Key Considerations when Starting Your Startup
By Martin Asingwire,
Partner LLB (Hons) Dip Lp (LDC)
Choice of Entity. i) By carefully deciding on the entity under which one’s business will operate one can reduce exposure to liabilities, save taxes and start the business in a form capable of being financed and conducted efficiently. In addition, formalizing the business enables founders and members of the business prevent misunderstandings among the participants by defining their ownership, roles and duties in the business
ii) There are generally 3 entities under which a business will be run. These are; a. A Limited Liability Company; this is a distinct legal entity owned by its shareholders and managed by a board of directors.
b. A partnership; this is a separate entity for some purposes but for other purposes is treated as a group of individual partners; it does not pay taxes upon its activities; instead, taxes upon its activities are paid by its partners based upon their respective interests in its profits. A limited liability partnership LLP attempts to combine the best attributes of the Limited Liability Company and the Partnership. Under an LLP, some members are only liable to any losses or liabilities of the partnership to the extent of their capital contributions or a defined amount whereas other members (general members) are liable individually to the full extent of liabilities or losses of the partnership.
c. A sole proprietorship; this is a business owned by one person and has little legal significance separate from its owner. Nevertheless, the sole proprietorship is probably the most prevalent form of business because of the large number of family businesses in the Country.
ii) Essentially the founders of the business will have the ultimate decision on which choice of entity is best for the business, however before making such a decision, it is prudent that the founders take into account the following considerations; a. Protection of personal assets from liabilities of the business
b. Compliance and Regulatory requirements that accrue to each entity.
c. Costs of setting up and maintaining the chosen entity.
d. Whether the entity will be attractive to potential investors and lenders.
e. Availability of attractive equity incentives for employees and other service providers.
f. Tax consequence that accrues with the chosen entity.
2. Vesting of Equity. Founders should consider whether their equity or that of any joining shareholders should be subject to forfeiture over time. For instance, if one founder leaves the business, the other founders may not want that founder to keep his or her full equity. This can all be streamlined in the Company’s articles or in a separate agreement by the founders or shareholders.
3. Shareholders’ Agreement. With multiple founders, a vital document to put in place in connection with the formation of the entity is a shareholders’ agreement (for a limited liability company) Such agreement will typically address the specific rights and obligations of the founders that may not have been covered in the company’s articles. These can include; the management of the entity, the right of founders to participate in future equity issuances, and the rights and obligations of founders with respect to equity transfers etc. In the case of the partnership, such rights and obligations must be specifically stated in the Partnership Agreement
4. Restrictive Covenants. Founders and investors in a start-up certainly do not want to see a founder leave and form a competitor or solicit partners, clients or employees away from the start-up. Therefore, whether it's in the shareholders’/partnership Agreement described above or in a separate agreement, or in the case of the company, within the company’s articles, each founder should be bound by reasonable restrictive covenants. The covenants should be carefully crafted so as not to be interpreted as unreasonable whereby they would run the risk of being invalid and unenforceable.
5. Assignment of Inventions. Founders, employees, developers, suppliers, and other contractors should all be bound by a written agreement stating that all intellectual property created in connection with the services performed for the start-up is assigned to the start-up. Absence of such a written agreement, may pose the risk of the individual or entity providing the services having ownership rights in such intellectual property, which will cause contentions for the start-up when it is looking to raise capital or be acquired.
6. Equity Incentive Plan. In order to incentivize key employees and consultants to help grow a start-up, the start-up may grant such individuals stock options (in a limited liability company) or profits interest (in a partnership). Such plans can be a very effective way for the start-up to incentivize employees without having to expend cash
7. Debt or Equity Financing. Founders often consider whether to raise funds through a debt or equity financing. Many factors go into determining what type of financing is most appropriate and likely to succeed. However, if founders would like to raise seed capital without having to value the start-up, the founders may utilise unique ways of raising capital for instance through a debt financing (convertible notes) which provides that the debt will convert to equity at a discount to the price offered in the next equity raise.
8. Recordkeeping. Founders should stay well organized from the start, and keep all important or executed documents of the start-up including books of account in one place. Investors and acquirers will need to review all such documents in connection with a transaction, and therefore the start-up will save time and money if such documents are organized. In addition having proper record of the books of the start-up helps the start-up manage its tax bill and ascertain how much tax is due and the deductions that the start-up may benefit from.
9. Choice of partners Arguably this is the most important decision when starting anew business. It is imperative from the start to have partners who not only share the same vision but are also capable of implementing the vision of the company. Obviously not all the founders in the business may possess the same or equal measure of skills to enable the start-up to grow, but it is important that all partners are able to bring something to the table that can propel the business’ growth.
This document is not intended to create an advocate-client relationship. It is prudent that you do not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult the author or any other professional legal services provider.