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Episode 23

In Search of the Unicorn: Advising early-stage start-ups

In this episode, Richard Pragnell discusses the unique legal dynamics of advising early-stage, high-growth start-up companies.
Substantive Law
7 August 2020
Richard Prangell
1 hour = 1 CPD point
How does it work?
What area(s) of law does this episode consider?Richard discusses the unique legal dynamics of advising early-stage, high-growth start-up companies.
Why is this topic relevant?Silicon Valley might be the first place that comes to mind when we think of innovative start-ups, but here at home, New South Wales is the start-up capital of Australia, ranking third behind California and Singapore for its number of start-up founders. It comes as no surprise that it’s no surprise that many lawyers advise the sector hoping to be the lawyer of choice for the next unicorn – but start-ups have unique legal needs, from financing, to defending valuable intellectual property, to corporate governance.
What principles are considered in this episode?Retention through incentives – share vesting:

  • Share vesting is a condition (usually set out in a shareholder’s agreement) that attaches to shares you are allocated in a company. A vested share is a share that you own completely, one that you can act on, vote on and sell.
  • An unvested share is one that is allocated to you, but that you don’t quite own yet – most of the rights associated with the share are conditional on a period elapsing or an event occurring.
  • Usually, if you leave the company before the vesting condition has occurred, you will forfeit your unvested shares and have to sell them back to the company for nominal value.

Defensibility

  • Defensibility helps a company stay strong and successful – it is what prevents another person from copying your unique value proposition. This can be achieved legally, through trade mark protection (for protecting a brand) or patent protection (for protecting a technological innovation) – but sometimes these techniques, especially patent registration, can be prohibitively expensive for early-stage companies.

‘Flipping up’

  • ‘Flipping up’ is where a start-up reaches a tipping point in their growth and needs to move to an overseas market to attract the level of venture capital investment required. Usually, this results in the company moving to the United States.

 

  • While a flip up gives a company access to all of those new investors, an international structure brings with it more compliance obligations and increased annual compliance costs, so timing the flip-up is important.
What are the main points?
  • The relationship between two co-founders of a start-up is very much akin to a marriage – in the early stages of the process in particular, two co-founders will likely spend more time with one another than they do with their own spouses or partners.
  • There are a number of ways to raise capital, including: issuing shares, issuing convertible notes, or using a SAFE, or Simple Agreement for Future Equity.  Whichever instrument is used, however, founders – and the lawyers advising them – have to make sure that the dilutionary effect of issuing an instrument is well-understood, so that the founders, and their other current and future investors, aren’t surprised by the results of those instruments in the future.
  • Shareholder management – frequent and detailed reporting to shareholders, and providing sufficient information to allow shareholders to make informed decisions –  is one of the skills that sets successful start-ups apart from the rest.
What are the practical takeaways?
  • Trade mark protection is a good first step for a start-up thinking about defensibility of their brand.
  • Patent protection is costly, time-consuming and complicated. A lot of start-ups are unable to justify the cost and process with the level of practical protection.
  • Given this, smaller companies might better protect their innovative technology by keeping it secret, with something as simple as a non-disclosure agreement. However, they must be deployed carefully – some venture capital firms refused to sign NDAs, on the basis that it would be impossible for them to keep track of all of their obligations under all of the NDAs presented by potential investments.
  • Some venture capitalists and investors are ‘founder first’ – meaning that they will first look to the founders and founding team, their work histories, and personal characteristics, before investing.
  • A legal problem for many start-ups in 2020 is privacy law compliance.  Because some technology start-ups, especially Software-as-a-Service (SaaS) start-ups, offer their services to customers all over the world, they need to be aware of and comply with a variety of privacy law regimes – though at the time of writing, the EU’s GDPR is still considered the ‘gold standard’.
Show notes15 Key Questions Venture Capitalists Will Ask Before Investing in Your Startup