Oversights which could destroy your startup or small business

This post is a part of a series based on my Law for Startups workshop at MaGIC in September 2015. It’s a basic introduction to legalities for startup founders. You can access the slides here.

Read the earlier posts for context:

  1. Law for startups in Malaysia — building on the best foundations.
  2. The legal landscape in Malaysia for startups — a hybrid of traditional corporate practices and Silicon Valley models.
  3. Choosing the right business vehicle for your startup or small business in Malaysia.
  4. When should a startup hire a lawyer?

The opening slide for this part of the workshop reads — “Don’t let your business end up like the Titanic”.

Not something your startup wants to see in its journey.
Not something your startup wants to see in its journey.

The story of the Titanic is well known. The biggest, most-expensive, most-advanced cruise ship at that point in time, with the best technology and crew on board, was sunk on its maiden voyage after colliding with an iceberg.

An iceberg of course is known to have the vast majority of its ice underwater; what you see on the surface is just a glimpse (usually 10%) of how big that iceberg is. Looking at an iceberg from the surface, it’s impossible to tell how big and what size it is.

What I mean by “don’t let your business end up like the Titanic” is this — sometimes business owners have the best idea/service/product, and happen to be some of the brightest minds in their market, but they only think through the obvious issues, or the ones which are usually thought of as the important issues.

In reality, the seemingly unimportant or non-essential issues may come back to haunt a business in years to come. It’s crucial when building the foundations of a business — especially if any contracts are being signed — that all the issues are brought to the surface, and addressed as comprehensively as possible.

As I’ve already mentioned, the best way to do this is to invest in a good lawyer. Advisors who are experienced in advising startups and businesses will know exactly where to look and what to ask in order to allow all possible issues to be ventilated as early as possible. However, even if you have engaged a lawyer or other advisor, you must always personally know and understand as much as possible about issues related to your business.

It may not be possible to bring all the issues to the surface, and naturally in commercial negotiations some concessions will have to be made, but you should always aim for as much as possible to be above the surface — don’t enter into contracts or business relationships where, like an iceberg, 90% of the issues are lurking in the dark, below the waterline.

The following are a few examples of instances where business owners leave too much unknown or unaddressed, creating an iceberg in the path of their journey.

Not doing due diligence on co-founders or investors

Many startups don’t do enough due diligence on their co-founders or investors.

They are sometimes blinded by the expertise which the co-founder brings, or the money and partnership-value which the investor brings to the table. Perhaps they feel that some issues are too sensitive to ask about, or that inquiring too vigorously will offend the other party — so the questions are left unasked, and the issues left beneath the surface.

Locking yourself into a partnership with the wrong co-founder or investor will destroy or severely handicap the growth of your business in the long-run.

Before entering into a partnership or signing a contract with another party, always do your due diligence on them. You not only have to ask them the questions, but you also should ask around.

Check the background of the company, and the individuals behind the company, and the other ventures which those individuals are involved in.

Connect with other startups they have worked with, and ask how the working relationship has been. Look for yourself whether the businesses they’ve previously partnered with have done well or not.

Investors should understand your business goals and preferred timeline for development and growth.

If they are going to be an active investor, you will need to get along with them.

Even if they are passive investors, relationship and reputation matters. By being associated with them, your reputation may be affected by other ventures they are involved in.

These parties will inevitably have a seat at the table when future investors or partners come in — you need to be able to work with them and ensure they don’t place roadblocks in your growth.

If you are giving equity to investors, if you get proper legal advice in the beginning, you may be able to push them out if there is a dispute — but an ugly shareholder fight will always result in a reputational loss, and may be a red flag for future funders.

Not putting everything in writing

It’s really important that any important terms are properly documented.

Unfortunately, it’s also common that things are left as verbal agreements (deceptively called a “gentleman’s agreement” — as if putting things down in writing is somehow impolite and unnecessary).

Many business owners are pressured into leaving things undocumented, sometimes even key terms. Some who push for terms to be in writing get brushed off by an experienced investor, and told to just leave it as a verbal agreement, because “that’s the way things are done”. Keen to lock in the partnership and not to offend the other party, business is done based on an unwritten understanding as opposed to a written agreement.

Of course when things are going well and everyone is happy, the lack of a comprehensive written contract isn’t an issue. But when a dispute arises, its absence becomes damaging.

Putting things down in writing ensures that disputes don’t end up being a “he said she said” — in those situations, everyone ends up a loser.

My
My “Law For Startups” workshop at MA2015.

Ignoring crucial contractual terms by treating them as “boilerplate” clauses

I mentioned above how business owners sometimes only focus on the “important” clauses in a contract and ignore those they deem as unessential.

For example, in a shareholders agreement as part of an equity investment arrangement, the focus would be on the percentage of shareholdings, board seats and voting rights, shareholders voting rights, and terms and conditions related to the day-to-day management of the company and the business.

Many of the other clauses (particularly the ones towards the end of the agreement) are deemed to be “boilerplate” clauses, and not much (if any) attention is given to them in the negotiation process. This is a flawed approach, and ends up leaving the contract which is signed as an iceberg, and your business as the Titanic — with a large portion of the contract being unknown and “underwater”.

This may seem like it’s stating the obvious, but experience has shown that too many startups and business owners don’t realise this — before signing an agreement, you should understand every clause.

If you don’t understand any part of the agreement, or if you feel that an issue which is important to you has not been sufficiently addressed in the agreement, mention this at the negotiation table. Bring the issue to the surface, above the waterline.

One of the common examples of clauses which are very important, but are often under-discussed due to their status as “boilerplate” clauses are the sections of the agreement which address termination and how to resolve disputes. Many businessmen and investors also sometimes avoid dwelling too much on these clauses because it’s traditionally seen as negative to be focusing on disputes or how to end the relationship at the beginning of a partnership or venture.

In reality, these clauses are some of the most crucial ones to discuss in depth and agree on right at the beginning. Once a dispute arises, it will be too late to have a clear and fruitful discussion.

The details are too complex to go into in this workshop/post, but here’s a quick run-through the key questions which you should be able to answer if the clauses are comprehensive enough:

  1. What are the parties’ obligations? — Contracts should clearly set out specific obligations, and avoid generic wording which can be disputed later on. Milestones and deliverables should be put in writing if possible.
  2. In what circumstances would a party be deemed to be in breach of its obligations? — Who gets to decide whether a party has lived up to its end of the deal? Objective and subjective criteria may be required.
  3. What can the other party do when a party is in breach? — There’s no point being able to say that the other party is in default if there are no repercussions.
  4. What happens if the parties cannot agree on something? — It’s important to address “deadlocks” where parties simply cannot agree on something, and a vote is locked 50-50. There are many different routes which can be taken when a deadlock arises — liquidation, buy-out (fixed price, fair value, or based on a formula), Russian roulette and sealed bids — whatever it is, the contract shouldn’t be silent on the outcome. A contract which doesn’t address deadlock results in parties being stuck — there’s no way out, but the parties cannot agree, so the business will suffer or stagnate. There must be an exit process.
  5. In what circumstances can a party terminate the agreement? — A party shouldn’t be able to walk out without a proper reason.
  6. Are there any alternatives to termination? — It shouldn’t be the case that all disputes and defaults should lead to termination. Alternative methods of resolving disputes should be considered and agreed on.
  7. How does a party terminate the agreement? — If a party has a right to terminate, what are the steps required to be taken?
  8. What happens after the agreement is terminated?— The effect of termination, and the parties obligations post-termination, should be clearly set out.
  9. When do disputes end up in court? — The last thing any party would want is to be caught up in a court battle. As above, alternative methods of resolving disputes should be considered and agreed on — a conciliation or mediation process could be made mandatory, or the parties could agree on arbitration (in which case the arbitration details should be set out in the agreement).

It’s possible for the conciliation process to be set out in great detail (how often to meet, where to meet, how long each meeting will be, etc) — and for it to be mandatory that parties go through this because commencing court proceedings or terminating the agreement. Here’s a sample:

Sample conciliation procedure clause

(1) The Shareholder who issues a Conciliation Notice must briefly describe in the Conciliation Notice the matter to be discussed, their position in respect of that matter, and their evidence and arguments in support of their position.

(2) Within 10 days of the service of a Conciliation Notice, the other Shareholder must give a written response to the Shareholder who issued the Conciliation Notice, briefly describing their position in respect of the matter to be discussed, and their evidence and arguments in support of their position.

(3) Within 10 days of receiving the response in paragraph (2) above, representatives of each of the Shareholders must meet with each other in person and discuss their respective positions in respect of the matter described in the Conciliation Notice for a period of at least 30 minutes.

(4) If the matter cannot be resolved to the mutual satisfaction of each of the Shareholders following the meeting in paragraph (3) above, within 7 days of the said meeting, representatives of each of the Shareholders must meet with each other again in person and discuss their respective positions in respect of the matter described in the Conciliation Notice for a period of at least 30 minutes.

(5) If, within 40 days of the service of a Conciliation Notice, the matter has not been resolved to the mutual satisfaction of each Shareholder, the deadlock provisions in clause [xx] will apply.

It may seem silly when the contract is being negotiated, but remember that these clauses come into play when the relationship has broken down, and the atmosphere is very different.

The next post deals with the dangers of using “standard” or template contracts.

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