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According to CB Insights, legal complications are in top-20 reasons why startups fail. Quite often the problems appear in the very start due to inaccurate documentation. How to avoid such scenario and minimize legal risks for a new company - read in our new article.
We talk to startups and investors, you get the value.
In Russia, despite the difficult economic situation, investment companies and funds continue to work with startups and cut new deals. Thus, the “Yellow Rockets” fund invested more than 6 million rubles in the development of QB, a Russian storage service with delivery in April 2020.
However, before they make a name for themselves and apply for financial support, beginners need to draw up basic documents for the legal packaging of a startup. Lack of attention to this stage can cost a company a lot. The Decide.com project, for example, was forced to close shortly after its opening in 2011. It was created to predict price changes on marketplaces. The tool was initially connected to such popular networks as Target, Best Buy and Amazon. However, Amazon said that due to the discrepancy with their legal requirements, they will have to block Decide’s affiliate account. This meant a disaster for the startup as 80% of the revenue came from Amazon.
And this is just one example of how inconsistency in preparing the necessary documents can not only cost a startup company time and money, but jeopardize its existence. To prevent this, it is important for the startup founders to understand very clearly how to protect the new business from legal problems as much as possible.
A startup doesn’t need a lot of legal documents to start a business. A standard list usually includes a conceptual agreement for founders, a charter, a confidentiality agreement (NDA), and an agreement for registration of intellectual property rights. But in reality a company needs more documents to launch in order to ensure maximum legal security, and should take this very seriously.
First and foremost, it’s the charter, which must include:
Rights and obligations of parties. This includes the coordination of voting processes, profit management and distribution, etc., as well as the obligations of participants — for example, actions when paying shares, corporate information disclosure ban, etc.
The procedure for transferring a share of a party or its part to another person. It usually includes the information on whether other parties need to give consent to this, as well as the possibility of using the preemptive right to acquire a share or its part.
The procedure and conditions for a party to exit the business.
Corporate Governance. This includes what the managerial authorities will be, their level of competence and who is responsible for operative business.
The procedure for conducting transactions in which there is an interest of participants, and the procedure for carrying out large transactions. It is necessary to define such agreements and establish who makes decisions on whether they have been reached.
The procedure for the reorganization and liquidation of the company, including who has the authority to make such decisions, the procedure for their adoption, as well as a list of documents necessary for this.
The corporate agreement that the participants constitute among themselves is also of great value. Strictly speaking, it is not necessary for the registration of a company, but it is vital in order to minimize the risks of conflicts both between the founders themselves and with investors. For an LTD, such an agreement will be in the form of an agreement on the exercise of the rights of its parties, for a stock company it will be in the form of a shareholders’ agreement. In general, corporate agreements regulate how exactly participants will exercise their corporate rights or abstain / refuse to exercise them, how they will vote at the general meeting, acquire and dispose of shares (stocks) in the authorized capital, or refrain from alienating shares (stocks) until certain circumstances etc.
If a startup is going to hire employees, the company’s internal labor rules, labor contracts, job descriptions and NDA for employees are definitely needed. In addition, the list of mandatory legal documents includes consent to the processing of personal data (if it is not in the employment contract, it is executed separately), and in some cases an agreement on the full liability of the employee may be necessary. Ignoring the signing of such documents can lead to serious legal consequences. The easiest way to explain this is with examples.
Let’s say a startup employs a designer who actually produces intellectual property (design projects). However, the company did not take care of creating the job description, and the employment contract did not specify the transfer of rights to the projects being created. This means that the use of designer’s work will be limited by copyright. In this case, it will be very difficult for a startup to get the opportunity to own projects — in the best case scenario, the company will have to pay substantial compensation to the employee in order to avoid lawsuits.
Here is another possible example showing the importance of legal documents for staff. A startup fired an employee “with cause”. He appealed to the labor inspectorate and court against the company’s actions. And if the organization does not have the necessary set of documents, the court will reinstate the employee in the post, also obliging the employer to pay compensation for forced absenteeism.
To conduct business, it is extremely important for a startup to develop an agreement with its customers and contractors, taking into account the main type of activity. In such agreements, it is important to write down all the details, otherwise the consequences can be disastrous. Even managers of large brands sometimes make huge mistakes — just remember the example of IKEA, which, due to vague wording in the documents, was forced to pay an enormous amount to the counterparty.
So this is how it was: in 2006, the Swedish corporation did not have time to connect two “Megas” in St. Petersburg to the city power grid so it rented diesel power plants from the company of businessman Ponomarev. IKEA managers obliged him in the contract to supply the malls with energy of a given capacity — but they did not stipulate with what means and, accordingly, the specific price. Taking the opportunity, Ponomarev brought more and more generators into the shopping center, and the price of his services grew by leaps and bounds. IKEA managers soon realized the mistake, but instead of paying a forfeit and terminating the contract, they threatened Ponomarev. He filed a lawsuit for 18 billion rubles, and the brand ultimately decided not to bring the case to a court decision, prioritising the company’s reputation. As IKEA decided to settle the offence out of court, they ended up paying a total of 25 billion rubles. Since it’s a really big corporation, IKEA has survived this crisis, but try to think what would happen to a smaller company.
Thus, any startup must have the necessary package of documents to regulate relations with both founders and investors, its employees as well as customers and contractors to ensure legal security in the first stages. It should be borne in mind that there are still a lot of risks and pitfalls in the process of preparing such documentation, so it is best for startup companies to use the help of a professional lawyer with relevant experience.