By Ela Levy-Weinrib
Globes, Tel Aviv, Israel.
The “Globes”-Bank Hapoalim (TASE: POLI) Smartup3 competition is over and the four winning startups will soon enjoy the promised prize: advice from high-tech and business experts in a range of pertinent subjects.
The advice will help the new companies survive the legal intricacies and the regulatory and other hurdles in the entrepreneurs’ path, but the labor pains and teething problems from their babies — the startups themselves — are behind them.
They have already come up with an innovative idea, raised initial capital, sought protection through a patent or other method, and begun work on developing the technology that they hope will take them to the hoped-for exit — and the big money.
How will they do this, and what are the legal obstacles they must — really must — overcome en route? The legal advisers of the incubators assisting the start-ups have responded to these questions for “Globes”, offering legal tips that will facilitate the potential entrepreneurs’ lives.
Adv. Lior Baruch, partner at Pearl Cohen Zedek Latzer Baratz, the legal adviser of 8200 EISP, which is assisting Paybox Ltd.
The founders agreement is your financing agreement
1. The founders: again and again, investors say that they invest in people, not in ideas, technologies, or market share. The most important and diverse resource is you and the other entrepreneurs on the team. Think about each of your strengths and weaknesses and the possible contribution now and down the road. Then sign the founders agreement for coordinating your expectations and relations in the first stage, until an external investor comes in. A good partnership between the founders is important, but the founders agreement is your financing agreement and insurance policy, and it must regulate all options for solving disputes, deciding disagreements, and returning shares to the company if a founder leaves sooner than expected.
2. The external advisers: the basic team, which ought to advise the founders until the company is founded, includes a law firm and CPA firm with experience in advising start-ups, and which can refer the company to another adviser, such as tax, intellectual property, employee options trusts, and regulatory experts. A good adviser is not cheap, but saving $1,000 when founding the company can easily cause $1 million in damage at a poorly planned exit.
3. Founding the company: to allow you diverse activities and avoid personal liability, you will want to found a limited company at an early stage. It is important to seek consultants for advice on where to incorporate, which will affect your options for raising capital from both government and private sources, and the applicable tax laws, which will ultimately determine how much money you will earn. Moving a company after it is founded will incur various payments.
4. Distributing the rewards: how many shares will each founder receive when the company is set up? This involves a delicate balance. In many cases, entrepreneurs distribute generous percentages, and are subsequently unpleasantly surprise to discover that they have lost control of the company. In other cases, entrepreneurs struggle to recruit partners because of unwillingness to allocate holdings. It is important to remember, a company will almost always need one or more outside investors, who will expect to receive a substantial stake in the company at the entrepreneurs’ expense.
5. Call to order: anyone who has worked in the business has encountered examples of brilliant ideal which failed at a start-up because of improper conduct by the entrepreneurs. Work in an organized way. Document every act. Involve your expert consultants whenever there is doubt. Do not reveal your ideas to other without signing a confidentiality agreement. Do not cut corners, especially when hiring employees or with the tax authorities. If you do your work properly, you will discover that the chances that due diligence conducted by a future investor will not torpedo the deal.
Adv. Maya Bar-On, legal consultant at Explore. Dream. Discover, which is advising TapReason Ltd.
Start the patent registration process as soon as possible
1. Where to register the company: whether you decided to incorporate in Israel or in another country, know that this fundamental decision will have consequences down the line, in terms of tax aspects of the company and the entrepreneurs, potential investors, the company’s target market, and the ability to obtain support from Israeli government agencies, such as the Office of the Chief Scientist.
2. The proper distribution of the company’s share capital: the company’s share capital should reflect the distribution of company shares between the entrepreneurs. It is important to ensure that everyone important to the company’s success will hold a respectable stake in the share capital. You will find it difficult to persuade an investor to invest in the company if the entrepreneurs who are supposed to be running it own only a fraction of its share capital from the outset. Take into account that the shares allocated at the outset will be taxed at the relatively low capital gains tax rate, but that subsequently allocated shares may be considered as labor income and be taxed at the higher income tax rate. In addition, do not forget to include in the table everyone who was promised a stake in the share capital at the outset: employees, subcontractors, consultants, investors, accelerators, finders, etc.
3. What is important to include in the founders agreement: on one hand, it is important to make sure that all the founders agree on the partnership and to anchor the agreements in a formal document. On the other hand, it is necessary to take into account that, upon the entry of the first investor, the founders agreement is liable to be amended and rendered obsolete. If you decided to draw up a founders agreement, give thought to the structure of the company’s board of directors, what each entrepreneurs should contribute to the company, will happen if one of the entrepreneurs fails to deliver the goods or decides to leave, a commitment by all the entrepreneurs not to compete against the company, how to finance the company until the first investment, ensure that every entrepreneur transfers his intellectual property to the company, and dispute settlement. It is advisable to include dispute settlement and separation mechanisms in the agreement, as well as right of first refusal mechanism, preemptive rights, tag-along rights in the event of a sale of shares, etc.
4. Protecting company assets: ensure that the company’s intellectual property rights are clear and that no external party, such as former employees of the entrepreneurs or research institutes, has any rights therein. Check with a patent attorney whether it is possible to patent the technology; if so, it is worthwhile to initiate the patent registration process as soon as possible. If not, check other ways to protect the concept, such as copyright.
5. Picking the right investor: pick an investor who can give you added value beyond the money he is injecting — an investor with a track record of helping create relations with customers or strategic partners, helping the business side, and raising follow-on capital. Picking the wrong investor is liable to result in a disproportionate holding structure in which a small investor owns a large stake in the company at the expense of the entrepreneurs. Such a distortion will drive away other investors.
Adv. Stephen Barak Rozen, partner at Amit Pollack Matalon, the legal advisor of Nielsen Innovate, which is assisting The Grid
Adopt an options plan as quickly as possible
1. Plan the start well: if there is more than one venture and it has not yet been decided whether to found a limited company, draw up a founders agreement. The agreement will anchor, inter alia, decision-making, what happens to an entrepreneur’s shares if he leaves, how much time the entrepreneurs must commit to the project, and whether or not a founder should return shares to the other founders if he leaves.
2. Always be prepared: at each stage of the venture, you must be prepared. Save copies of every document, agreement, commitment, contract, etc.
3. Draw up an options plan: if you are planning to award options to employees, adopt an options plan as soon as possible so the employees will benefit from the relevant tax breaks. We frequently encounter cases in which an options plan was not adopted in time, and employees who leave and wish to exercise their options face income tax problems.
4. Seek the assistance of the Office of the Chief Scientist: in the early stages of a project, it is worthwhile to consider taking money from the Office of the Chief Scientist. If you are already seeking investors, this is supplementary money at good terms in the early stage; it does not dilute stakes, and the money is only repaid in the event of success. There are subsequent restrictions, but it should be considered.
5. Consider when to incorporate: the timing of incorporation is critical. There are tax and liability aspects if you do not operate as a limited company, as well as hiring and other issues. On one hand, it costs money to establish a company, and there are related expenses, but on the other hand, there are many advantages in terms of protecting the entrepreneurs and their limited liability.
Adv. Ronen Hausirer, partner at Herzog Fox Neeman, the legal advisor of Moneta Seeds, which is assisting Finupp
Know the rules of the game; they are liable to change during play
1. The relationship between the founders: it is worthwhile being friends, but being business partners is more important. To have an efficient and productive work relationship between the entrepreneurs it is advisable to formulate them in a founders agreement. There is not necessarily a right mechanism, but it is necessary to find a mechanism that suits the specific team. It is also important to define clear roles and areas of responsibility for each entrepreneur in the company in a way that will allow each one to express his skills in his field.
2. Pick a strategy for raising initial capital: different ventures have different financial needs over different timeframes. Ventures in some sectors can complete the initial development process in a short time with a small team and start generating income quickly to finance further development. Other ventures require small financing to see the technological feasibility, after which it will be possible to raise substantial capital, and there are ventures that require substantial initial investment.
3. Manage the company’s holdings table properly: managing the company’s holdings table is one of the biggest challenges during the venture’s life. From the outset, it is important that the holdings table reflects the contribution of each subscriber in the company, and it important to build the table in a way that preserves the entrepreneurs’ skills in the company over time. It is important to avoid as far as possible the granting of options or shares to service providers or consultants who are not expected to contribute to the company. Remember, investors tend to first invest in the human capital, so an investors who concludes that the company’s talent will be greatly diluted after the first investment round will hesitate to invest in it.
4. Tailor the right protection for the company: it is common to divided the world of intellectual property into four segments: patents; copyrights; trademarks; and commercial secrets. Many entrepreneurs are aware of patents, but do not fully understand its advantages and disadvantages. In some fields, such as software, even if it is possible to patent the means, it is not certain that a patent will provide the expected protection. There may be cases to suffice with copyright law for software and to focus on registering trademarks in cases in which the reputation attributable to the company’s trademark has important value for the business plan.
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Reputation could have significant value in technology.
5. Regulation: know the rules of the game; they are liable to change during play. In many cases, there is more than one regulator for each field, and regulation may change frequently. Familiarity with the regulations in all their diversity from an early stage will allow a company to develop the right technology strategy and reduce costs, correct errors, and create the right value for the company.
My first legal hurdle
Every new entrepreneur knows he will face and overcome several hurdles en route to an exit. Good legal advisers save a lot of headaches, but does the entrepreneur know how to ask the right questions? “Globes” asked the CEOs of the Smartup3 winners what were the first legal hurdles they encountered, and how they dealt with them. They common response was the well-known adage:
knowledge is power.
Social payments solutions provider PayBox co-founder and CEO Tal Grinberg says, “Our legal dilemma was that when we sought to raise money from family and friends, we needed to understand the advantages and disadvantages of raising money from a fairly large group of people 12-15 individuals and whether the number of investors we could bring in before the company was considered a public company, was limited. We discovered, with the help of our lawyers, that we could bring in up to 35 new investors a year, and up to 50 investors altogether before the company would become a public company, and we really did not want to be a public company. We never reached that threshold, but it was important for us to know that in advance.
“Another legal dilemma we dealt with was the question whether the entry of these first investors would disrupt the entry of heavier and stronger investors, including venture capital funds, in the future. We wanted to ensure that raising money from family and friends would not disrupt the entry of future investors. The solution in this regard was to sign the investors on proxy agreements, in which they transferred their voting rights as shareholders to someone else in the company, which in our case, were the founders.”
Cloud-based financial and accounting information management solutions provider Finupp CEO Assaf Regev says that because he is a lawyer and accountant, he did not face legal problems, but adds, “The main matters I encountered were the location for incorporation. For tax purposes, incorporation in Cyprus was preferred, but, in my opinion, incorporation in a tax haven is liable to deter angels who would benefit from tax breaks on investments in Israeli companies. Therefore, in the seed stage, it is worthwhile incorporating in Israel. In the event of success, it is possible to apply for a tax break under the Law for the Encouragement of Capital Investment, or to work with a foreign company on a cost-plus structure.”
Mobile app viral sales and distribution platform TapReason CEO Nimrod Elias says that dealing with the law was a foreign language for the company. “For us, as a company with a deep technology DNA, legal issues were practically a foreign business. For us, privacy issues of end users were the burning issue. The challenge was even greater because in order to support tier-1 companies and organizations, we had to comply with different regulations in each country. This included adapting the product’s technology to the accepted sensitivities and policy terms in the large markets and vis-a-vis Apple and Google.
“We also thoroughly learned case studies of competing and supplementary products, and turned the challenge into an opportunity by emphasizing the importance of privacy in our study models, in contrast to other tools, which are more intrusive and less adapted.”
Instant package delivery app The Grid CEO Gur Harel says, “The main issue that worried us was our wish to be involved in the service process in order to guarantee the optimal experience for all parties at interest, while keeping our legal status as a platform. It is important for us to accompany every task through our support network and to be available to help both the client and the service provider performing the task. As I said, the problem is that the greater your involvement, the murkier your legal standing as a mediator becomes. Ultimately, we chose to take part everywhere that we deemed to be significant, commercially and in principle, and at the same time to act as required and accepted as a platform.”
