4 legal issues that early-stage entrepreneurs should consider

This article was first published by the Wade Institute of Entrepreneurship on 21 September 2017. 

You have an early-stage start-up.

You’re ready to start implementing your vision – building the initial prototype, pitching to angel investors, and spreading the word on social media.

But have you stopped to consider matters such as how you’re going to set up and fund your business, protect your intellectual property and manage your team?

Here are four key legal issues you need to be considering while your start-up is still in its early stages:

1. Protecting your intellectual property

It is vitally important that you think about how best to protect your IP early, particularly if it is a key asset for your business. And you should think about ‘IP’ in broad terms – it may not just be about traditional forms of intellectual property such as copyright, trademarks and patents; it could also be confidential information, ‘big data’, licensed-in rights, know-how, supply networks, customer lists and relationships.

Once you have identified the IP of relevance, the next step is to ensure that your business owns or controls (and will own or control) that IP. In some cases, such as copyright, this can arise by operation of the legislation. In other cases, such as patentable inventions, this is best addressed in express terms of a contract.

Employees and contractors should be dealt with separately as different rules apply. It is also important to consider various types of restraints, in particular when it comes to some of the non-traditional types of IP, although restraints have to be drafted carefully to remain enforceable. If the business is dealing with personal information, it is also advisable to understand the legal requirements regulating data protection and best practices accordingly.

While the term ‘intellectual property’ or IP is often used, in reality, the different forms of intangible property which make up this collection of rights are developed at different times and for different economic reasons. There are also different international conventions applicable to different types.

It is advisable to seek advice on:

• how and when the different rights come into existence;

• how best to conduct your business so as not to jeopardise the validity of such rights (particularly in the case of patentable inventions);

• how best to protect your rights, including by way of registration if available; and

• contractual means to commercialise the IP and endeavour to avoid infringement.

It is also worthwhile giving some thought as to which entity will hold the IP in the business. A common structure is where one entity actually holds the IP while another entity’s function is to act as the operating entity for the business. That first entity would then license it to the operating entity for nominal consideration. The effect of this arrangement is that, if in the unfortunate event the operating entity is wound up, the IP will be ‘quarantined’ in the first entity and hence be protected. It does however add complexity to your business structure.

2. Structuring your business

Another important thing to consider when starting out is your business structure. You are probably already aware of the common business structures – partnership, limited liability company, sole proprietorship and so on.

The choice of your business structure is one of the most important decisions you will make about your start-up. It will significantly affect your business’ legal liability, asset protection and operational risk (among other things). Careful consideration should also be given to the future funding of your business (discussed in more detail below) and the level of control you wish to retain over the business if new investors come on board.

The choice of business structures is generally a tax and accounting-driven exercise, but appropriate legal advice should be obtained for the drafting of your business’ constituent documents (such as constitutions and partnership and shareholders agreements). By having well drafted documents in place you can avoid some common pitfalls, such as one of the founders leaving the business after a few months without any right for the company to claw back part of their significant shareholding. These types of issues can be a major deterrent for later stage investors.

3. Contractors vs employees

How does your start-up want to build your team? Do you want to take on independent contractors (which may have more flexible arrangements) or employees?

Whether a person is an employee or independent contractor at law is significant. Among other things, it is relevant for tax, superannuation, employment entitlements and claims under the relevant employment legislation. It also affects certain duties persons have towards your start-up – for example, duties of fidelity and good faith depend upon an employment relationship. Employees may also have additional rights, such as notice requirements and redundancy entitlements.

In this context, the courts have colourfully observed that “parties cannot create something which has every feature of a rooster, but call it a duck and insist that everybody call it a duck.” With the shift away from traditional working arrangements, there will be ongoing contests about whether a given working arrangement is a ‘rooster’ or ‘duck’ – it will be increasingly important to ensure that the correct mechanisms are in place to support the distinction between whether an individual is in fact an independent contractor or an employee.

The penalties for getting it wrong are significant and include substantial underpayment claims (including minimum pay rates, penalty rates and allowances). If your business model is predicated on engaging independent contractors rather than employees, you need to get this right from the start. Simple mistakes early on can be costly down the track.

4. Funding your business

The fourth issue you need to consider carefully when starting out is how you are going to fund your business.

Generally speaking, there are two ways for companies to raise funds: equity or debt financing (or hybrids such as convertible notes). Equity financing involves the issue of new shares, while debt financing involves borrowing funds.

For most start-ups, particularly those which are not yet cash-flow positive, equity financing will usually be the more viable fundraising option. Existing investors are typically given the right to take up new shares in the company on a pro-rata basis proportional to their existing interest in the company, however companies will often raise money through a private placement where shares are issued to new investors (usually with existing shareholders also participating in the raising).

New investors are sometimes issued preferred shares or have certain rights embedded into the shareholders agreement or constitution of the company (for example, to give themselves the right to appoint directors). Accordingly, you need to be careful to ensure a situation doesn’t arise where you lose the ability to control the company you have worked so hard to create.

These four issues are all ones that our specialist online service for entrepreneurs, CorrsEdge, can assist with. For more information, visit www.corrsedge.com.au