Category Archive Startup Law Guide

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Common legal bloopers a start-up should avoid

In recent years, we have witnessed a tremendous upsurge in start-ups business.This resurgence in entrepreneurial spirit could be attributed  to various favourable latitudes and easy-business ecosystem, which many countries are vigorously accommodating in their economic and social spheres. India in particular has really become a magnet for start-up hubs, attracting massive investments, evolving technology and burgeoning market. However, in the  excitement of launching a business, the necessary evils of legal considerations and compliances are often kept at bay. This could add up to a huge mistake that any entrepreneur can make.

Therefore it is very crucial for any entrepreneur or a would-be entrepreneur to keep following legal considerations in mind to avoid any blunders:-
 

Error in choosing the right corporate entity for your start-up

Some of the most basic questions a start-up faces are “Should i be an entity?” and of what type? Perhaps a corporation, LLC or proprietorship etc. What is best suited for my business? These common questions have serious consequences and an error in deciding on your business entity can lead to disaster for your start-up. A corporate structure ensures your “separateness”, which protects you from unlimited personal liability. Different structures offer different opportunities and restrictions. For example if you do not want losses for your start-up, go for a limited company.

Therefore it is imperative to consult a good corporate lawyer early on to make things easier in long run, especially if you wish to attract investors since this will ensure your start-up has all correct legal paperwork in order.
 

Not having a corporation or LLC members agreement

How do you decide who should act as a CEO, what should be the contribution of each member or how to split equity? There are so many questions that founders do not think about. Your long term business plans would seldom be consistent, if there is no instrument to determine your organisation’s operating terms.
 

Jeopardizing your intellectual property rights

Intellectual property is a start-up’s most valuable asset. Whether it is a trademark, patent or copyright, they all require legal protection. In the midst of various things that go into building a business, intellectual properties are often not in priority or are considered as too expensive proposition for a start-up to act on. If you don’t protect your intellectual property, you are exposing your business to others. Therefore, it is essential to register your intellectual property as soon as possible.
 

Not having adequate employment agreement

It is important to have a contract with everyone who is working in your start-up and their classification. Whether they are an employee or independent contractors, it is common for employers to provide computers, email and interest access. There should be a well-drafted work-place policies that govern how these systems can be used or restrict employees from sharing confidential information.
 

Not adhering to securities law

Once a start-up is incorporated, they normally issue stocks or equity to investors, friends or families etc. These are governed by securities law. Which are very complicated. Issuing stocks which do not comply with specific disclosures or filing requirements lead to serious legal repercussions.
 

Mixing your personal expenses with business expenses

When setting-up a start-up, there are chances where your personal and business expenses become indistinguishable. This can lead to confusion when taxes are being filed or deductions being disallowed by revenue authorities. The company therefore, should ensure there is a financial account early on itself and there should be a separate record of expenses.
 

Lack of proper documentation

Every activity or transaction in your start-up must be properly recorded. Documentation of employees and interactions involving your company is very important. These considerations have serious influence on due diligence procedures which can make or break an investment deals.
 

Not insuring important tax considerations

Adhering to a sound tax-planning is very crucial for your business, as it can save lot of money and protect you from incurring liabilities. It is important to take stock of your profit and loss statement regularly and pay taxes on time and in prescribed instalments. Your start-up must have a tax consultant to insure all regulations are being followed. This would give you more time to focus on your company.

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All you need to know about your Investor Term Sheet

Investment plays a critical role in backing up as well as making a business stand firmly in the initial stage and pitching your new business or start-up is the most critical exercise you will ever perform, if you wish to secure funding for your business. Amidst the big hullabaloo of pitching your start-up or new business to investors for months, you will finally secure: A Term Sheet (hopefully more than one) from an investor interested in funding you. This guide will try to explain you what exactly is a Term sheet and its implications on your business.

What is a Term Sheet?

A Term Sheet is perhaps one of the most important documents a founder will ever encounter. It outlines the “Terms and conditions” for an investment. These terms will define things like the agreed upon valuation of the company, price per share for the investment, the economic rights of the new shares and so forth. In addition to these a term sheet may specify some of the options, rights and responsibilities of each party.
Generally, a term sheet itself is not binding. It acts as a blue print for the formal legal documents that will be drafted by a lawyer. However, you do agree to confidentiality to not to enter into negotiations with any other investors at the same time.

What are the important clauses in a Term Sheet?

A Term Sheet can take many forms, from a single page or up to 7 or 8. And if you are first time entrepreneur, you may come across very confusing terms and conditions. A typical Term Sheet contains following important clauses: –

Valuation – 

This is the single most important term in a Term Sheet. The company’s Valuation along with amount of money invested determines the percentage of the company the new investors will own. This has direct Impact on who owns what and how much cash each shareholder shall receive when the company sells.

The valuation of the company is based on pre-money and post-money valuation. A pre-money valuation stipulates the company’s valuation before the investment and post-money valuation is simply pre-money valuation plus new investment.

There is lot of ambiguity regarding valuation. Sometimes a poor valuation can ruin the deal even if other terms were in your favour. But this is not necessarily true, because a great valuation may not guarantee success, if there are unfavourable terms on the term sheet.

Option Pool – 

A Term sheet may stipulate the creation of reserve of stock for existing and future employees. Option pool is used as the way of compensating services to the company through stocks.

Many founders calculate the option pool stock after post-money and force the investors to share in the dilution. But the standard for most term sheet should be to calculate it pre-money.

Types of Stocks – 

There are usually two types of stocks that are negotiated in the term sheet. Common stock and preferred stock. Common stocks are held by founders and preferred stocks are given to the investors. Preferred stocks come with rights, preferences and privileges, owing to the financial interest that holder this stock has in company.

Liquidation Preference – 

Liquidation preference clause is added for the protection of the investors. Investor would want your business to succeed so that their stake in the company is worth more than they invested. But what if your company is not performing well? A liquidation preference gives them some security of not losing all money. It determines the amount of money returned to investors against the original purchase price at the time of the liquidation of the company.

The Term Sheet defines what exactly constitutes a liquidation event. Perhaps it is mergers or acquisition or selling off your company’s assets. It does not mean winding-up or closing down of the company.

Participation Rights – 

Participation stipulates who gets a share of the remaining proceeds in liquidation event. The participating right offers following benefits to the preferred stock holders:

Full Participation – This means that a preferred stock holder gets not only their share of preference but also on the left over proceeds alongside the common stockholders.

Capped Participation – The preferred stock holders gets share of the leftovers up to a certain limit.
Non Participation – The preferred stock holders get no shares further share in the leftover proceeds, after the preference is paid.

Dividends – 

Dividends, expressed as percentage provide monetary amount to the shareholders by the company. All term sheet includes a dividend clause which lays down the dividends to be paid by the company.

Anti-Dilution – 

Anti-dilution is one of the most important clause of a term sheet. It protects investors from getting totally diluted in the event of a ‘down round’ i.e. when numbers of shares alter or lowers the price of the share.  

Pre-emptive rights – 

Pre-emptive rights are given to existing investors to give them preference to participate in the future round of the funding. This ensures that investors maintain the right to maintain their ownership by buying the proportionate numbers of shares of any future issue of the shares.

Board of control – 

This clause stipulates that a good mix of investors and promoters will form the part of the Board team. A third party may also be included to give an unbiased and fair decision. A Board observer may also be included at the insistence of the investors.

Vesting period of founders – 

Vesting means an ownership on the shares of the company. This clause is generally included to protect the investors in the event where founders exit. This ensures that founders do not invest too much, too soon. The average vesting period is of four years with one-year cliff period.

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What are the eligibility Criteria for Start-up India Initiative

The Indian Start-up ecosystem has clearly taken the nation by storm. Backed by factors like massive funding, consolidation activities, driven workforce and a massive domestic market, the fever of entrepreneurial spirit has mushroomed across various cities with such ferocious speed that the country is now being recognized as the biggest start-up hub in the world.

Recognizing the potential and talent of this young entrepreneurial rage, Government has also launched various schemes and plans to promote it. One such move is the Start-up India initiative. Launched on 16th January 2016, the scheme aims to promote Start-ups in India. The government has also published a notification on the eligibility of a Start-up for this scheme. The following eligibility criteria are –
 

Private company, Partnership or LLP

It must be an entity registered or incorporated as Private Limited Company under Indian Companies Act, 2013 or a Limited Liability Partnership under Indian Limited Liability Partnership Act, 2008 or a Partnership firm, registered under the Indian Partnership Act, 1932.
 

5 years must not have elapsed since creation

All Start-ups which have been incorporated or registered within past five years from the effective date of this are eligible to participate in this scheme.
 

Not formed by splitting or restructuring

If a Start-up was formed by splitting an organization into two or more organizations, it would not be eligible under this scheme. Similarly, an organization formed by reconstructing an organization shall also be ineligible.
 

Annual Turnover not over 25 crores

Annual Turnover of a start-up must not have exceeded rupees twenty-five crores in any of the past years since its incorporation or registration. Turnover means the aggregate value of the amount realized from the supply of goods or provision of services during a particular financial year.
 

Approval from DIPP that your business is innovative

Every Start-up has to obtain approval from the Inter-Ministerial Board set up by the Department of Industrial Policy and Promotion (DIPP). To obtain approval, you will have to submit an application to corroborate the innovative nature of your business along with supporting documents. Such as:

  • Recommendation from an incubator established in Post-Graduate College in India
  • Recommendation from an incubator funded by the Government of India in relation to a scheme to promote innovation
  • Recommendation from an incubator recognized by Government of India
  • Letter of at least 20% Equity Funding from an Incubation Fund or Angel Fund or Private Equity Fund or Accelerator or Angel Network, registered with Securities Exchange Board of India (SEBI). Such fund must not be listed in the negative list of funds as may be issued by DIPP in future.
  • Letter of funding from Central Government or State Government as a part of any scheme to promote innovation

The patent, filed and published in the Journal of Indian Patent Office, in areas affiliated with the nature of the business being promoted.

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Decoding a co-founder agreement

A Co-founder Agreement is an agreement between Co-Founders laying down the ownership, initial investments and responsibilities of each Co-Founder. This agreement acts as a safeguard in the event of any dispute, as it can provide protection to show what the co-founder agreed too.

Equity and salaries of each founder

Under this clause, equity ownership, profit or loss sharing and the salary of each founder is to be clearly stipulated. It is advised to include how change in salaries will be addressed as well.

IPR 

When you are working on building a product/company, business plan, you are  creating intellectual property (IP) for the company. This clause states that every IP developed belongs to the company and not the individuals creating it.

The direction of the company

This clause contains information about how the firm is going to run, how are the operations set to happen and in what direction,how things will proceed when you decide to expand the firm and hire new people under you, what happens in case of  an acquisition or closure.


Roles and responsibilities

Each founder is in the business for a specific set of roles and responsibilities. Those have to be stated under this section. Ensure that you clearly define the duties of each founder so that there is not duplication of work or any confusion of “who is to handle what” at a later stage. This clause should be so clear that, each founder knows exactly what he has to handle and what jobs do not fall under his umbrella of work.

Co-Founder details

This section talks about the founders, their family background, education details and work experience. It is mainly used for evaluation purpose by outsiders to check if the founders are actually capable enough of handling the business.

Equity breakdown and initial capital contributions

This section talks about the breakdown of assets – who owns what. It also talks about how much capital has each founder invested in the business. This section is and will always remain as proofs of investment by each founder. It should also cover important aspects like what percent of the equity is vested etc.

Management and approval rights

Under this section, the founders negotiate and agree upon decision making rights and approval rights. Who is going to approve budgets? Who is going to sign the cheques? Who is going to take decisions on everyday decisions? All these questions are answered in this section. Usually it is always better to have all the founders approvals and signs on all big decisions and the active partner can be responsible for all the day to day petty decisions.

Non-compete and confidentiality clauses

This clause includes all the confidentiality statements, which are private only between the founders and need not be disclosed to anyone except them.


Resignation, dissolution and removal of directors

This is the final requirement which talks about how everything is going to be distributed amongst the founders, in case of liquidation or closure of the company. It also talks about on what terms will one founder have the right to terminate another founder. Questions like what happens when one founder leaves need to be addressed.  Does the company or the existing founders have the right to buy back that founder’s shares and at what price?

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Guidelines on naming your company

The most basic and an important step in setting up your company is choosing an appropriate name for it. The naming should be in accordance with the Companies Act, 2013 or Limited Liability Partnership Act, 2008. There are three elements to the name of your company.

Name

The Companies Act or the LLP Act suggests that a unique and acceptable name be given to the set up. The name should not resemble any existing entity or LLP or trademark in the same industry. However, the same name for a company in a different industry may be allowed. Hence, the founders must ensure the sanctity of the names.

Object

The object part of the name is that which tells what is your company about and its business. It defines the company’s activity. Although two companies may share the same name, if their objects are different, the name will be allowed to be registered. However, it is important for the object part to be absolutely clear.

Constitution

This part of the company name defines the type of entity it is. Private Limited Companies are represented by Private Limited Company or Pvt. Ltd Company; One Person Companies are represented by OPC or One Person Company; Limited Companies are represented by LTD Company or Limited Company; and Limited Liability Partnerships are represented by LLP or Limited Liability Partnership.

Naming Guidelines

The Companies Act has laid down certain guidelines when it comes to naming a company.

  • Don’t use the Plural Version of any of the words in an already existing company name.
  • Do not try joining words or separating words.
  • Changing the tense or number of a word from the name is also not acceptable if the company works in the same industry
  • The use of different phonetic spellings or spelling variations does not make a name unique.
  • Do not add internet-related designations such as .com, .net, .edu, .gov, .org, .in to make the name unique.
  • Addition of common names or titles or the name of a place cannot be added to make the name sound unique. However, names with places may also be allowed if no objection from the existing company by way of Board resolution is submitted.
  • Different combination of the same words is not allowed. Example, Contractors and Dealers cannot be made Dealers and Contractors.
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Labour law compliances for startups in India

With Start-up storm gripping the nation and the tremendous potential that it promises for country’s growth, the Ministry of Labour & Employment has issued an advisory to the States/UTs/Central Labour Enforcement Agencies for a compliance regime based on self-certification and regulating the inspections under various Labour Laws. The move is to promote the Start-Up ecosystem in the country and incentivizing the entrepreneurs in setting up new start-up ventures.

It has been suggested that if such start-ups furnish self-declaration for compliance of nine labour laws for the first year from the date of starting the start-up, no inspection under these labour laws, wherever applicable, will take place.

Exemptions granted –

Start-ups have been exempted from inspection by labour inspectors for up to 3 years if they give a self-declaration for compliance to the nine labour laws. It has also been recommended that if such startups furnish self-declaration for compliance of the required nine labour laws for the first year from the date of starting the business, no inspection under these labour laws, wherever applicable, will take place for such start-ups.

Labour Law relaxations provided to startups –

Startups shall be allowed to self-certify their compliance (through Mobile App) with 9 Labour Laws and Environmental Laws. However, startups may be inspected on the basis of a written complaint filed for violation subject to approval of at least 1 level senior to the Inspecting officer.

 In case of environmental laws, startups which fall under the “white category” would be entitled to certify and only random checks would be conducted once in a while.

 
This significant exemption shall be available with respect to the following labour laws –

  • Building and Other Constructive Workers (Regulation of Employment & Conditions of Service) Act, 1996
  • Inter-State Migrant Workmen (Regulation of Employment & Conditions of Service) Act, 1979
  • Payment of Gratuity Act, 1972
  • Contract Labour (Regulation and Abolition Act), 1970
  • Employee’s Provident Funds and Miscellaneous Provisions Act, 1952
  • Employees’ State Insurance Act, 1948

From the second year onwards, up to 3 years from the setting up of the units, such startups are required to furnish self-certified returns and would be inspected only when credible and verifiable complaint of violation is filed in writing and approval has been obtained from the higher authorities.

The labour minister further stated that the advisory to state governments is not to excuse the startups from the ambit of compliance of these labour laws but it is to provide an administrative mechanism to regulate inspection of the startups under these labour laws, so that startups are encouraged to be self-disciplined and adhere to the rule of law. 

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Legal considerations for every startup business

According to Merriam-Webster Dictionary, Start-up means “the act or an instance of setting in operation or motion”.

Here’s a quick guide for startups to know the basic incorporation and other legalities involved.
 

Registration of a start-up:

It is very important for a start-up to be in a legal form of business. It can be a one-person company, private limited company, partnership firm, limited liability partnership or sole proprietorship.

The whole point here is to analyze what can be the best option for your start-up considering the budget of the organization:

  1. A single founder looking to start a Private Limited Company can choose One Person Company initially which mandatorily gets converted into private limited company subject to fulfillment of certain conditions as laid down in Companies Act, 2013.
  2. Single founder or multiple founders having individuals or businesses as customers and amount involved in a transaction is high, should choose between private limited company, LLP or one person company.
  3. Single founder or multiple founders who are not confident enough about their start-up should stick to Sole proprietorship or Partnership respectively.

Labour Laws:

Human resources related laws or employment laws in India do not stem from any single legislation and there are over 200 laws at the federal level and the state level. Essentials one include:

  1. Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013
  2. Maternity Benefit Act, 1961
  3. Equal Remuneration Act, 1976
  4. Payment of Bonus Act, 1965
  5. The Payment of Gratuity Act, 1972
  6. Employees’ Provident Funds and Miscellaneous Provisions Act, 1952
  7. Employees’ State Insurance Act, 1948
  8. Employment Exchanges (Compulsory Notification of Vacancies) Act, 1959

Financing:

Venture Capital investment is the most formal way. Despite the young age of the start-up, the investor will usually conduct a due diligence on the Company.
 

Obtaining a License:

Licensing depends on the nature of business. One should contact their counsel for details regarding the same as ignorance of law is not an excuse in legal matters.
 

Contract Law: 

Contracts are indispensable tools of entrepreneurs. Hence, basic knowledge of certain fundamental principles of contracts certainly helps. Contract Law in India is governed under the Indian Contracts Act, 1872.
 

Ways of Dispute Resolution: 

Disputes are inevitable in today’s business world. Knowledge always helps whether it is about the formal (how court cases work) and informal (arbitration, mediation, conciliation, etc.) ways of dispute resolution.
 

Accounts and Taxation:

Indian Tax laws are divided into two types: Direct Taxes, as the name suggests, are taxes that are directly paid to the government by the taxpayer. It is a tax applied on individuals and organizations directly by the government e.g. income tax, corporation tax, wealth tax etc. Indirect Taxes are applied on the manufacture or sale of goods and services.
 

Risk Management:

A start-up should keep in mind, the risk involved in the day to day regime of their work:

  1. For an e-commerce/internet based company:

The minimization of the liability of the start-up on the internet largely depends on the nature of representations made by the start-up on its website, like Terms of Use, privacy policies, and the usage agreements.

  1. The IT Act, 2000:

With the computerization of the Ministry of Company Affairs, digital signatures have gained significance as a convenient way for foreign companies to conduct their Indian operations. This act recognizes such transactions.

  1. Content Regulation:

Laws primarily applicable include the Indian Penal Code, 1860, the Indecent Representation of Women (Prohibition) Act, 1986 and the IT Act itself, amongst others.
 

Intellectual Property Laws:
 

There are broadly five types of Intellectual Property Rights (IPR’s) that a startup needs to protect to leverage its intellectual property, which are: (a) Patents, (b) Copyrights, (c) Trademarks, (d) Designs, and (e) Trade Secrets.

The information provided in the article is a general overview on how a Start-up should be legally ready. One should always consult a Lawyer and other professionals for customized service according to the Start-up’s requirement.