Saving a great business idea is one thing, but starting a new venture is another. Setting up one’s own venture involves a lot of legalities and first-time entrepreneurs are rarely able to fully comprehend the implications of various legal terms and conditions. If you are embarking on an entrepreneurial journey or are on the verge of raising your first round of investment, then here are some legal formalities that you need to be familiar with.
Documentation at the time of starting up
An entrepreneur can choose to register his venture as a company, a LLP, or a partnership. However, most often ‘company’ is the preferred entity. Also, if he is considering venture capital funding as a source of growth capital in the future, incorporating a company will be necessary given the relative regulatory and operational flexibility it offers. “Assuming that the founder chooses to incorporate a company, he will need to acquaint himself with the memorandum of association, and the articles of association of the company,” says Ashwini Vittalachar, partner at law firm, Samvad Partners.
Memorandum of Association, Articles of Association, and Founders’ Agreement (in case of multiple co-founders) are the defining documents for a venture.
The memorandum of association sets out the main objects and activities of a company. The founder should identify the core business of the company and ensure that the same is reflected in the ‘main objects clause’ of the memorandum of association.
And, the Articles of Association acts as the rule-book or bylaws of the company. It contains provisions pertaining to transfer of shares, further allotments, board and management procedures, Vittalachar adds.
She further notes that Founders’ Agreement is reflective of the intended relationship among the founders. So, rather than acquainting oneself with the terms of a Founders’ Agreement, a founder must discuss the various aspects of how the multiple founders propose to own and operate the company. Accordingly, the agreement will need to be crafted. Typically a founder’s agreement will have provisions relating to shareholding and percentage splits, dilution mechanisms (especially in the context of a fund raising in future), share transfer restrictions and board seat/ management rights, etc.
Clarity is key, believes Sunil K Goyal, managing director and fund manager, YourNest Angel Fund. “Co-founders may ponder between themselves while starting a venture on aspects such as position and role of each partner, delegation of decision making, decision making process for major decisions, clarity on initial and subsequent funding by partners, valuation norms for investments by partners, sweat equity, rate of interest on loans extended by partners, signatory for banking operations, norms for profit sharing, salaries, etc., keeping in mind engagement levels such as full-time or part-time or a sleeping partner, exit valuations between partners, settlement of accounts on liquidation or exit,” he stresses.
Besides having clarity on role and equity, founders must ensure necessary registrations/operational licences are obtained, labour compliances are met with, intellectual property, if any, are registered, and that contracts are properly formalized. This is useful not just from a future investment perspective, but also ensures that the corporate house is in order and that risks are mitigated, Vittalachar says.
Term sheet: A key legal document during fund raise
Once a founder has an interested investor on board, the parties generally enter into a letter of intent or a term sheet. The term sheet essentially sets out the basic framework of the transaction. While the same is non-binding in nature (except for certain terms like exclusivity), the term sheet becomes an extremely important document as this determines how a transaction unfolds. The definitive agreements signed are broadly based on the provisions contained in the term sheet. This document also allows the parties to gain exclusivity, and hence becomes important.
A term sheet is basically a non-binding document. Apart from two or three clauses – like those relating to exclusivity, confidentiality and governing law – the other provisions in the term sheet do not constitute a binding contract. The idea of a term sheet is to say that the parties – founders and investors – have, after discussions, reached a stage where they have a preliminary level of comfort with each other.
It’s a broad, in-principle agreement relating to the key deal terms, including the valuation, explains Vijay Sambamurthi, founder and managing partner at law firm Lexygen.
The term sheet codifies the discussions and includes things the parties have agreed to informally, not legally. Subsequent to the term sheet, there will be a due diligence process and the parties will eventually negotiate, agree on, and sign the definitive agreements.
Term sheet is only the beginning of a funding process, according to Goyal. “A well-prepared entrepreneur should be prepared to cut down the lag from term sheet to money in the bank account. It requires having audited accounts, tax filings, RoC compliances, highlights of major customer and partner agreements, patent filings, and the books of financial statements of the venture,” he says.
And, assuming that the outcome of the due diligence has been satisfactory, an investor then proceeds to negotiate the definitive agreements – typically the shareholders’ agreement, share purchase or share subscription agreement (as applicable), Vittalachar says.
Mishandling an exit, when the engagement level becomes part-time or one of the founders becomes a sleeping partner, is one of the most common mistakes committed by entrepreneurs. Upfront clarity in the Founders’ Agreement can ensure smooth sailing in such times. And, during rounds of external funding, the founders must retain the management control or the board control with themselves, understand implications of key terms such as liquidation preference and drag-along rights of the investors.
Adding to the point, Vittalachar cautions, “Often, founders undermine the importance of reading and understanding the fine print.” This is true both in the context of material contracts as well as term sheets and definitive agreements. “Another common mistake is laxity in formalising employment terms and incentives (including ESOPs). This becomes difficult to formalise and manage as the numbers increase, and tends to take a nasty turn, especially in the context of disputes.”
Having a legal counsel to assist on various issues helps address all these problems. According to Vittalachar, most of the legal issues that a founder battles with are not necessarily “business law” issues. There could be concerns around IP law, taxation, real estate, employment law, litigation, to name a few. Hence, it is necessary to choose a lawyer who can provide advice relevant to the founder and the business. But this is often overlooked. The right lawyer can anticipate issues and will guide entrepreneurs in the right direction.
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Source – Kotak Business Boosters – VCCircle