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).

For start-ups, which sooner or later seek an investment, only the capitalistic legal forms can be considered as they are, from a technical perspective, easy to invest in. At the same time, they provide limited liability for their owners, so that if a lawsuit is brought against the company, it will only affect the assets owned by the company and not those owned by its shareholders. Investors do like such things.

As a founder: think about how to hold your shares

Holding shares in a start-up sounds easy: just subscribe and there you go. Quick and easy. And potentially wrong.

For a host of reasons, it may be preferable to hold shares thru a vehicle, read: another company. In some jurisdictions, it may even be advised to hold that holding company through yet another holding vehicle. Complicated tax laws sometimes give rise to such considerations. Yes, I am looking at you, Germany.

Changing ownership of shares later is possible but may have a lot of tax ramifications. Additionally, it can trigger all kinds of complicated clauses in shareholder agreements, such as rights of first refusal.

Make – and keep! – the start-up investable for venture capital

After a friends-and-family funding round and maybe some angel investment, many start-ups are a mess. I have, with my very own tear-filled eyes, seen start-ups attempting a pre-seed (!) round with 17 shareholders already in the cap table. As investors, for very good reason, like clean businesses, such start-ups are virtually un-investable.

Cleaning them up is possible but cumbersome, setting things up the right way is easier. Here are a few ideas:

  • Keep minor investors out of the decision-making or at least the cap table. Give them a virtual share, set up a VS(O)P, create preferred shares with no voting rights, give them a SAFE that only kicks in during an exit event, or make them silent partners.
  • Angel investors very often demand outrageous percentages and control rights while at the same time overestimating their ability to support the start-up going forward. Negotiate at this point.
  • A disease of many start-ups is to hand out real equity against consulting and services (SEO, sales, influencing, etc.) before such services are even being rendered. Sometimes they never will, and if they are, they often are of sub-standard quality. Yet the equity is gone and hard to get back. Set up an ESOP or VSOP for such service providers and choose the parameters of such a program wisely.

Protect your Intellectual Property (IP)

“Protecting IP” is a staple on any legal to-do list, yet many founders believe “protecting IP” means filing for a trademark. And while a trademark is a terrific thing to have, the task is a bit more comprehensive.

Founders often produce code, designs, texts, or other IP, something whole digital MVPs, before founding. Afterward, nobody takes care of collecting all that intellectual property into the business which creates irritations and blackmail potential down the road.

It is always helpful to ponder the question of how the IP situation would look in an investor’s due diligence. If a start-up cannot prove they own their IP, they are toxic and will not be considered for investment.

Find the right structure for investments

It is not impossible but rare that start-ups can finance their growth out of their cash flow. Instead, sooner or later money is needed. Since there is typically no collateral and the success of the business is uncertain, a bank loan is out of the question. Alternatives need to be found. There are quite a few, all with their pros and cons.

  • The classic deal structure, especially in VC financings, is to create new shares and sell them to the investor – to swap cash against equity. That approach works well if founders and investors can agree on a valuation of the company.
  • If no valuation is sensible, a convertible loan is a brilliant alternative. It is also quick and easy to negotiate. Sometimes, the US-Cousin of a convertible, the SAFE (Y-Combinator’s Simple Agreement for Future Equity) may be useful. For most European jurisdictions it must be adapted though.
  • In certain situations, crowdfunding campaigns, or even exotic instruments like an ICO, might be considered.
  • Governments, cities, or other organizations may offer grants and funding programs.
  • An elusive form of financing is Venture Debt – typically uncollateralized high-yield loans. They are, however, more talked about than seen in the wild.
  • In certain cases, silent partnerships and similar instruments can be valuable, especially in friends & family rounds.

Negotiate Investment Agreements and Shareholder Agreements carefully

Investors are humans, too. They can be flawed, inexperienced, delusional, greedy, or they may misunderstand situations or misjudge developments. Thus, some demands investors make and want to have outlined in the investment agreement may simply be not in the best interest of the business.

There is, of course, always the valuation question, which is not in the strict sense a legal one. Yet the classical deal terms, or lack thereof, can also create conflict and harm.

  • Most start-ups and most investors seek an exit at some point. To that end, precautions must be taken. The most obvious one is to enable the company to actually be sold with a clean cap table to the purchaser in the exit event. This is typically done with a drag-along stipulation.
  • Start-ups should be careful with liquidation preferences, down round, and dilution protections. Somebody always has to pay for those things and investing means taking a risk, not passing all risk on to the founders. There is a reason why it’s called Venture Capital.
  • Excessive rights of investors to control and micromanage, veto and blockade must be avoided, especially as they add up during financing rounds.
  • Founders and key personnel need to be kept incentivized as the success of the business depends on them.

The overriding goal that must always be pursued is to keep the start-up capable of acting, making decisions, and executing them. That means managing and balancing conflicting interests. Mutual blocking, the excessive exercise of veto rights and gridlock can kill even the most promising business.

Do not let that happen.

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