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Keeping Start-ups investable with proper legal setup

Strawberries as a symbol for keeping start-ups investable, because: why not.

Most founders of start-ups perceive legal stuff as rather dry and boring. I passionately disagree, as legal work can be exciting, creative, and surprisingly entertaining. Yet we can consent that founders need to concentrate primarily on their business. But proper structuring and set-up of a start-up is not just useful but essential: if done wrong, the business will be un-investable down the road.

Most issues that are very hard, expensive, and time consuming to correct when done wrong, could have been easily and elegantly set up in the first place.

Here is a short and non-exhaustive list of things to consider.

Choose a suitable jurisdiction

A start-up is often formed in the local jurisdictions of the founders by default. However, rather often not all founders are domiciled in one country. Or the market of the start-up is non-domestic. The local jurisdiction may not be suitable, too cumbersome, or cannot be taken seriously. It makes therefore sense to ponder the options. Here are a few ideas to consider:

Some jurisdictions smell like rotten fish. Unless the founders want to trade in insider information, dodge taxes or circumvent certain legislation, there is little good reason to use them, and serious investors shun them for that reason.
Other jurisdictions often serve special purposes. For a while, Malta was fashionable for crypto firms and Switzerland will remain a favorite for royalty-generating IP companies.
Smaller jurisdictions may have the disadvantage that investors simply do not know them, are not comfortable operating in them, and indeed such jurisdictions may not be overly sophisticated simply for lack of experience of the whole ecosystem (including lawyers, advisers, registers, and courts). Nothing should prevent start-ups in such jurisdictions to be founded, but they might have a change of jurisdictions at least on the radar and structure the organization accordingly.

Determine the legal structure of the start-up

Most jurisdictions offer a wider variety of legal forms in which businesses can be established. The main difference between the forms runs between more personal forms of organization (sole proprietor, partnership) and more capitalistic ones (limited companies such as, depending on jurisdiction, LLC / Ltd. / GmbH, or also classic stock companies).

Real-word applications for Smart Contracts: Service Level Agreements

Image of a strawberry as symbol for an SLA because we can

Smart contracts seem to be a terribly clever and useful thing: a self-executing contract without the need for middlemen while saving transaction costs and being immune to manipulation. That seems to be good to be true, and of course, it is, as a smart contract, in most cases, is neither very smart nor necessarily a contract in the legal sense. Not to mention how many smart contracts were hacked or bypassed or otherwise tampered with.

Smart Contracts in the wild

Yet the subject is interesting, but from my practical perspective as a lawyer, I see relatively few examples of real-life use of smart contracts (in the narrow sense, excluding the notorious soda vending machine). This is not to say that such use does not exist: it does in many blockchain transactions, in DAOs, in facilitating revenue shares when digital assets such as NFTs are sold on, in insurance, healthcare, and finance / DeFi applications. But compared to the amount of “other” contracts, their market share is tiny.

Furthermore, many of the use cases that are often proposed for smart contracts are not convincing or practical. For example, it is in most cases a terrible idea to use smart contracts to facilitate insurance payouts, as the circumstances under which such payout is supposed to happen can often not easily be proven or simply fed into a ledger by oracles or similar mechanisms. The world is a noisy place and who is at fault in a traffic accident is sometimes hard to determine.

There are, however, many situations in which there is much less noise and uncertainty and where all necessary information can easily be obtained and may, in many cases, already be recorded anyway on some form of electronic ledger, albeit not necessarily a blockchain.

The Service Level Agreement (SLA) as a use case for smart contracts

I propose to consider the use of smart contracts in tech Service Level Agreements (SLA). I have no illusions of being the first one to do so – a short Google search shows that the idea is not completely novel. Yet it is certainly not yet mainstream. That is surprising insofar, as SLAs may be a rather low-hanging fruit in that respect.

How to think about a DAO

The three most important inventions mankind has made are, in my opinion, fire, money, and the organization. The latter being the coordination of the activities of a group of people towards a common aim.

All three of those inventions are still work in progress, and regarding two of them, things like crypto, the blockchain, tokens, and smart contracts have been proposed as a means to raise them to a new level. When it comes to organizations, the thing to talk about is the DAO.

What is a DAO?

To find out what a DAO is, one might be inclined to look at what the abbreviation stands for: Decentralized Autonomous Organization.

Of course, every single word in this name is wrong, misleading, or at least wildly exaggerated. Certainly, for the current iterations of DAOs. One might, however, think of it as an aspiration, as something that is, one day, going to be. Let’s break it down.

A DAO is or at least can be, as claimed by the “O”, a form of organization. As legal thinking has been going for centuries, if not millennia: something only exists if a label can be put on it. DAOs as such are, at least in any sane jurisdiction, not a thing in itself but rather a form or part of some pre-existing form of organization. This may be a partnership, an association, an LLC / Ltd / GmbH, or, in fact, any other entity structure. At least one US-State (Wyoming, of course) has recognized DAOs as an entity structure per se. On closer inspection, however, the legislation made it an LLC with the word “DAO” attached to its name: basically, a legal gimmick.

A DAO is decentralized – the “D” – insofar as there is no central authority but decision-making and most execution is distributed across the stakeholders. One might think of those as shareholders in a corporation where the same distribution structure is to be found. The difference is that in a DAO many more tasks of the management may be distributed in a similar fashion, while in a more traditional corporation a centralized management may make most day-to-day decisions top-down.

The “autonomous” part of the abbreviation is the most misleading: the DAO does nothing autonomously, and, most crucially, it does not own itself. On the opposite: it provides a wonderful mechanism for making and executing decisions, done by the participants. The decisions are made online, often using tokens, and stored immutably on a blockchain or similar ledger (technically, a DAO “just” needs code execution, blockchain and tokens are optional). But what the “A” really means is that no management execution is, in theory, needed. That is because a DAO should have its processes implemented in self-executing smart contracts. Therefore, the decision is already the execution.