privity of contract

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You have a great business idea, you got it validated from friends, family, advisors and now you are going to take the plunge of starting up. Maybe you have already started the journey and battling market forces on multiple fronts, pushing your products or services. If you are looking at high growth, there are a few typical phases in which you will have to interact with the legal system in India.

Yes, you have to build a great team, create a kickass product, forge a service delivery system, do awesome marketing, conquer social media, raise investment, become a sales superhero – and then your company will become hot property in the market. And then, bam, you will deal with a host of uncool things, this being India. Some of them will make or break your business.

India is a very difficult country do business in, and the number one reason for that is India’s complex, slow, inefficient legal system. Out of 191 economies in the world, India comes in rank 134. It is easier to business in countries like Pakistan, Nepal and Bangladesh! Why is it so difficult do business in India?

There are a lot of things to blame – but most of it comes down to this: regulatory and legal system. Who enforces your contracts if the counter-party refuses to honour it and perform its duties despite agreeing in writing? What do you do when people ask you for bribe to issue you a simple license? How do you even know what all licenses you need to obtain before starting a business and what all registers you are supposed to maintain? What can you do to reduce your massive tax bill? What to do when getting money from willing investors abroad is so difficult?

While Mr. Modi is promising to change all these and make India a great place to do business soon, we know that us entrepreneurs cannot afford to wait for that to happen. After all, every government promises the same thing, and we are still where we were 15 years ago. Actually, we have slipped on that index a bit.

Before you get into trouble, however, let me share with you the condensed wisdom of many corporate lawyers, entrepreneurs and even big businessmen that I became privy to while working as a lawyer for many startups, through investment rounds and tortuous journey of building a business. I also worked as an M&A lawyer at one of India’s top law firms. What I am going to tell you will prepare you for things that otherwise will come as bad surprises. You can ask experienced entrepreneurs, and they will confirm each of these points as well.

Remember, these work as barriers to entry to many people, and kills unsuspecting entrepreneurs. But if you are on the right side of the game, you benefit from the same entry barrier, as it kills your competition for you. See, silver lining. Why do you think Reliance is spending close to 1200 crores on legal expenses in one financial year? This gives them a huge strategic advantage over competitors. It’s not only Ambanis, here is what other top Indian companies are spending on legal and regulatory expenses: Tata Consultancy Services: Rs 613 crore, Larsen & Turbo: Rs 526 crore and Infosys: Rs 504 crore.

Well, as a startup, you are not going to compete with these budgets, but your main focus will be on avoiding spending on legal bills at all. How are you going to do that? Let’s get started.

Pre-investment and early stage startups

Incorporation and Founders’ Agreement

This is the fun part, the honeymoon period of entrepreneurs. Many entrepreneurs get a private limited company registered without a second thought. A few things you need to watch out for at this stage:

It is more important to have a written agreement amongst founders than incorporation right at the beginning. My thumb rule is that don’t incorporate till you start getting real revenue, but have a detailed co-founders agreement in place. This will save you money, time and much hair-pulling later on.

If you do incorporate, go for a simple no frills service like Vakilsearch who are also startup friendly rather than some random lawyer or CA. Startups are different breeds of business, and their documentation should be different. Lawyers or CAs who don’t work with startups often don’t get that – and if you don’t pay attention to this aspect, you are sowing a poisonous seed of many problems for the future. Also, lawyers and CAs will often charge you a lot more for routine work than what you need to pay.

What is even more important though, is to take into consideration the following:

Tax liability of the business: LLP can be much cheaper in terms of tax bills, and good for service businesses, family businesses, lifestyle businesses etc. especially when you don’t plan on raising any investment in near future. If you are going to raise money anytime soon and give ESOPS to hire high quality talent for cheap, you can still incorporate an LLP. You can always convert an LLP into a private limited and vice versa. However, to know what to do when is crucial, and you will see the veterans in the industry gets these things very well. You can look for guidance to angel investors, mentors who have been in business and other entrepreneurs. Depending on lawyers to handhold you for everything may not be such a good idea.

When you take foreign money, business structuring goes to another level of complexity. Many Indian startups, quite big ones, take investment through offshore parent companies. This can be a very smart move in terms of saving income tax. It is great if at least one of your co-founders or CFO gets these things, and this is one reason why investment bankers and management consultants who bring in such strategic skillsets are in high demand as co-founders.

Business Licenses

It may surprise you, but doing almost any business in India, or even running any kind of office or establishment requires several licenses. Some licenses are simple tax registrations. Some businesses just need a trade license or Shops and Establishment Registration. For some specific activities like manufacturing and export-import you may need a bunch of licenses. For employing more than 10 employees you may need various labour and employment related registrations. Not having these things in order when you are growing fast can be fatal and slow down investments as investors will ask you to first sort of license issues before they put in money. These things are seriously looked into during any legal due diligence before investments are made.

Also, not following licensing norms lead to fines, costly legal suits and even business shutdown. If you are a business owner in any sector, you better have a sense of what licenses are essential. You should also know what are the important license conditions and ensure that these conditions are not being violated in course of your business.

I have played a key role in conceptualizing an online course offered by National University of Juridical Sciences, Kolkata called “Diploma in Entrepreneurship Administration and Business Laws” to entrepreneurs. Recently, after taking the business license module of our course, a student wrote an email to me. She learned how to get licenses to export and import, and got the necessary registrations done for her family business. Her family has been supplying leather goods from UP over decades, but through an export house. Now that she learnt how to get the paperwork done, she spoke to the elders in her family and got their own export license! I was immensely proud.

Accounts and taxation

A lot of businesses completely fail on this point and many founders face massive fines, possibility of imprisonment and highly unproductive lawsuits and criminal cases with respect to tax bills, simply due to negligence and ignorance, usually both combined. Take the famous example of Su-Kam, the founder of which almost went to jail due to non-payment of excise duty over years. He was simply not aware that he needs to pay excise duty. However, ignorance of law is no excuse in our country.

As the founder, the buck stops with you. So you better have some understanding of the accounting procedure and taxation aspects of your business. If you ignore it because it seems boring and highly technical, it will almost definitely come back later to bite you hard. Outsourcing it blindly to a CA you know is also not advisable, because stakes are sky high here.

When the business is too small for the tax authorities to bother, you are safe. However, as soon as the business starts growing, you will come under the radar of tax officers, who will go over your accounts with magnifying glasses to find something wrong (even in transactions that occurred years earlier, when you were not really a ‘big company’ owner). If they find something, you will have to either make a costly settlement or face a long legal war where you would end up paying a lot to tax lawyers.

Vendor contracts

The vendor contracts one enters into at the early stage of the business can be very important. For example, if you have outside assistance on design or development of the product, manufacturing contracts, EPC contracts (relevant when one sets up a factory or plant), platform contracts (for instance, at iPleaders we offer online courses and use outsourced technology from WizIQ, GradeStack and Trutech for our online courses and these contracts are very important to our business), marketing contracts, content supply agreement, distributorship agreements, advertisement agreements (for instance, we have several long term contracts for advertising with many websites like lawctopus.com or livelaw.in), franchisee agreements and so on – depending on what business you are in.

Now imagine if some of these contracts you enter into contain some hidden clauses that could trigger unforeseen price escalation, or gave away the power to the other party to terminate without notice – your business could be in chaos. Sometimes, people enter into unenforceable contracts. More frequently they forget to include important clauses in the contract that leaves them very vulnerable.

For example, the company of an entrepreneur friend, whose name I cannot take, engaged a PR agency and signed a minimalistic contract without thinking about it twice. As it is the nature of having a PR agent, you need to share many advance plans with them so that the media coverage strategy goes hand in hand with developments in the company. Well, my friend soon figured out that the PR Agency has since taken up a new client: his biggest competitor, providing the same product to the same industry. My friend was so paranoid that sensitive insider information will be leaked to the competitor ahead of time, he did not fire the PR agency, but neither did he use them much. What do you think he could have done to avoid such a situation? Money spent on that contract was pretty much wasted.

Ensuring that the contract he signed had a suitable non-compete and confidentiality clause, of course!

Several years earlier I was conducting a due diligence on a company, the Indian arm of which was getting acquired by Morgan Stanley (as a PE investment). As we were looking through documentation and checklists, we realised that the contract authorising the Indian arm to use the trademark of the parent company in India was not enforceable in India at all for some technical reasons. If the parent company refused to honour this contract at any point, or demanded a huge premium later, the buyers of the Indian arm would have lost a lot of money!

Make sure that your important contracts are not like that! Learn some contract law, because as a businessman you are going to enter into probably thousands of them.

Even Steve Jobs was of the opinion that every intelligent person should know how to read and negotiate a contract, just like everyone should start learning how to code!

Enforcing a contract

World bank says that India ranks 184th in the world in terms of easiness of enforcing a contract. This means India is one of the 5 worst countries in the world when it comes to enforcing contracts. If you can’t enforce contracts why should someone bother to uphold the side of their obligations in an agreement?

This is why almost every businessman in India needs to be either a muscleman or an expert at enforcing contracts if they want to survive in the marketplace. Do not just enter into a contract and expect everything will now go as clockwork. Big companies in India hire contract managers and a battery of lawyers to ensure contract performance! If you are a startup founder or SME owner, you can probably afford neither, so if you don’t plan ahead and build in certain practices into your business, you are in grave danger. You can learn about systems like arbitration (this can help you to bypass lengthy court battles), advanced money recovery strategies deployed through contracts, registration as MSME which gives certain privileges which will add great advantages to your business.

If you are significantly better than your competitor at negotiating and enforcing contracts, these skills will add immense value to your business over the years and you are much more likely to triumph eventually!

Want resources to learn about these skills in detail? Check out http://startup.nujs.edu

In the next part of this article I will cover the legal challenges faced by growth stage startups during and after investment rounds.

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1 COMMENT

  1. What are the legal stuffs to take care before starting a company in India?

    1. Incorporation (structure your business – is it going to be an LLP, partnership or a pvt ltd? get the agreements between shareholders/ partners made, incorporation/ registration done) 2. Business licenses – in every sector there are different licensi…

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