7 Fatal Legal Mistakes Startups Make

01
June 2022

Contact: Nina Radin

Although in comparison to statistics from previous years, the success rate of startups in 2022 has increased (according to an analysis published by Failory), on average, 90% of startups fail. Given that such research is mostly focused on companies from developed countries such as the USA, it is expected that this percentage would be higher if the research was conducted only in the territory of Serbia. Why is it so?

We believe that one of the main reasons is that people aren’t sufficiently informed about the basic terms and principles of investing and starting a small business; thus, it remains unknown to many domestic businesspeople.

In that regard, we decided to point out the most common legal mistakes in practice, which could be fatal for the success of a startup. Although these mistakes may appear in the business performance of different types of startups, the focus of this blog will be on tech and digitally oriented startups.

1. You Haven’t Reached an Agreement (in Time) on Most Important Aspects of Your Business

A) Agreement Before Establishing a Company – Letter of Intent

How the startup will be managed, who will have what role, and what will happen in case a founder wishes to quit, should be decided upon in long conversations and planning, prior to establishing a startup. Still, experience has shown that founders do not pay enough attention to these questions, but rather enthusiastically focus on developing a product. Even when these conversations do happen, and when it seems as if everything is clearly arranged, founders often face numerous open and unanswered questions. This is why it is extremely important to have a written agreement even before establishing a startup.

In the phase when a startup is still not legally established, i.e., while the company is not yet registered in any country, a common practice is to conclude an agreement, usually named Letter of Intent. With the Letter of Intent, the future founders of the startup express their intentions regarding the startup on a piece of paper (who will occupy what role, who will have what (percentage of) shares in the future company, and in what manner will that share be acquired (whether through a so-called vesting period), etc.).

Regulating the relationship through a Letter of Intent, or any other similar document, is of great importance in the case when prior to establishing a startup, certain “preparations” are made – such as buying a domain, or if the work on certain projects which will be in the ownership of the future company – the startup has already started. Since at that moment, the company does not exist yet, the company cannot own a domain name, holds rights over the intellectual property, or acquire other rights and obligations. In that phase, the holders of all the abovementioned rights and obligations can be only the future founders of the startup, in the capacity of a natural person.

Therefore, it is important to foresee with the Letter of Intent that all these preparatory actions are taken for the future startup, and that all parties commit to transfer all rights that were acquired during that period (e.g. copyright to code or domain name) to the company (startup) once it is officially registered.

B) Agreement between members of (a registered) startup

When the startup is registered as a company, the Letter of Intent usually “evolves” into another agreement, usually an agreement between startup members (shareholders’ agreement, an agreement related to the company).

One should distinguish this agreement from the agreement on company formation (Memorandum of Association), which is a necessary document for registering a company in Serbia before the Serbian Business Registers Agency.

Without a proper agreement between the startup founders (and Letter of Intent beforehand) you are at risk from problems arising in various fields, since, by the rule, disputes occur within the subject matter traditionally regulated by the shareholders’ agreement, and not the company formation agreement.

Only a few of the relevant topics that should be regulated by a startup shareholders’ agreement are:

When an investor enters a startup, usually the whole setup of the startup gets complicated – this is why regulating a contractual relationship with an investor is one of the most complex matters. Some of the examples from practice that require special precaution are:

  • an investor who is asking to be the Managing Director (or to have a seat on the board of directors, if such board exists) – carefully think through whether this is good for your business,
  • investor’s right of veto when deciding on certain matters – how much is your vote actually worth? If an investor could veto a certain decision in your company, it could have negative consequences.
  • Setting up inadequate key performance indicators into the Term Sheet – conditioning that the next installment of the investment will be paid if the company, for example, makes X $ in 3 months, 6 months, etc.; is this commercially acceptable to you, or more importantly: is it realistic?

C) Vesting – what is its purpose?

Another important question: in what way does the percentage of investors’ shares change in relation to the investment? In foreign legal systems (such as the USA, particularly Silicon Valley) where the startup ecosystem has been developed for many years now, this question is regulated by the so-called vesting – a disposition of using options for acquiring shares in the company, i.e. acquiring rights to a permanent share (percentage) at the company, through time. Although in Serbia an investment model identical to vesting is not implemented so far, there are certain mechanisms that can produce a similar effect, and which could be a great stimulus for foreign investors to think about the possibility of investing in a Serbian startup. We have covered this topic in our blog – Make your Best Employees your Partners with ESOP.

An example: a vesting period of 4 years is foreseen for the investor, so that after the concluded monetary investment, during these 4 years they acquire 40% of shares of the company (10% each year). If they give the startup up and quit before the first year is over, they won’t get anything. If they quit a few days after the first year is over, they are left with 10% of the shares. The remaining part of the shares that the investor hasn’t vested (in the first case, 40%, and in the second, 30%) the company may buy out from the investor.

When it comes to monetary investment, it is crucial to properly define this type of investment, as it becomes more complicated when so-called funding rounds are used. That situation requires defining the funding dynamics, as well as regulating the rights that are acquired at each phase.

On the other hand, vesting does not have to be specifically tied to a certain time period and depended on monetary investment (which is common for a vesting investor), it can also depend on accomplishing smaller goals (so-called milestones). This form of vesting is typical for other founders who can also use vesting, and by the rule, invest their work and know-how into the startup. Knowledge and experience of the founder are most often the primary motivation of the investor to invest in the startup and the main resource that the founders bring to the startup, thus, it is not surprising if the investor insists on agreeing upon criteria for evaluating the work performance of the founders.

On the other hand, this knowledge and experience of the founders have likely led to the creation of different intellectual property even prior to meeting the investor. Hence, it is relevant to specify at the beginning what will happen with the intellectual property that was created prior to this event that the founders are now bringing into the new company. The existence of intellectual property prior to establishing a company, represents more of a rule than an exception in practice, because most companies are not established prior to the creation of a so-called MVP (minimum viable product) or prior to the existence of a proof of concept, often with the goal of reducing the expenses.

Why vesting?

  • vesting encourages members to stay and fight for the startup longer (mostly a few years), because it stimulates further work and investing, upon which the growth of the members’ percentage of shares depends;
  • as a general rule, investors aren’t willing to invest in a startup where founders can quit whenever, and at the same time, keep a large percentage of shares.

In order to avoid possible unpleasant surprises, you should keep in mind all the previously listed matters before you enter into negotiations with the investor. In these paragraphs we have presented some of the basic terms, however, when drafting these agreements, these and other important questions should be regulated in a more detailed manner.

D) The legal form of a startup

Finally, although the question of the right choice of a legal form for a startup should not be neglected, the practice has shown that there are almost no mistakes there. Namely, in Serbia, startups are mostly established in the form of an LLC (Limited Liability Company), and less frequently in the form of an entrepreneurial company (since a startup is characterized by the existence of multiple members who share the ownership over a company). The third option is seldom seen in practice unless the founders decided to establish a company in a foreign country. In any case, if a startup intends to use the possibility of exercising its right to tax incentives (more details below), LLC may be the only option.

2. You Do Not Have All the Necessary Agreements that the Startup Will Execute

For startups, besides the agreements listed in the first part of this text, the agreements of great relevance are:

1) an agreement that the startup shall conclude with their customers in the future

2) an NDA

1) Customer Agreement

The type of agreement that a startup will conclude with its customers in the future will, of course, depend on the startup’s business activity. In most cases, that will be a so-called cloud agreement (for a startup that has, for example, developed an app), which will be concluded between the startup and their customers for access and use of the app on the internet (so-called remote access). As the cloud agreements differ significantly from professional services agreements, these rights of access and use should be highlighted, since the cloud agreements do not transfer ownership of intellectual property or licensing rights. In general, these agreements are referred to as the Terms or Terms of Service.

These agreements are key to the functioning of the startup because they determine the “rules” for all customers.

For many startups (especially those which belong to the Software-as-a-Service business) this is solved by drafting a general Terms of Service through so-called click-wrap or browsewrap agreements. These agreements are publicly available and while they save time for the startups (considering that they do not require negotiations with each customer), they do carry a challenge of creating an agreement that shall “cover” all specific situations for a great number of individuals.

In addition, particularly since they are public, these agreements are often subject to various attacks which can often end up in court, even as the subject of mass lawsuits. And as the startups are trying to lower their costs when starting their business, copying others’ general terms of service happens frequently. However, acting in this manner is seriously problematic, and it can lead to multiple problems – from the startup which hasn’t protected their business (since the copied conditions were adopted for another company) to violation of the third party’s copyright. We have written more on this in our blog on Website Terms of Use.

In essence, two modalities of agreements may occur here, along with the ones listed: (1) cloud agreements – Terms of Use, which the startup may conclude with their customers; and (2) separate agreement that was previously subject to the negotiations, and which is made exclusively and specifically for this particular contractual relationship between the startup and the client (not public). Usage of these agreements primarily depends on the specific business or product, on who the startup’s clients are, i.e., whether the startup is predominantly B2B or B2C oriented, and how much space the startup will leave to clients for possible negotiations and amendments in the agreements.

2) Non-disclosure Agreement (NDA)

A particular mistake that startup founders make is when they don’t have a Non-Disclosure Agreement (NDA). This agreement, or at least a very resourceful and precise confidentiality clause under another agreement is a “must-have” for:

In other words, you should have a Non-Disclosure Agreement (NDA) with literally everyone with whom the startup has an agreement.

3. You Have Not Properly Regulated the Processing of Personal Data

To be able and secure to develop your business seamlessly in the online ecosystem, you should have suitable documentation for your website.  That primarily includes an adequate:

Terms of Use and General Terms of Service are essential documents for startups. However, in addition to the specific mistakes (explained in section 2 of the blog) that occur in connection with the Website Terms of Use, the experience taught us that startups often make a great mistake when they treat this documentation as templates that they can “pick up and copy” from another website. To make the damage even greater, they generally prefer foreign websites and foreign documentation that can often be very problematic (even dangerous) in our legal system. Some examples of bad practices include “copying” the clause on applicable law, for example. the U.S, as well as the jurisdiction of the U.S. court,  or the terms and legal concepts that either do not apply in Serbia or their meaning in the Serbian law system defers to a great extent from the law of the country defined as the applicable law of the original terms of use. It is not uncommon to inadequately regulate the limitations of liability, intellectual property rights, etc.

It is particularly dangerous if the startup does not regulate the issue of personal data processing, especially if personal data is processed within the EU. Namely, the General Data Protection Regulation of the EU (GDPR) not only obliges data controllers and data processors in the EU but also applies in certain cases in Serbia (which we wrote about in the article “Territorial Scope of GDPR in Serbia”). Several million-euro fines are certainly a good incentive to properly resolve this issue. Besides, experience shows that startups often make mistakes when collecting personal data through website cookies, another dangerous and vast issue. In that manner, they risk the fate of Google (the fine of EUR 100 million), which has experienced firsthand the bitter-sweet taste of cookies due to neglecting the website cookie policies, i.e. illegally collecting personal data in France.

4. You Have Not Properly Regulated Intellectual Property Rights

When it comes to startups, it cannot be stressed enough how important the protection of intellectual property (IP) rights is, especially for the startups where the IP often carries the greatest economic value.

  • Due diligence of investors as a detector of all your shortcomings

The issue of intellectual property is important not only because of properly regulating relations between startup founders but also for the future investors, who will seek to see a proof that all intellectual property rights related to startups are in sole ownership by the startup (or at least: that there are proper licenses). Don’t let yourself miss the opportunity to get your startup bought out by a powerful company just because you’ve been negligent about the transfer, i.e., protection of intellectual property rights.

  • Have you made it easy for anyone to steal the intellectual property of your startup?

The problem that startups with great ideas may face in practice is that someone on the internet “sees” their business and takes over an idea, by, for example, copying the startup logo and registering it as their trademark. In addition, if a competitor registers your startup name as their trademark (for the same territory) it directly creates a problem for your trademark registration, but also for your domain name (if it is identical to the startup name, which is most commonly the case) because your domain name then infringes the trademark of your competitor.

Therefore, another fatal mistake for a startup may arise when not thinking about:

Inadequate regulation of intellectual property rights carries numerous risks, from the loss of the intellectual property to give away the brand and startup reputation to a competitor.

5. You Have Made a Challenging Choice of Startup Name, Logo, Domain Name

Some of the most common mistakes regarding the name, logo, and domain of the startup are the following:

  • You have chosen the name for your startup that infringes someone else’s trademark (e.g. the name of your startup is the same or similar to the name of a competitor who markets the same or similar products/services, where the competitor has registered the trademark before you) – in this case, rest assured that your competitor will file a lawsuit against you, and thus drag you into long and costly litigation, while, in addition to money and time expenses, you face losing the startup name. It should be noted here that if you have chosen an entirely identical business name as another company, the Business Registers Agency will not allow such registration, so it will be a signal to change the name on time. However, in practice, it often happens that the name is different enough to pass the “control” of the Business Registers Agency, but not different enough not to infringe someone else’s trademark. This is because the Business Registers Agency, which registers startups, and the Intellectual Property Office in which the trademark is registered, are not governed by the same criteria and regulations when making their decisions.
  • You chose a logo that infringes someone else’s trademark (mostly like the previous issue). Caution is even more important here because with logos (graphic signs) the distinctiveness of the sign (diversity relative to others) is harder to determine than when it comes to the name (verbal trademark) as it requires good knowledge of trademark rights.
  • Finally, mistakes often happen with domain names, and the most common mistakes occur when you buy a domain name that infringed someone else’s trademark (the domain name is identical or similar enough to someone else’s trademark). Therefore, before buying a domain, make sure that there is already a registered trademark that is the same/similar to your domain name. In any case, the safest way is to buy a domain name and register such a trademark because it “rounds up” the protection.

6. You Do Not Have an (Adequate) Employment Law Framework

Given that the Employment Law regulations generally tend to protect employees as a weaker side in the employment relationship, and given the judicial practices in this matter, there is no doubt about the importance of quality and professionally prepared employment documentation for startups. In this way, a startup, as an employer, can prevent a number of negative consequences but also the risks of being held liable by the state authorities because it has not harmonized its internal acts with regulations.

In this regard, a startup should initially consider introducing adequate procedures and policies (properly and precisely regulated employment agreements, employment handbook, and other rulebooks; confidentiality procedures and non-disclosure agreements, codes of conduct, the rulebook on data protection, and video surveillance policy, IP transfer agreement, etc.).

Lack of information can cause you to miss out on the many benefits offered to startups, such as state subsidies and employment benefits, tax breaks, etc., or overlook the ability of employees to acquire share ownership at startups (ESOP).

Finally, it is almost inconceivable nowadays to talk about the labor law legal framework without regulating the issue of data protection and privacy in the workplace. Having in mind the high penalties and other negative consequences brought on by not complying with the law, it is fatal not to regulate these issues adequately and professionally.

7. You Haven’t Thought about Taxes

The tax issue is closely related to:

  • Selection of the legal form of the startup,
  • Services or a product that the startup will provide or develop,
  • Whether to market their products or startup services in Serbia or (more often) for the foreign market (and which),
  • Whether the startup will be in the VAT system, and so on.

In addition, the tax issue is always twice as important:

1) because you want to make sure that you have done everything in accordance with the law and that you will not be exposed to various inconveniences (criminal and misdemeanor charges, high penalties, etc.), but also

2) because you don’t want to pay more than is required by law and because you want to achieve all the tax breaks and benefits that are available.

For example, the so-called IP Box regime enables the income tax to be reduced from 15% to an effective 3%. In order to be eligible for this tax break, it is necessary that the copyright, for example, software (or the subject of related rights), is deposited with the Intellectual Property Office. If the startup product is an invention, it is necessary for the patent to be recognized or that the patent application has been submitted to the Intellectual Property Office.

Furthermore, an important tax break for startups dealing with research and development is the ability for the startup costs that are directly associated with R&D to be recognized as expenses in the tax balance in double the amount of accounting calculations. Since the IP Box and R&D deduction can be cumulated, and the startup income tax may effectively be reduced to 0%, it is very important to be informed on whether your startup is eligible to use these benefits.

Startups often become incredibly attractive to large investors who are willing to invest in further development. Precisely one of the mechanisms to attract investors, and an additional reason to convince them that startups are a great opportunity to invest, is the tax break for investing in startups. Namely, an investor can reduce their tax liability, i.e. achieve a tax exemption of 30% of the investment made. It should be noted here that the right to this tax exemption is exercised by an investor (company) who does not own 25% of the shares/shares/votes at the startup at the time of investing in the startup.

These are just some of the examples, and for the full picture of all the benefits, we strongly recommend that you take a look at our list of tax incentives in Serbia for businesses, to make sure that you are not paying for what you do not have to.

Not being informed about your rights and potential benefits is usually a very expensive mistake.

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