Planning for the future

24 April 2019

The development of any new business is always a staged process, with long term success depending on a multitude of factors. In the earliest stages there are some key issues that need to be addressed by the entrepreneur(s) concerned that can potentially have long term impacts on the business concerned. Unfortunately they are sometimes overlooked, leading to unwanted aggravation at a later date. 

A couple of such examples are:

IP ownership

It is the nature of many businesses that rely upon IP that substantial work is undertaken prior to a business being investment ready. Investors tend to want to put in equity to develop a business rather than to fund a proof of concept. Thus often before a company has even been formed, an entrepreneur, and frequently others, have carried out research, written code and/or developed inventions. In the midst of such work a company may be formed, but what is often overlooked is ensuring that the IP that has been developed is formally transferred to the company concerned. Often the founders assume that because they are the shareholders and directors of the company the IP magically becomes owned by the company.

While that can usually be rectified fairly easily by the founders subsequently transferring such IP to the company, things can become a little more problematic, if friends or third party consultants have produced any of the IP concerned. Unless there is a contract in place setting out ownership rights in favour of the company or founders, in the case of copyright (which governs ownership of computer code) ownership lies with the author. While the provision of any such code by the author may create an implied licence of use, any future investor, or purchaser of the company will likely be seeking warranties that the company owns its IP. If due diligence turns up that there is no documentary trail from the author to the company, problems may arise. If the IP concerned is not material, and can be replaced, that may be a solution. However even then delays can cause disruption to any such funding or sale. If the IP concerned is actually material to the company’s business, any such problem could potentially jeopardise such a transaction. Right from the beginning of a business life cycle, if anyone is developing IP which is likely to be material to the business going forward, the founders need to be careful to ensure ownership of that IP by the company concerned is clearly established.

Founder ownership interests

Where there are multiple entrepreneurs involved in a start-up, all too frequently there is a lack of long term planning as to the appropriate spread of equity. There can be a tendency (and university spin outs are a frequent example of this) to spread the initial equity around all those involved, without giving thought to the likely future contributions of those founders. The reality is that at its earliest stages, most start-ups aren’t worth anything. They might have a good idea, but there will be a lot of work that will need to be undertaken in order to generate real value. Will all founders provide equal contributions to achieve that value? Indeed do they even plan to all work full time in the business going forward? If not, then all you are doing by handing out equity equally is creating the basis for conflict in the future. Those who do all the work, often for little or no money, may not be at all thrilled that their fellow founder, who is now working in separate employment, holds a similar stake in the company.

If the value of the company grows quickly, then altering respective equity interests can start to be expensive. It also means that when equity is subsequently used to incentivise additional talent the company may need, that all founders are being diluted as a result, being a further hit to those founders remaining in the business. While the discussions can be awkward and often difficult at a time when all founders are gung-ho with enthusiasm for their new project, from the beginning founders need to consider, and hopefully agree, what is to happen if one or more of them cease to be involved with the business on a fulltime basis. Buy back rights, good leaver/bad leaver provisions all have a place in such discussions. Having reached agreement on the principles, and enshrining them in a suitable shareholders agreement, everyone then knows where they stand going forward, and what the ramifications of departure are. Failure to do so can potentially mean the key drivers of the business are not prepared to continue to work for the benefit of others who aren’t contributing. Many a business has ground to a halt as a result of such an impasse. 

The content of this article is for general information only. If you require any advice please contact Quentin Golder or a member of Birketts’ Corporate Finance Team. Law covered as at April 2019.

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