Regulate relationships among founders
1.1 Establish the relationship contractually.
Because it is very common for founders to join and leave a start-up and conflicts can often arise among founders, it is very important to define the relationship among founders clearly. Certain methods of defining founding relationships involve greater legal cost but provide greater clarity. As such, we must first ask what level of legal investment makes sense at this early stage of the business venture. Three common ways of defining relationships among founders include:
- (A) Founders Agreement: as detailed above. Incorporation + a Founders Agreement is a more straightforward means of defining the relationship between founders than a Shareholders Agreement (described below).
- (B) Shareholders Agreement: a Shareholders Agreement is a more complex document than a Founders Agreement, goes into much more detail about various situations involving actions that are triggered when founders join or leave the company (through the purchase or sale of shares) and is not as easily amended later on.
- (i) Founders Agreements are often one of the first contracts the founders of a business may sign. Founders agreements are a straightforward way to address crucial legal issues at an early stage. The contract should outline roles and responsibilities of the founders, equity ownership and vesting, and IP assignment.
- (ii) Incorporation of a business has numerous benefits for a start-up company, including limited liability, facilitating access to capital, and perpetual existence. Law clerks are a helpful resources with these government filings. Incorporation is usually accompanied by one of the following:
1.2 Establish ownership of IP
- (a) Establishing ownership of IP should be part of whichever of the above methods is used to define the relationship between founders. This will usually include:
- (i) IP Assignments: This agreement should be signed by all co-founders, employees, and other contributors. It helps ensure that any IP produced in the course of employment remains the product of the corporation after the contributor’s departure.
Disclose the business to third parties
2.1 A business cannot be kept between the founders forever. At some point a company must seek out advisors, investors, partners and customers. In many cases there may be legal implications surrounding the disclosure of the business. For example, general disclosure prior to filing for intellectual property protection (e.g. a provisional patent application) may make it impossible to protect IP later on. This is why companies must usually make use of:
- (a) Non-Disclosure Agreements: NDAs are often seen in the context of a teaming agreement or at the outset of business negotiations. They are used where the company wants to protect the confidentiality of information that is being shared with another party for a business purpose. As a practical note, venture capital firms and other sophisticated investors may not be willing or able to sign NDAs due to the volume of deals they consider and the potential liability associated with inadvertently investing in a company with a similar business plan. After a venture capital firm decides to work with a compnay, they may sign (or have a technical advisor sign) an NDA later on. However, whenever possible, at an early stage in a company’s lifecycle, an NDA should always be sought prior to disclosure of the company’s business plan and/or intellectual property.
Develop an IP Strategy3.1 An early stage start-up should consider at least two aspects of IP strategy:
- (a) Patents: For a company with a novel product or technology, patent protection is the cornerstone of its competitive advantage. Often, obtaining patent(s) is a pre-requisite to raising money from professional investors.
- (b) Brands / trademarks. A company that is actively selling its product or service needs to consider its brand, which is tantamount to its reputation in the marketplace. Trademarks help ensure that this reputation is not tarnished by another party, by protecting the exclusive right to use logos, phrases, and other facets of the brand. It is very common for a start-up to pivot on its name and branding, but a start-up should obtain a search for existing trademarks at the very least in order to avoid infringing on another company’s brand.
Regulate relationships among workers
4.1 A start-up may hire workers as either employees or independent contractors. There are a number of legal agreements that are relevant at this stage:
- (a) Independent Service Provider Agreements: Often an early-stage company will not hire employees, but will instead use contractors to carry out its work. This arrangement has a few advantages over traditional employment, including no tax withholding and/or minimum wage requirements. If the company does hire employees, then proper Employment Agreements will be necessary.
- (b) Employee Stock Option Plans (ESOPs): Cash is often in short supply with early-stage companies, but employees and contractors still need to be compensated. Stock option plans can be an alternative or addition to a salary, and are a means of enabling workers to reap the benefits of their hard work and share in the success of the company.
- (c) IP Assignments: As described above, this agreement should be signed by all co-founders, employees, and other contributors.
5.1 A start-up will usually employ a go-to-market strategy that develops in incremental stages. For example, a company may launch with a minimum viable product (MVP) and later roll out a Beta version, followed by a soft product launch and a hard launch. Rolling out a product in stages allows the company to gather customer feedback as soon as possible, validate a market or idea, pivot early and even fail early – before incurring significant expenses. As the company enters the market in these stages, a number of agreements are relevant:
- (b) Teaming Agreements: Often, part of a start-up’s marketing strategy is to partner with an incumbent company to provide a product or service jointly. A teaming agreement covers this type of activity, and is crucial as a means of protecting the start-up’s rights against a more sophisticated partner. A number of crucial considerations should be included in Teaming Agreements, Pilot Agreements and Collaboration Agreements such as: who owns the feedback provided and intellectual property that arises through the joint venture? How much should the start-up charge its corporate partner (start-ups are often too quick to work for free, which can have an adverse effect on valuation)? What is the overall goal of the partnership?
6.1 At some point most start-ups need to consider external investment. This usually occurs after market traction can be proven (after at least some data has been gathered from the MVP stage) but may occur before (in the case of a team able to raise funds on the merits of the team members alone) or after this point. Just as with a company’s go-to-market strategy, fundraising occurs in stages (e.g. early seed (including friends and family), later seed (including Angel investors), Series A, Series B, and so on…) in order to limit investor risk. A company goes onto further financing rounds, often at higher valuations as it meets targets and gains traction through utilizing funds received during earlier rounds. It is important to have proper legal counsel as a company scales because when more money is involved, greater scrutiny is placed upon the company. Agreements relevant at this stage include:
- (a) Simple Agreement for Equity: For a company to grow out of a start-up stage, it will eventually require external capital. SAFE agreements are a straightforward way to raise this capital, as they defer the complex valuation process until a time when a professional investment firm can assist with the process.
- (b) Other term sheets. A wide array of agreements may be relevant at this stage such as Convertible Notes (wherein a company receives cash in exchange for issuing debt in the company, which debt can be converted to equity upon later monetization events) and less-commonly straight Equity Investments (wherein an investor or group thereof provide cash in exchange for a direct equity stake in the company).
7.1 As the company grows, many of the above items will need to be revisited. Many of these issues are addressed by Norton Rose Fulbright Canada’s Scaling Readiness Package. For example:
- (a) Intellectual Property issues that arise from the company’s expansion may involve developing Distribution Agreements, Licensing Agreements and investigating implications of open source software in the product stack. Additionally, the company’s IP strategy takes on differing forms as it becomes increasingly internationalized.
- (b) Regulatory implications of the business will become increasingly relevant as the company gains more exposure. Legal guidance should be sought to ensure the company avoids regulatory pitfalls.
- (c) Corporate governance issues will become more important both internally (as the workforce grows, corporate structure will have greater practical ramifications on the company’s culture and efficiency) and externally (as the company receives greater investment, the company will come under more scrutiny). It is critical to have quality legal insight to ensure the company’s corporate structure is both practical and investor-friendly.
- (e) Human resource issues become increasingly relevant. Most notably, immigration issues require expert legal guidance as a company expands its workforce to include team members from multiple jurisdictions.
- (f) Financing may become increasingly regulated. For example, a company must have a careful strategy as it moves toward an initial public offering (IPO). IPOs are becoming increasingly common for early stage companies and can be far less complicated provided a company receives proper legal guidance well in advance of an IPO.