A great idea, sharp entrepreneurs, innovative technology, talented developers, and sound financial backing are critical for establishing a successful start-up. But there is another necessary condition for its success - suitable legal advice to protect itself from competitors.
Three start-ups won the “Globes” and Hapoalim Smartup2 competition: Green IQ Ltd., HopOn Ltd., and Zeekit Ltd. We asked the legal advisers of the incubators where the companies operate about the legal aspects of founding a start-up.
Naschitz Brandes Amir partners Gil Brandes and Noga Devecseri Spira, who advise 8200 EISP, say that the first important step that a start-up must take is to create intellectual property rights free from the rights of third parties. “If an entrepreneur with an idea begins to develop it while he is still an employee of someone else, he should pay attention to the wording of his employment contract on this matter. Investing time and resources in an idea that someone will later claim belongs to a person who is not smart," says Brandes.
Brandes and Spira say that this matter gains in importance when the idea for the start-up is in the employer’s area of business, and is also expressed in the contracts with the people who first help the entrepreneur. “You must write a document that emphasizes that all the fruits of assistance belong to the company that will be established, because not everyone who helps you as an entrepreneur will stay with you when the company is founded to promote the idea. It is also important that the assisting parties, who are sometimes colleagues, will not claim that they are parties to the intellectual property rights," says Brandes.
Maya Bar-On, the legal adviser of Explore.Dream.Discover., where Green IQ operates, says that the transition from a group of entrepreneurs with a brilliant idea to a sustainable legal entity involves many labor pains, deliberations, and difficulties, which should be addressed at the outset. “The first and most important step is to coordinate expectations among the entrepreneurs who are going to found the company,” she says. “Coordinating expectations at the start will prevent unpleasant situations at more advanced stages.”
She recommends that the entrepreneurs decide ahead of time who will be the venture's partners, the role of each entrepreneur in the company, the stake each of them will hold in the company, and what each entrepreneur will contribute to the start-up’s success. “Coordinate in advance how much money and time each person will contribute to the venture, when they will quit their current jobs and start working full time for the venture, whether or not they will draw salaries from the beginning, how decisions will be taken at the company, how it will be financed until the first financing round, when the first financing round will be held and from who,” she says.
After this stage, Bar-On advises the entrepreneurs seek a lawyer to decide how to incorporate, whether in Israel or abroad, and if abroad, where. “These initial decisions have tax, investor, marketing, possibilities of government support, such as from the Chief Scientist, authorized enterprise standard, and other aspects,” she says.
Founders agreement and taxes
Nielsen Innovate CEO Esther Barak-Landes, who advises Zeekit, says that the first step in founding a start-up is choosing the partners for the road. “I don’t recommend founding a start-up alone, although it is possible and even happens sometimes. A good partnership between entrepreneurs is a huge asset for the company’s success. Many companies collapse because of the dynamics and relations between the entrepreneurs. To reduce unnecessary friction down the road, it’s important to draw up, immediately at the start, a detailed founders agreement,” she says.
“Globes”: What should the founders agreement include?
Barak-Landes: “First of all. it should define each person’s job. Many partner couples tend to appoint themselves as co-CEOs. This is a big mistake. A company should have one CEO. The second partner can be VP in his area of expertise, and if you want to give him an honorary title to distinguish him from the other senior VPs, he can be appointed company president. Defining each person’s jobs and responsibilities should be done at the outset, even if this only a two-person company, it’s very important for the continued efficient functioning of the company.”
Barak-Landes says that a second critical issue in the founders agreement is the breakdown of ownership. She says that it is impossible to begin operating without a decision on this point, and that there is no point in putting it off. “Sometimes, you begin together at home, in the garage. Each side wants his share of the venture in a different way, and they only seek to raise money from outside sources a year later. At this stage, problems and disagreements are liable to crop up over the breakdown of ownership. That is why it is better to decide on the distribution at the start,” she says.
Barak-Landes also says that the founders agreement should state what happens if one of the entrepreneurs leaves after a period of time. “You should discuss departure, especially in the company’s early years, and the effect on his holding in the company. Investors will make this demand in the future, but also on the relations between the entrepreneurs. It is important to decide that the holding of each entrepreneur is subject to a vesting period.,” she says, adding that the board of directors’ structure must also be decided. “Usually, all the entrepreneurs opt to sit on the board. When investors come in, they usually also demand a dilution of the entrepreneurs on the board of directors. It should be decided at the start who will stay and who will step down if necessary.”
Barak-Landes says, “Another point that should be settled at the start is what happens when one of the entrepreneurs leaves the company and decides to found a rival company. Although there is a major ruling that non-competitiveness by employees also applies to an entrepreneur, it’s important that the issue of intellectual property rights is discussed in advance.”
Barak-Landes emphasizes the importance of early tax planning, saying, “Once it is decided where to register the company, ensure that the company’s lawyers and accountants know the laws of that state. Companies sometimes try to save on legal and accounting fees in the beginning, but early mistakes are liable to result in wasting a lot of money to correct them later. It’s better to spend money on professional consulting at the beginning. The moment a company is founded, any change in holdings, IP, or other issues is liable to result in a tax liability.”
Barak-Landes says that the location of the company should be thoroughly examined, taking into consideration taxes of both the entrepreneurs and future investors “In my opinion, nothing prevents the establishment of a company in Israel, and it is even desirable to do so, but there are investors, especially foreign investors, who consider this a problem. It’s important to consult with tax experts and make the right decision for the company, the entrepreneurs, the future employees, and the future investors. From the tax perspective, attention should be paid to other important points, such as ownership of the company’s patents.”
Patenting
Brandes and Spira also emphasize the importance of the founders agreement, advising high-tech entrepreneurs to consult with a patent attorney to know whether the idea is patentable. The say that protecting the idea is also important and advise requiring confidentiality from anyone talking or with information about it.
How should this be done?
Brandes: “It can be done with a confidentiality agreement or some other way. Even if this does not achieve its objective in full, the listener is more careful, and that is what is important. The founders agreement or understandings between the founders are also important. For example, it’s logical to ask questions, such as who will serve as CEO and who will serve in a secondary position, even if it’s VP development, how decisions will be taken, how to settle disputes if there are two equal partners, and other issues, such as financing operations until the first financing round. By the way, the entrepreneurs will usually be asked to cancel the founders agreement with the first big investment in the company, but until then, definitely settle all the important issues and this has a lot of value.”
Bar-On also stresses the importance of registering patents, saying, “To protect your technology, you should see a patent attorney. If you need a patent, you should begin the patent review and registration as soon as possible, because the determining date is the filing date. If the idea cannot be patented, think about other ways to protect it.”
Like her colleagues, Bar-On says that writing a founders agreement is an important legal step for a new company. “If you decide to write a founders agreement, it is important to mention several major points, such as the company’s share capital structure, and the structure of the board of directors who has the right to appoint a director, how many directors there will be, what happens if the board is deadlocked and who has the deciding vote.”
Distribution plan
Brandes and Spira say that a common legal mistake by new high-tech entrepreneurs involves organizing the employee options plan, which is often delayed, resulting in headaches later on “Another common mistake is that part of the initial team includes a person who is subject to rules and provisions as a university faculty member. If you do not receive permission from the university for him or her to devote time to the venture, this could cause problems relating to ownership of intellectual property.” Israeli and foreign universities have technology transfer companies to commercialize ideas and inventions of their faculties.
What are common legal mistakes by start-ups that might cause them to subsequently fail?
Brandes: “Sometimes, entrepreneurs or investors will discover problems with the technology’s intellectual property rights. There is no shortage of examples in which it was retroactively discovered that a venture was partly or wholly founded on the basis of intellectual property of the previous employer of one of the entrepreneurs. The intellectual property was unclean.”
Can you cite an example?
Spira: “The best-known example is Facebook, which had to deal with a lawsuit filed by Cameron and Tyler Winklevoss and Divya Narendra. In that case, Facebook had to pay $65 million in compensation to settle theft of concept claims to establish the social network.”
Barak-Landes says, “It is very important to prepare the options plan by the book with the assistance of a trustee. This issue also has a tax element and it’s important to understand everything from the beginning. Every company needs, in every case, a trustee for its options plan. Here too, it is better to conclude everything at the outset.”
On this point, Bar-On says that in most cases, the decision will be to incorporate as a limited company a decision that protects the company shareholders and limits their liability to the nominal value of their shares. She advises entrepreneurs to build a capital table for the company. “This is a material matter which stipulates the ownership of the company between the founders, and how much each will own. It is important to include in the table everyone who has been promised a share in the company’s share capital.”
Brandes and Spira point to the potential problem in creating a holding structure. They say that a common mistake is a disproportionate stake in the company due to pressure to raise initial capital at an early stage, even if the valuation is very low. “Such financing distorts the holding structure and hinders bringing in an investor later,” says Spira.
“The rule of thumb is to keep it simple. The share structure should closely reflect the contribution and importance of each entrepreneur in the project. It will be important for an investor to see that the significant entrepreneur in the project has a major holding. It is not worthwhile to get stuck in a situation in which an investor owns half of the company when it is founded in exchange for an inadequate investment.”
Brandes and Spira also say that it is not worthwhile for all kinds of advisers, mediators, and so forth to have large stakes in a company at the early stage as they will not contribute to the company later on. They say that an effort should be made to keep a clean and simple capital structure.
Published by Globes [online], Israel business news - www.globes-online.com - on July 24, 2014
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