Ten Legal Tips For Start-Ups

By Ela Levy-Weinrib
Globes, Tel Aviv, Israel.

Do you have a brilliant idea, which you have been sitting on and discussing in secret for months with your family, army buddies, or classmates at university?

The moment after you have examined the market and discovered that no one else has yet invented the technology you have conceived, and that there is a real need and market demand, your enthusiasm is at a peak, and you have decided that the time has come to turn the dream into reality. What do you do now?

“The way you go forward involves many deliberations and difficulties, but the decisions that you take at the start of the road will fundamentally affect the rest of the journey and the future success of the company,”

Explore.Dream.Discover legal adviser Adv. Maya Bar-On, an adviser to GreenIQ Ltd. as part of the Smartup2 program, tells “Globes”. “The first and smartest step you can take for your business is to coordinate the founders’ expectations.

The same expectations should be precisely reflected in the legal agreement that will be drawn up between the members of the venture.”

Adv. Stephen Barak-Rozen, a special adviser in the high-tech and venture capital practice at APM & Co., the legal advisers of Nielsen Innovate, which is advising Zeekit, hones Bar-On’s remarks, saying, “It is hard to later correct mistakes that young entrepreneurs make at the beginning, which is why it is important at each stage to pay attention to arrange legal matters.

For example, if the founders do not give thought to tax issues at the early stages of a company’s incorporation, or if they make a mistake in distributing stakes between the entrepreneurs, it will be very hard to correct these things.”

Although he believes that “anything can ultimately be fixed, the question is, what are the consequences of the correction, and, especially, how much will it cost.” Therefore, “Stress the important legal steps when founding the start-up.”

What are the first necessary legal steps that a start-up should take, and how is it possible to avoid future mistakes that will cost the company a lot of money?

As part of the “Globes”-Bank Hapoalim (TASE: POLI) Smartup2 program, we asked the legal advisers of the incubators where the program’s start-ups are operating, and we examined the regulatory and legal obstacles that an entrepreneur must overcome in order to found a successful company.

1. Where to incorporate

“The decision about the legal location can strongly affect how the company will be taxed in the future and its ability to obtain support from government agencies, such as the Office of the Chief Scientist,” says Bar-On. “Just before you decide where to incorporate, whether in Israel or overseas, it is advisable to consult a tax expert and understand the financial and tax ramifications of each of your options.” She advises drawing up a table of pros and cons. “Only then, take the right decision for your company. Remember, changing the location of a company’s incorporation in the future is liable to create a tax event for the company and the entrepreneurs.”

2. How to incorporate

Ways of incorporation in Israel and other countries are varied, and include partnership, association, incorporation, and limited company. Each of these forms of incorporation is relevant for a different kind of business. In the case of a start-up, there seems to be only one right way. “Most start-ups incorporate as a limited company. This kind of incorporation limits the liability of the shareholders, protecting them from possible future personal liability for commitments taken by the company,” says Bar-On.

3. When to incorporate

The question of where and how to incorporate leads to the third question: when. It turns out that the timing of a company’s incorporation is important. “An entrepreneur should think about when to incorporate his company both in terms of tax aspects and liability aspects,” says Barak-Rozen. “On one hand, founding a company costs a lot of money, and there are related expenses, which create a focused mechanism that must be dealt with. For this reason, entrepreneurs are usually in no hurry to found a company.

On the other hand, the tax aspect usually results in a preference to found a company as soon as possible, so that intellectual property and all the developments belong to the company and there is no subsequent problem of transferring ownership of them to the company. If the developments are made before the company is founded, or if you later want to transfer intellectual property to the company, this is usually a tax event whose consequences should be examined.”

4. With whom to incorporate

One of the important obstacles that a new start-up must pass through is the question of the partners of its idea. In other words, who will be the founders. These relationships are not relations of friendship, the kind that were created and strengthened during meetings at the parents’ garage or in a rental apartment, but have legal importance for all intents and purposes. “First of all, the inventor should see if he has partners to the idea, and if he is not the sole inventor.

If he has partners, he should settle matters between them,” says Barak-Rozen. “The idea is to ensure that, down the road, a third party won’t turn up to claim that the idea is his. For example, a researcher who invents a product while working as a salaried employee, the university can claim that it owns the idea. The same is true for a researcher at a hospital, or an employee at a workplace, and so on.”

Barak-Rozen therefore warns that, even before starting to protect the idea, it is necessary to verify that there is no third party with rights to it. However, it is not always possible to sever existing rights, in which case the start-up’s system of agreements is completely different: the employer or university before your partners, and possibly even the owner of the idea or product.

Amir Sadeh is a partner in the international commercial department at Pearl Cohen Zedek Latzer Baratz, the legal adviser of 8200 EISP, which advises HopOn Ltd. He says that the question of with whom to incorporate has other aspects as well.

“On the commercial side, first of all, it is important to link up with other entrepreneurs or a group, which complements the entrepreneur’s skills. For example, if the entrepreneur is a technologist, he ought to team up with an operations oriented person, and vice versa. Entrepreneurs who go it alone, without being covered on the technology or operations side, are liable to quickly face problems and may link up with a technologist who will take a bigger stake in the company than their own.”

5. Allocating stakes in the company

Once you have settled on your partners, you must decide the company’s capital structure. “The company’s table of shareholders will reflect the allocation of shares between its entrepreneurs, effectively anchoring the percentage of holdings of each partner,” says Bar-On.

“It is necessary to take into account that an investor will want to see large stakes held by the company’s dominant entrepreneurs,” she adds. “After you have discussed each of the partner’s stakes, do not forget those people whom you earlier promised a share in the company, such relatives or friends who financed the venture in the beginning, and employees or consultants who helped you reach this stage. At this stage, you should think one step ahead to your first financing round and plan how much money the company ought to raise in the first stage and what percentage of the company you’re prepared to give for this investment.”

6. Drawing up a founders agreement

Drawing up a founders agreement is a dramatic legal step in the life of a start-up. Without one, it is impossible to move forward, as it sets the foundations on which the company is built. “This is basically an agreement between the company’s first shareholders, which will determine how the company will be run and how decisions will be taken,” says Bar-On. “On one hand, it is important to anchor the agreements between the entrepreneurs in an orderly founders’ agreement. On the other hand, if the company is already seeking an investment at this stage, it is necessary to take into account that when a new investor joins, the founders’ agreement may have to be amended and it is possible that the investment at this stage is unnecessary.”

She adds, “If you have decided to draw up a founders’ agreement, it is important to mention several important points, such as the company’s share capital structure, the structure of the board of directors, and precisely set out the function and contribution of each of the venture’s partners. It is also very desirable that the agreement mention a situation in which one of the entrepreneurs does not properly fulfill his job or decides to leave the company. Make sure that you have established a reverse vesting mechanism that will return the departing partner’s shares to you, or part of them.

“The agreement should also include a commitment by all the founders not to compete against the company so long as they serve in any capacity at the company and for a specified period afterwards. There should be agreements on financing the company until the first financing round: are the entrepreneurs bringing some money from home; at what point should you embark on a financing round, and so forth.”

Sadeh adds, “The founders’ agreement is one of the most important things that entrepreneurs embarking on a joint venture must do. It must set out the relations between them at both the legal level and as shareholders in the company, as well as their areas of responsibility and the level of involvement required by each entrepreneur. We’re talking about very important coordination of expectations between the entrepreneurs.

At the outset, the entrepreneurs should also agree on what will happen if one of them leaves the venture later on, and what happens in case of disputes between the parties. In other words, the agreement should establish mechanisms for settling disputes and mediation.”

7. Registering patents

Patenting an invention is an important milestone for the start-up’s technology. “This is the only way you can protect your product from competitors,” says Bar-On. “Who hasn’t heard about the huge fights between Apple and Samsung over patent infringement? To protect your product as best as possible, go as soon as possible to register patents.

The patent registration examination process is not cheap or short, but you should initiate it as soon as possible, because the determining legal date is the date the application was filed. If you cannot patent the idea, consider other ways to protect it.”
Adv. Yosi Barkai, a partner in Pearl Cohen Zedek Latzer Baratz’s patent department, adds,

“It is advisable for a new team to obtain preliminary advice on which intellectual property tool is suited to that product or service that it is about to develop. On one hand, most start-ups we meet are aware of the patent issue, but most of them do not know that patents are not adequate protection, and even impossible for certain products. For example, when the main, or even the sole, component is software, it is very hard to protect software products or software developments only with patents. A team developing software-based products should consider additional solutions, such as registering copyright on the software and so forth.”

8. Preparing the groundwork for securing investors

There are also legal obstacles that must be passed when seeking investors and their examination of the company. “Investors carry out thorough reviews of a company to check whether everything to date has been done properly, whether the company is legally protected, tax issues, and so on,” says Barak-Rozen. “Lawyers are involved at this stage, too, both on behalf of the potential investors and on behalf of the company.”

He adds that the terms of the investment require legal handling. “For example, in Israel, entrepreneurs take money from the state through the Chief Scientist. It is also possible to raise money on the private market and supplemental funding from the Chief Scientist, and each financing round has its own legal consequences.” He continues,

“In the beginning, entrepreneurs are pressed for money to pursue development. This financial pressure is liable to create a disproportionate holdings structure in the company and lower than desirable valuations. These circumstances are liable to result in a distorted holdings structure in the company that will make it more difficult to secure additional investors.”

9. Options plans and hiring

Even if you have successfully negotiated all the important steps so far, the course is not over. The time has now come to think, as employers, about your employees. “The moment you have raised money, the company already has employees and you have to give them options. At this point, it is necessary to create an options plan, submit it to Income Tax, hire a trustee and an accountant to oversee it, and so on,” says Barak-Rozen.

10. Check there are no regulatory restrictions

The final stage, which not every start-up must deal with, is to check whether there are special regulatory restrictions on the type of invention you are developing.

“An inventor must check whether the country he believes he will have a commercial interest in requires an additional regulatory process. For example, drug development requires the seal of the US Food and Drug Administration (FDA),” says Barkai. “It is therefore necessary to check in advance whether the product meets US regulations and passes the threshold.”

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