A LEGAL GUIDE FOR START-UPS

Photo (Vidyut Madam)-3

By – Vidyut Bedekar (co-founder of TLA [Tree of Life Associates], a boutique law firm)

Introduction:

So you have finally resolved to start your own business and become an entrepreneur. You either have a great product, a well thought out business plan and a blend of the right kind of people to establish a start-up or you just have an idea!

Starting a business involves a lot of legal intricacies which are often non-comprehensible and sometimes results in abandonment of great ideas or a bad start to a really good business prospect.

Through this article, we have attempted to provide you with a brief insight into the legalities of starting  a company  and  succinctly  explained  the  various  aspects of  a start-up  life cycle, including choosing the right type of entity, funding from  investors, protection of intellectual property, employment basics and other aspects you need to know for a start-up company.

  1. Getting started: types of entities

Choosing the right type of entity is the first step for any start-up. Currently, Indian laws offer a variety of options, namely:

  • A  company  incorporated under  the Companies Act,  1956 (public or  private limited company);
  • A limited liability partnership (LLP);
  • A partnership firm; or
  • A sole proprietorship concern.
  1. Choosing the entity: advantages and disadvantages
  • Company: A company incorporated under the Companies law can be either a private limited company or a public limited company. Typically, most start-ups with  limited  funds  and  resources choose to  incorporate  a  private  limited company as the incorporation  process is  faster (on an average 3-4 weeks) and does not cost as much as a public limited company. A private limited company requires minimum of 2 shareholders and 2 directors at the incorporation stage. Moreover a private limited company is typically closely held, without any public participation and therefore management and control is easier and stays with the founders. In addition, the level of compliance required under company law is comparatively  less for a private limited company. Another advantage of incorporating a company is that it is much easier from the perspective of India’s extant foreign exchange laws to get investment from a foreign national, entity or a Indian residing outside India.
  • Limited  Liability  partnership  (LLP):  The LLP is  a new type of entity  under Indian  law,  which  is  a combination  of  a company  and  partnership.  Like  a company, an LLP has a separate legal  status, separate from  its  partners. But unlike a traditional partnership, the partners in an LLP do not have unlimited liability. The partner’s liability is limited to his/ her acts in the LLP. The biggest difference between an LLP and a company is that the internal operations of a company  are regulated by  law, whilst those of an LLP  are regulated by  an agreement between the partners, thereby offering more flexibility in operations. Further,  the level of  legal compliances is less in an LLP  as compared  to  a company.  The LLP  is  now  emerging  as a front  runner  for  small  business enterprises.
  • Partnership: A traditional partnership can be registered or unregistered and is regulated by a partnership agreement between the partners. A partnership need not be compulsorily  registered and therefore easy to set up as compared to a company or an LLP. However the biggest draw-back of a traditional partnership is that  the partners  liability is unlimited, for  instance if the property  of  the partnership is insufficient to pay any dues or debts, the personal property of the partners will be attached for  recovering the dues. Moreover  all partners are collectively liable for the acts of their fellow partners, thereby expanding their liability exposures. From a foreign investment perspective, it is  not as easy to invest foreign funds into a partnership concern as that in a company. Typically, consultants and service professionals such as chartered accountants, lawyers set up partnership firms.
  • Sole proprietorship: A  sole proprietorship can be a chosen form  of business, where  a single person is involved. The sole proprietor and his concern are treated as one and the same in the eyes of law. There are no separate laws which deal with setting up and operation of a sole proprietorship concern and therefore the level of corporate legal compliance is nil.

Choosing the type of entity  is critical to a start-up  as the growth  of the start-up  is dependent thereon. For instance, a company is the appropriate choice of entity  if the growth predicted is faster, albeit the initial costs of setting of a company may be higher. Typically a VC or PE investor will invest in a company and not in a partnership or sole proprietorship. Additionally, if a start-up  plans to  look for  foreign  investment, the regulatory  framework   supports  foreign   investment  in  a  company  rather  than  a partnership or a proprietary concern.

  1.  Raising capital

Raising capital is the next critical stage for any business and the success of a business depends on the initial capital flow. The choice for  start-ups is typically between the entrepreneurs own  funds  (including funds from friends and family) against funds  from investors who  are willing to invest in start-ups. Typically, most start-ups have great products/ ideas, but  they don’t  have the capital required to grow  in a competitive market environment.  Here is where angel investors, private equity (PE) investors and venture  capitalists  come in who  invest  in the capital  of a start-up  by giving it the requisite impetus.

An angel investor is typically an individual or a group of high net-worth  individuals who invest their own money as seed capital, at an early stage in a start-up’s life cycle. An angel investor comes in at a stage where PE or VC investors are typically reluctant to invest, given that early-stage investments are considered high risk. In return  an angel investor may look at high return over investment (ROI) and early exits, to maximize his profits.

Choosing  the right type of investor is  critical for a start-up as the entire success and future of a business depends on the harmony between the promoters of a start-up and the investors. An  investor should be one who  brings in its strategic expertise and experience in developing an eco-system for your start-up.

Whatever the mode of capital infusion, it is imperative that the promoters of a start-up enter into a shareholder’s agreement, setting out the promoters and investors rights and obligations in detail. Often investors are looking for a guaranteed rate of return (ROI) over  their  investment  and  it is  imperative  for  the  promoters  to  understand  the implications of such guaranteed rate of return. Here are some of the things a promoter must bear in mind while dealing with potential investors:

  • Promoters must understand the type of instrument that the investors wish to invest through;  for  e.g. most PE investors utilize convertible instruments to invest  in companies.  These instruments  will convert into fully paid-up  equity shares over a period of time. It is important that the promoters track the period of conversion to ascertain the extent of investor control in the affairs  of the company.
  • Promoters must retain sufficient seats on the board of directors of their company.Typically the investors will have their nominee who will have affirmative vote on almost all the internal management matters in the company. These affirmative voting  items need to be examined and pruned to keep out as many day-to-day management items as possible. Keeping key management positions such as CEO, CFO in the hands of the promoters could be the key to retain control over the management of the company.
  • Watch out  for  firm commitments on the time  frame for  an IPO. Often these timelines can be unrealistic and cannot be adhered to. This can lead to some amount of acrimony between the promoters and the investors or worse costly exits by the investors.
  • Look closely at the investors exit options. The investors should ideally be tied into their investment for a definite period of time during which they cannot exit. An investor will typically look at an IPO as its exit. If an IPO is not possible, the investor will expect the promoters to create an exit with a definite rate of return.

If news paper reports are to be believed, we have recently seen a bevy of cases where the promoters  and  investors  have parted  ways  in the  early  stages of  a deal  due  to disharmony in working styles. If the promoters keep these basic things in mind whilst seeking investment and ensure timely  involvement of their  own  set of lawyers, the investor-promoter relationship can be more fruitful. This is an eternal conundrum  for promoters  who  are  looking  for  quick  infusion  of  capital  into  their  start-ups  to concentrate on  their  business  expansion;  however  seeking  timely  legal  advice  will guarantee smooth functioning at later stages in a company’s life cycle.

  1.  Intellectual Property Protection and Sharing

Typically a cash strapped start-up company will give the least attention to protecting its intellectual  property.  Not  giving  enough  importance  to  protecting  the  intellectual property often stymies the growth prospects of a start-up or entangles the start-up in IP related litigations. Additionally, basic intellectual property protection often scores brownie points if the start-up is looking for investment from a VC or PE fund or any strategic investor, in India or abroad.

Essentially there are the following types of intellectual property  protections available under the Indian IP regime:

  • Patents: for protecting new and useful inventions;
  • Trademarks & service marks: for protecting the brand, the identity, name of the product/ service;
  • Designs: for protecting the aesthetic features of a product;
  • Copyright:  for   protecting   original  literary,  artistic,   musical,   dramatic   or cinematographic work.

A start-up should have a holistic approach to protecting its intellectual property and not concentrate on protecting  one type of IP. For instance, protecting  the name of your company, product or service is absolutely necessary irrespective of whether the product is capable of being protected as a patent.

If a start-up intends to outsource its IP development to third party consultants (who are not  in full time  employees  of  the  start-up),  proper  IP  assignment  agreements are necessary. Often  the  start-ups  utilize  the  services of  consultants  without  proper documentation and lose out on owning and documenting critical IP rights.

If a start-ups most valuable asset is its IP, then developing and implementing a strategy for adequately protecting such IP at inception, is crucial to the growth of the company.

  1.  Employment basics

Another  important area that  often tends to be ignored by  start-ups  is employment related documentation and legal compliance. Typically, start-ups tend to “borrow” from their earlier employment agreements and draw-up  half baked employment agreements which lack a definite structure and the clauses to safeguard the start-ups from employee attrition and misuse of confidential data. In addition to the employment related documentation,  start-ups often end up ignoring the plethora of employment laws in India,  leading  to  non-compliance  of  these laws  which  have  severe implications especially for the directors of companies.

Emerging  start-ups often face the following employment related legal hazards which could hamper the future prospects of the company, especially if the start-up is looking for VC or PE investment:

  • Failure to document employment agreements, tie-in key personnel through key- man agreements and the terms and conditions associated with employment;
  • Failure to comply  with all the applicable labour  legislations  leaving  loopholes that  cannot  be fixed within  such  time  so as to  not  hinder  a  prospective investment;
  • Failure to protect intellectual property developed by employees by entering into IP assignment agreements;
  • Failure  to  establish  a  proper  employee  exit  mechanism  by  following  the appropriate procedure prescribed under applicable law.
  • Issuing stock options without drawing up a stock option plan.

If a start-up takes steps to avoid the above enumerated issues, then operations can run smoothly without interruptions or expensive litigations.

  1. Tax and other Regulatory compliances
  • Income tax: A start-up will have to pay income tax at the rates prescribed under the Income Tax, 1961, depending on the type of entity. For instance, a company will be charged income tax at corporate rates, whilst a partnership will be taxed either at the partnership level or at the level of the individual partners. A start-up must  understand  the basic tax  laws to  ascertain the tax  liability and  make provision towards tax payments. If the start-up plans to engage in international transaction, an understanding of the direct tax avoidance agreements is a must.
  • Other indirect taxes: Depending on the business, a start-up will have to register itself under the service tax law, Value Added Tax related laws applicable in the State in which the start-up  is incorporated, Central/ State  Sales Tax, Central Excise etc.

© TLA (Tree of Life Associates)

This publication is intended to be a general overview and discussion of the subjects dealt with herein. It is not intended to be, and should not used as a substitute for taking legal advice in any specific situation. TLA will accept no responsibility for any actions taken or not taken on the basis of this publication.

About TLA (Advocates & Legal Consultants):

TLA is a full service law firm based out of Bangalore and offers the breadth of a full service firm but  the  depth  of  a  boutique  one,  especially  in  the  areas of  Technology,  Outsourcing, Employment, Retail and (transactional) IP. Lawyers at TLA  provide  a synergistic mix of big corporate law firm and in-house counsel experience, which enables solution driven legal advice, focused on delivering value to the client. TLA’s approach is premised on legal risk mapping, risk analysis and evolving risk mitigation strategies that synergise with client business environments. TLA  has primary presences in Bangalore and Mumbai  and network  offices in Chennai, Cochin, Delhi and Hyderabad.

Our SME Practice:

To meet the needs of the burgeoning SME sector in India, TLA  has devised a separate SME focused service vertical.  The SME vertical is premised on (i) pragmatic, pre-emptive, solution- driven and unequivocal advice synchronous with an SME’s stage of business, its constraints, drivers and ethos as well as future risks and (ii) cost efficiencies and fee models that recognise SME  resource crunch and offer a viable  array of alternatives. TLA  sees itself  as a business enabler who is strategic to the business and operations of clients and early engagement with an SME serves as the cornerstone to this role. The bottom-line is the long-term relationship with the client, not the immediate benefit.

We would be happy to discuss our SME vertical in greater detail. Please feel free to contact either of the individuals below to discuss your idea, venture or business:

CONTACT DETAILS

E-mail: vidyut@tlaindia.com

Ms. Vidyut Bedekar is the co-founder of TLA [Tree of Life Associates], a boutique law firm with depth of understanding and domain expertise in Technology & Outsourcing, IP, Privacy law, Labour & Employment matters, and Start-Up legal offerings. Ms. Bedekar ’s focused domains are Corporate and Commercial laws, M&A, Laws relating to in-bound and out-bound investment, IP, in specific trademark and copyright law and start-up investments and she is the Practice Head of these areas at TLA, Bangalore. She has been in practice for twelve years and has a law degree from the ILS Law College, Pune, India, one of the top ranking law institutes in India. Ms. Bedekar also specialises in corporate and commercial transactions which includes legal advice on various corporate law issues, contract drafting for commercial transactions including technology transfer, collaboration, reseller and licensing transactions and other day to day commercial contracts.

Disclaimer: This article is not intended to provide legal advice. For specific legal advice on the information provided and related topics, please contact the author.

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