Common Traps and Pitfalls for Early-Stage Startups to Avoid
Building and launching a startup is not for the faint of heart. Founders of startups face significant legal and business challenges. However, there are ways that founders can minimise (and in some cases, eliminate) these challenges.
When advising founders and investors of emerging growth companies, we have seen all manner of matters which needed to be resolved to ensure that the company can be successful, these have included:
documentary issues – documents not signed properly, poor drafting and non-enforceable terms;
employment agreements not being in place with key employees; and
intellectual property not properly owned by the start-up.
We have unpacked some common mistakes for startups to avoid in more detail below.
Have a Shareholders’ Agreement
The first document any startup should invest in is a Shareholders’ Agreement. Any external funder is going to want to have one in place, it is also useful for ensuring the founders have discussed key considerations for their personal circumstances.
When a disagreement or dilemma arises down the track, having proper agreements in place can be the difference between the failure and success of the business. For example, a properly drafted shareholders’ agreement puts shareholders (including founders and investors) on the same page from the outset. It keeps the company on track when disputes arise, sets out each party’s roles and responsibilities, and provides clarity about how certain situations should be handled.
Ideally, a well drafted shareholders’ agreement will resolve disputes before they even happen. It will also protect the interests and rights of each party to the agreement and prepare a startup for stronger growth.
Make sure documents are properly signed and you can find them
When a dispute arises, a question is asked, or a data room is filled with documents for an investment or exit event, it is a lot simpler if documents are properly executed and in the right place.
This has become substantially simpler with changes to the law since 2020 which have permitted almost all documents to be executed electronically – this includes witnessing of documents electronically where required.
It is unfortunately somewhat common to find copies of a shareholders’ agreement which has not been signed by all parties, or a deed of accession to a shareholders’ agreement which was not received from an incoming shareholder. Situations also arise where parties have moved forward with a commercial arrangement (such as a contractor relationship) without signing the final agreement.
Ensuring documents are actually signed at the start is far simpler and cheaper than fixing this at the end – and you have invested the time and money into getting these documents prepared, they might as well be signed.
Keep and eye on your cap table
Startups need to be careful that they do not issue shares to more than 50 shareholders during their capital raising activities. Section 113(3) of the Corporations Act 2001 (Cth) (Corporations Act) prohibits a private company from having more than 50 non-employee shareholders on their share register. Further, companies which have more than 50 shareholders (regardless of employee status), are subject to the takeover provisions in Chapter 6 of the Corporations Act. This can hinder future exit events by creating more onerous processes for potential buyers who will be required to make the acquisition through a permitted exception (e.g. a formal takeover).In addition, capital raising (particularly in its early stages) often involves the issue of convertible securities such as SAFEs or convertible notes. Convertible securities are well suited to early-stage capital raising because they are generally faster, cheaper and more flexible than raising money via a priced round. However, founders should be careful to analyse the impact of any conversion discounts or valuation caps under future fundraising or exit scenarios. Failing to do so can see founders giving away more of the company than they expected.
Neglecting intellectual property
Intellectual property (IP) can be confusing territory for founders to navigate. If a startup has developed a product, this does not automatically mean that the IP in that product will vest with the startup. Without a properly drafted agreement, critical IP may end up being owned by founders, employees or contractors of the company rather than the company itself (or a subsidiary of the company). Seeking legal advice, properly assigning IP and applying for any necessary IP protections such as patents and trademarks are all essential steps to safeguarding the overall value and future growth of your company. It also helps to prevent disputes in the future.
They do due diligence on you, you should do due diligence on them
In the same way that investors are going to undertake due diligence on a company, so should founders undertake proper due diligence on their investors.
Founders should verify the legitimacy and stability of investor funds and ensure that there is compliance with regulatory standards. Ideally, investors will be aligned with a startup’s long-term goals and vision, particularly concerning control and valuation.
Where possible, founders should also opt for investors with expertise and network in their startups particular sector and a proven track record of guiding startups at a similar developmental stage. Whilst securing capital is a fundamental step in the startup lifecycle, partnering with unsuitable investors or accepting detrimental investment terms can lead to legal issues and disputes, wasted time and money and will ultimately limit the growth of a company.
If you can, it is always good to speak to other founders of companies in your potential investor’s portfolio.
Don’t do it too soon, don’t leave it too long
Timing is everything when it comes to capital raising, particularly in the early stages of a startup. Whilst raising money too early can cause unnecessary dilution to a company’s cap table (valuations can be a killer), a shaky balance sheet can make it harder for a company to attract solid investors.
Leaving it too late for capital raising to occur can cause untold stress. It is important to build a strategy for capital raising, including what forms of raises might be best (for example, the use of a SAFE Note) and consider whether you need to raise funds or if other options may be available – for example lending.
Navigating the tricky terrain of early-stage capital raising is unavoidable for any founder. However, obtaining proper legal advice from the outset can minimise risk and save founders a lot of future headaches.
How can we help you?
Merton Lawyers are experienced in the start-up landscape and provide expert advice to founders in the early stages of setting up their company and raising capital. To discuss how we can assist you, please contact our corporate team on 03 9645 9500 to arrange for an initial consultation.
