Startups need to adjust how they work with lawyers as they grow, scale and expand. How can lawyers help startups meet their changing legal needs?
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Lawyers Ronald JJ Wong (Associate Director, Covenant Chambers LLC) and Patrick Dahm (Consultant, Samuel Seow Law Corporation) educated startups and shared crucial tips on how startups can work with lawyers depending on their stage on funding during a panel discussion co-organized with partners NUS Enterprise and e27.
Stage 1: Seed Capital
Startups should engage a lawyer as early as possible, or at least have a short consultation. Ronald warns that startups, especially those in the Fintech and Medtech industry, may realise too late after proceeding with their good idea that there are all sorts of regulatory hurdles to cross.
At the start, founders should incorporate their company and seek legal advice on creating a founders’ agreement. Most startups in Singapore are registered as Private Limited (Pte Ltd) companies, which according to Ronald is the most advantageous for startups who take a long-term view of growth, funding and expansion.
“It allows for investors to easily come in,” Ronald explains. “You can easily work out the manager-owner, voting / non-voting distinctions.”
Patrick comments that mere incorporation can be had relatively cheap in Singapore, whereas the cost of a founders’ agreement depends on what the founders want and need.
Ronald shares that a comprehensive founders’ or shareholders’ agreement should deal with:
Board of directors and the quorum and approval thresholds
Share Issuance and share transfer restrictions including: tag-along rights, pre-emption rights, drag-along rights, valuation
Other legal documents which startups may need from day 1 include:
Non-Disclosure or Confidentiality Agreement.
IP Assignment Agreements, if there’s pre-existing IP vested in any founder which then needs to be assigned to the company.
In Patrick’s experience, startups need to place more emphasis on their employment contracts for employees who are not a shareholder or co-shareholder.
He says, “What often gets overlooked in the beginning are non-competition and non-disclosure provisions to protect confidential information even beyond an employee’s time with the company. Initially, we assume nothing will go wrong, but things may change over time.”
Both lawyers warn against splitting equity by 50/50. Such an arrangement is susceptible to deadlock when the founders disagree, which would be very difficult to resolve if the founders haven’t contractually set down what they’re supposed to do in such a situation.
Stage 2: Angel Investor Funding
Startups with anything that can be patented should file for a patent even before raising seed stage investment. According to Ronald, investors won’t look favourably at startups who don’t protect their assets.
As a first step, startups can file for a provisional patent. The filing date and where the patent is filed are important details which investors will check in their due diligence.
Ronald clarifies that what’s patentable are a startup’s novel inventions, and not their ideas. Instead of a patent, a Non-Disclosure Agreement (NDA) would be more appropriate for protecting any confidential trade secrets or know-hows.
Nonetheless, investors generally won’t sign NDAs from the get go. Ronald recommends startups to pitch investors with enough to sell the business model, then wait to release confidential information with an NDA executed when the investor is serious and ready to talk about term sheets and due diligence.
When raising funds publicly, startups need to consider different aspects of fundraising according to the platform they are using. Ronald explains:
For crowdfunding platforms where goods or services are offered without any financial or equity returns (e.g. Kickstarter), startups need to ensure that what is represented through the platform is accurate.
For securities-based crowdfunding, such as money for equity or a convertible loan or a for-interest bond, startups need to consider how much for how long they are raising. Startups need to take MAS regulations and the Securities and Future Act (SFA) (which has been recently amended) into account when fundraising involves securities.
For digital currency funding which involves raising funds by giving people cryptocurrency, e.g. initial coin offerings (ICO) or token sales, this appears to be presently unregulated but startups have to see whether or not the sale of cryptocurrency could be GST taxable.
Some founders may waver between issuing equity or convertible notes for their fundraising. Both lawyers agree that convertible notes are more founder-friendly in terms of giving founders more flexibility.
Nonetheless, convertible notes come with risks too. Patrick warns of the risk of using purely contractual convertible notes, “If one of the parties goes bust, then it’s a paper contract.”
Depending on what founders negotiate into the convertible loan, they can get out of that arrangement if there’s a pre-payment clause which would allow them to pay off the loan and interest due. Ronald suggests negotiating aspects such as:
Whether the loan converts at the maturity of the loan
Whether the loan is payable on demand or payable on demand after a certain amount of time
Conversion price / discount
Other conversion events
While lawyers may provide a list of key issues in negotiations with investors, founders typically do the negotiations themselves. In Ronald’s opinion, the key for startup founders to get funding from seed investors is really to build the relationship, show they know their stuff, show they really want to learn and get support from the investor beyond the money.
Stage 3: Venture Capital Funding
When negotiating with VCs, founders may fear that they will hardly have any influence left. Patrick advises founders to manage expectations and seek legal advice on aspects of a term sheet before setting the terms in contractual stone.
Ronald shares that founders typically face the issues of:
Valuation, for which founders can use services and platforms online to calculate their post-money and pre-money valuation.
Control in terms of board seats, which can be negotiated in the shareholders’ agreement depending on the founders’ bargaining power.
To remain in control after raising funds, founders should consider their voting rights. According to Patrick, VCs would want to get as many voting rights as possible in order to exercise their power when they clash with the founders.
However, there are certain aspects of the venture where it’s vital for the founders to keep their rights and protect themselves from being overvoted. Patrick recommends anticipating these aspects and putting them down in contract, e.g by way of veto rights.
Ronald suggests crowdfunding and taking out loans as other ways for founders to retain control. He shares that when VCs come in for Series A and above funding rounds, startups can work with lawyers on understanding the terms in the term sheets, due diligence and reviewing amendments to the relevant agreements.
Stage 4: Exit/IPO
Patrick relates that at a later stage startups typically receive traditional, old-school funding by banks. This comes with the issue of security on which only banks will lend.
Founders ought to negotiate at an early stage on how much control they would each have in the event of an exit. In Ronald’s experience, founders of startups reaching exit tend to have much less control than their investors, especially for an exit acquisition or IPO.
Ronald advises founders to take note of liquidation preference clauses, which basically determine the amount of money a class of shareholders will get if the company is sold, listed or wound up. They affect how much the startup should be sold for in order to make sense for both founders and investors.
“I think generally if it is not at least 4 times of the amount invested, it may not be very lucrative,” Ronald says.
This article was originally published on Asia Law Network.