One of the biggest concerns of entrepreneurs is to raise money, because building a business without capital can be very difficult. However, why do investors pass on some seemingly great businesses? Why do they offer great valuation to some and very low valuation to others?
This is a mystery for a lot of entrepreneurs.
A lot of times, this is a business decision, based on factors like your market size, growth rate, depth of your team, future outlook of a particular technology or market.
However, sometimes, the reason is hidden in legalities. These are points that lawyers as well as entrepreneurs need to understand. There are red flag legal issues that emerge during due diligence processes, that can lead to an otherwise viable deal getting canned or the valuation getting pummelled.
Clearly, these are things you need to learn about far earlier than when you want to raise funds, because these are not things you can fix in the last moment.
For law students and young lawyers this represents amazing opportunities because you can learn about these things and you can advise young startups to get these things right. They will immensely benefit from this knowledge and will be very impressed by your legal foresight and will also be very grateful for your timely intervention as they see the odds playing out later.
So what are these red flag legal issues that damage fundraising chances and decimate valuation of a startup?
We are giving you a list.
Co-founder conflicts over equity sharing and other issues
Being successful masks the problem of that is brewing underneath the covers of a successful startup. Co founder conflicts are very common. The conflict can be multi faceted or be due to various reasons. This can range from who owns what conflict as the founders lock horns regarding the compensation, leadership roles and responsibility, or equity distribution of the startup.
In many startups, after sometime it becomes apparent that equity sharing is unfair and unjustifiable. This makes some of the cofounders very unhappy. Cofounders may even quit in such circumstances which makes the startup unstable.
Here is an article by Harvard Business Review, where improper equity distribution is seen as one of the first few mistakes founders make when building a startup.
There can be a variety of ways that an equity distribution is done. There can be careful negotiations. Others have quick handshakes and get over it. It is generally good to analyse the input of every founder to the business. There is no normal or a formal way of splitting in equity. There are various examples of how splitting can go way wrong.
Equity distribution is how founders allocate the ownership within the founding team. The article argues the best way of equity distribution is when all co founders are equally unhappy.
It is imperative that the founders discuss their potential exit and agree on the terms ahead of time. This needs to be a part of the co-founder’s agreement. Having this in place go a long way in giving a potential investor some comfort.
However, note that even the slightest sign of cofounder conflict is enough to spook a lot of investors as this has always been the biggest cause of startup shut down.
Cofounder conflicts can often be easily resolved through negotiation, discussion and mediation. Most importantly, if there is a sturdy co-founders agreement in place, a whole host of issues and problems will not arise in the first place and disputes can be put to rest fairly quickly through a strong internal dispute resolution mechanism.
At other times, it is wisest to let go of cofounders who do not fit in with the rest of the team, due to their goals, aspirations, expectations, career growth, skill level, performance, personality etc.
It is better to lose a cofounder than get damaged by sustained conflict.
This is also a great area of work for lawyers. Here are the services lawyers provide around these issues:
- Drafting, advising on and negotiating cofounder agreements;
- Enforcing co-founder agreements at the time of cofounders leaving the company;
- Legal advice and paperwork for firing a cofounder;
- Mediation and conciliation involving cofounder conflicts;
- Litigation over rights of cofounders who are isolated or sidelined by others; and
- Drafting settlement agreements between cofounders to avoid future disputes.
Co-founders with reputation or integrity issues
The importance of honesty and integrity cannot be overstated in a business environment. More than anything else, it is important that in a startup employees, customers, vendors, investors, and other stakeholders can implicitly trust a cofounder because cofounders are almost always in leadership positions in a startup, at least in the early days.
However, what if there are serious allegations against a co-founder? Is it viable to retain him? How does the reputational issue impact his or her ability to navigate the ship and help attract the right kind of people to the organization?
These become huge factors for potential investors.
There can be disagreements in a team about whether to let go of a cofounder or not due to integrity or reputation issues.
However, investors will be very wary of cofounders in a team with prior track record of financial impropriety or other integrity issues.
Here are the services lawyers provide around these issues
- Drafting representations and warranties;
- Disciplinary proceedings;
- Internal enquiry;
- Litigation over firing an unwilling cofounder;
- Settlement agreements; and
- Advising a board regarding these issues.
Conflict of interest
Investors take conflict of interest very seriously. Imagine that your startup is into biotech and develops new therapeutic molecules. What if you also work with another company in the same business side by side? Or what if you are 15% stakeholder in a competitor?
These are conflict of interest situations where the cofounder’s personal interests are at odds with that of the startup. Cofounders should have their interests fully aligned with that of the company.
Sometimes related party transactions can come under the scanner as well. Is it ok if the CEO and promoter appoints his brother-in-law as a sole distributor or supplier of a certain product? It is a conflict of interest situation. The same is true when promoters give more importance to family members in hiring or promotions within the business.
This is again a major red flag issue.
Legal work around conflict of interest
- Every startup should have a clear conflict of interest policy that lawyers have to draft or vet; and
- Conflict of interest situations can be resolved before investments by divesting of stakes, putting in non-compete agreements etc. It is better to do these things before you talk to investors.
Can you really operate the business you are trying to run?
For example, Ola and Uber ran into huge license issues in India, as there were no rules and regulations under which such services were allowed.
One way to look at the license issue of a startup is that we are doing a new thing that is not legally prohibited so it is fine. As long as there is no legal restriction of carrying out a business, we should be free to do so. This is how many disruptive startups work.
However, the other way to look at it is that unless there is a specific permission or a license to carry out a business, it is always risky, especially in countries like India, as one would have seen in the case of Ola, Uber, Juul, Policybazaar etc.
Also, there is always a possibility that the government will make laws that will take away the freedom of a business to operate. This happened to Juul in India recently. There was a time when due to lack of clarity a whole lot of internet telephony startups in India were almost shut down!
Any kind of threat to license to operate will make investors very nervous. It is a huge red flag issue.
- Policy research and developing an understanding of the dynamics of government policy; and
- Conducting discussions and deliberations with the stakeholders involved, this would include legislators, regulators and people who have relevant experience in a specific domain;
- Proposing structures and legal turnaround to clientele to help them navigate through various policies of the government; and
- Campaigning and raising awareness by discussions through various mediums, this kind of an approach did work with Crypto and the events that followed.
Public policy issues
As the startup space grows, there will be laws and regulations that the founders will have to navigate through. One area could be license related, but there will be other issues like regulations, taxation, special facilities, protection from foreign competition, access to foreign capital and government subsidies.
Some startups need favourable government policies to survive, and tax breaks or access to capital can make a huge difference.
For instance, till some time back, in the space tech and exploration sector in India, foreign capital was allowed only recently by the government, and it would be a game changer.
Sometimes policy changes are negative and hurt startups as well. If there are policy overtures from the government that show the possibility of adverse impact, investors may hold back investments despite everything else.
A good example of this will be crypto startups in India. As there is chatter of the government discussing harsh regulations to ban crypto in India, investments have dried up and crypto startups have moved to other countries.
A lack of public policy expertise in a startup which works in highly regulated sectors can show a lack of vision on the side of the cofounders. Needless to say, the business can get in trouble if they are not efficient with their public policy concerns.
- Identifying policy threats and creating contingency plans;
- Promoting and pushing policies that are beneficial;
- Advisory and engagement with government, lobbyists and policy makers on policy issues; and
- Advisory for boards, key managerial personnel, investors regarding policy movements and risks.
Potential financial liability out of legal violations
There are a lot of risks that a startup takes on a day to day basis. When it comes to legal risks, the story is somewhat complicated. A legal risk in a country like ours may consume a massive amount of time and money and choke the growth of an organization. These risks can also be difficult to quantify or predict. This makes investors especially wary.
These are some common types of legal violations when it comes to startups:
Sometimes there are contractual violations that can create massive financial liabilities. Such liabilities can arise out of unlimited warranties, open ended indemnity clauses and such other contractual provisions. Startups sign the dotted line often without properly understanding the risks they are getting into, especially during early days. This can lead to very big liabilities that can wipe out an entire business. Investors need to be very careful about these.
Statutory violations and compliance defaults
India has hundreds of laws that can possibly apply to a business, and violations often have serious consequences ranging from heavy fines to cancellation of licenses, and sometimes even jail time for directors.
Sometimes, a statutory violation can have very serious implications that impact the value of an investable asset, especially when the consequence is a massive fine (for instance, under competition law, FEMA or GDPR) or possibility of one or more directors going to jail (failure to submit PF deductions of employees to the government).
Sometimes startups engage in shady practices to save on taxes. These can later create big problems. If there have been a lot of unjustifiable practices to avoid tax that exposes a company to risks of big penalties, investors may backtrack or may ask promoters to provide personal guarantees to cover such liabilities.
- Drafting and review of contracts;
- Compliance services, compliance audits, compliance softwares;
- Responding to notices, liaising with regulators and government authorities;
- Defending and prosecuting businesses and senior managerial personnel before tribunals for statutory violations;
- Tax strategy and planning, tax advisory, tax litigation; and
- Due diligence during investment and M&A deals.
Ownership of intellectual property
For most startups, IP is usually crucial. It could be patented technology, or even non-patented technology, apart from design and brand value that they need to protect.
However, from an investor point of view, two things matter the most. Are you infringing on someone else’s patent or copyright? And, is your trademark secure?
If you are a hardware startup, getting a patent is also crucial, because otherwise it is very hard to get into enterprise sales. If you are into software, then of course you need to ensure that your software is not based on violation of the IP of someone else. Further, if content in your business, then you need to ensure that your content is original and there are no large scale plagiarism or copyright violations of another content producer.
Also, not owning the brand name through a trademark can prove costly later as you may have to change your name, as Foodiebay had to change its name to Zomato. Being forced to change or drop a brand name can be very costly as all the money spent on promoting the brand and the time taken to gain prominence is now all lost!
Investors want to ensure that the IP profile of a company is solid before they invest. Red flag issues here can block investments and downgrade the valuation.
- Registration of patents, copyright, design and trademarks;
- IP licensing and assignment agreements;
- IP valuation and IP audits; and
- Copyright, trademark and patent enforcement.
False claims about finances or product
The best way to reduce the valuation or turn away investors is to make false claims about the product or financial numbers.
Lots of startups make claims that they cannot establish. This opens them up to product liability claims and investors also find such founders untrustworthy.
In recent times, many startups that claimed their product had AI capability were later exposed to not have any significant AI capability.
Another sureshot way to get turned down is to be caught while embellishing numbers. It creates a great trust deficit between investors and founders.
Also, if you get investments based on false numbers, please note that investors will take representations and warranties from you about the veracity of your claims. Later on, if those claims turn out to be false, there will be serious consequences including criminal liability for fraud, forgery or worse.
- White collar crime and corporate investigations;
- Due diligence and drafting detailed representation and warranties section in M&A and investment agreements;
- Product liability suits; and
- Shareholders’ dispute and class action suits.
Litigations with open ended and unlimited liability
What if the startup has been sued before or during the investment discussions? What if there are legacy issues and disputes from years before that can still be taken up in the court of law?
Investors know that very often the news of the investment itself triggers many people with valid cause of actions to approach the court, because now the startup has deeper pockets post investment.
It is therefore important for an investor to understand if there are pending or potential litigations ahead that can create big holes in the coffers of the startup.
Not all litigations are red flag issues, but some of them can be, especially if it looks like one may have to pay out big damages in case the case is lost, or that there may be a huge cost of litigation over many years that will drain resources of the business.
Often investors ask promoters to reach a settlement with such claimants or disputees before investment can be made.
- Settlement agreements;
- Advisory work on status and potential liability that may arise out of a litigation;
- Mediation, conciliation and arbitration.
How can LawSikho help startups?
Learn the practical skills that you need for doing meticulous legal work successfully through courses like these:
- Diploma in Companies Act, Corporate Governance and SEBI Regulations;
- Diploma in Business Laws for In-House Counsels;
- Diploma in Industrial and Labour Laws;
- Diploma in Intellectual Property, Media and Entertainment Laws;
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- Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution.
Check out our other executive courses which can be helpful:
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- Certificate course in Trademark, Licensing; Prosecution and Litigation;
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- Certificate course in Technology Contracts; and
- Certificate course Banking & Finance Practice: Contracts, Disputes & Recovery.
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Check out our new introductory courses
LawSikho can train you to draft contracts which are very essential to land a corporate job or be a better corporate lawyer dealing with startups. We have courses on legal writing, media law and practice, corporate law practice. We also have this course on decoding accounts and financial statements which can be very relevant for a startup lawyer.
A young law student can even earn a decent amount of money by drafting good contracts. This is a trend that our team noticed that startups do not have quality legal assistance when it comes to contracts and other basic compliance work. We have been regularly helping our students to find such paid internships and opportunities.
However, a lot of you regularly complain that you do not have the resources to take up a course that costs INR 30,000 and takes up a year of your time. Surely, it may not be possible for everyone to do this right off the bat.
Hence, we are now offering a course that is just a month long, with all the usual features but priced at just a miniscule INR 3000. It is an introductory practical contract drafting course that you can use to get your initial skills, using which you can solve some of your financial problems. However, this is for law students only. If you are not a law student, we will not accept you in the course.
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