene and wants to buy or merge with your company. The level of legals involved during any M&A process should not be underestimated (nor the costs associated as set out below). There will be lengthy due diligence process and a lot of horse trading and false starts before you get to a sale agreed status.

IPO — IPOs tend to occur when a company knows that it is ready (usually a combination of predictable revenues, high growth potential and no serious vulnerabilities). Again, the level of legal activity can be exceptionally high due to the regulatory nature of IPOs and a good law firm (and accountancy firm) can make this stressful process a lot more straightforward.

Winding Up — this is the obviously the worst outcome for your startup and not something that most founders like to think about unless the writing is clearly on the wall. Needless to say, there is a lot of paperwork to windup a company properly and so the level of legal activity will rise accordingly as you get your affairs in order. Unlike success driven stress, the ramifications of winding up your business are going to be very hard to take so make sure you surround yourself with as much outside counsel as needed during this difficult period.

Cost:

Some estimates from UpCounsel would put the legal costs for the acquisition of a technology company (with less than 15 employees) at between €8,000 to €20,000 (where the target is winding down). For a merger of a company of the same size, the costs can vary from between €25,000 to €50,000.

An IPO is by its very nature is much more complex and can cost €100,000 at the very minimum (and often a multiple higher than that). One must also factor in the considerable accounting and marketing costs also. The costs will also depend on the exchange on which the company is to be listed (e.g. a NASDAQ flotation will carry a multiple of the above costs due to the jurisdictional requirements to be observed in the US).

Winding up a company is somewhat procedural from a legal perspective and the costs would usually be in the €5,000 to €10,000 range depending on the complexity of the case.

About Editorial Team

Check Also

social_media

Why Your Sales Strategy Needs to Become a Social Media Strategy, Immediately

via Inc : Social media’s presence in the sales world is an old story by now, …