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Startups: Essential Legal Structuring Tips to maximise your chances for success

22/05/2024

Are you dreaming about launching your startup? Are you ready to embrace the exhilarating journey and take the first step to turn your dreams into reality?

If the answer to these questions is yes, you are in the right place!

Statistically, only 1 out of 10 startups survive.  But, reasons for startup failures are different. While there are no guarantees for success, you can do your best to minimize the risk and do things properly.

Even when collaborating with friends or acquaintances, it’s essential to adhere to proper legal protocols. For instance, you wouldn’t want to find yourself in a situation akin to the Winklevoss twins, outmanoeuvred by the next Mark Zuckerberg, with their ConnectU startup largely forgotten. Clear legal frameworks help prevent such scenarios, ensuring fairness, accountability, and the long-term viability of your venture.

 

1. Deciding on where the company will be incorporated

One of the first steps in starting your business is, of course, incorporating a company. This brings you to the important question – Where should I incorporate my business? The answer to this question depends on three core criteria that you should consider before making the final decision.

 

a) Defining Your Target Market for Users and Investors

At the very beginning, you should determine who will be your targeted customers, the so-called ICPs. For example, if you plan to develop an HR app for midsize companies, and your go-to-market strategy starts with the EU market, you might think aboutestablishing a company that will be the owner of the app in the EU.

However, it is not only important to know where your ICPs are, but also who your investors might be. For this reason, many companies opt for establishing headquarters in the US. Bear in mind each of the 50 states boasts its own distinct corporate laws. Among them, Delaware stands out as the preferred destination for incorporating tech companies. Renowned for its robust corporate governance framework, Delaware has established a precedent-setting body of case law. Investors favor tech startups registered in Delaware due to the clarity and predictability afforded by this well-developed legal landscape. Moreover, Delaware’s statutes afford unparalleled autonomy to company management, minimizing shareholder interference. This combination of legal clarity and managerial freedom cements Delaware’s reputation as a prime jurisdiction for tech ventures.

 

b) Building a Core Team

Having a good core team is vital for the success of your business. For example, if you intend to develop an app, it will be crucial to have a team of IT experts who will help to turn your idea into the (online) reality.

This means that you should look for a market that can offer you a set of IT experts. Considering that startups usually have limited budgets, it will be necessary to find a perfect balance between a competitive labor market that can offer educated, talented, and skilled manpower and lower living costs that influence the salary range.

It is important to bear in mind that even though it sounds more practical, it does not necessarily mean that establishing only one company is the best solution. For example, one jurisdiction can be a perfect solution for potential investors. However, it does not have to be the best choice for your core team and your targeted market.

If this is the case, you should consider establishing affiliated companies in the jurisdictions that are advantageous for each of the criteria. Many startups decide to open a parent company in Delaware, which is supposed to hold all IP, and open a subsidiary in countries like Serbia to get access to high quality workforce at lower prices.

 

2. Company Establishment and the law applicable to Fundraising

Before starting the company establishment process, it is advisable to make sure that the procedure is straightforward, and that it will go smoothly. Spearing a lot of energy into the company formation is usually not the start that the founder expects.

Upon the company’s establishment, it is important to open a business bank account as soon as possible. This will enable your startup to run properly. In this regard, you should also make sure that the bank account opening will be smooth and easy.

For example, with adequate legal support, company formation in Serbia will be a pleasant and straightforward process. As a country with a competitive IT labor market, a lot of startups have decided to establish their development center in Serbia.

If you are interested in company formation in Serbia, you can read more about this process in our blog.

Also, you should be aware that investors will, before investing in your company, perform due diligence on your company. Preparation for the due diligence starts the moment you establish the company.

It’s very important to have a clear vision of the type of legal entity that you would like to establish. In the initial stage, you will likely establish a private company, with one or more shareholders. In this regard, it is recommendable to take into account if one jurisdiction imposes any limits regarding the number of shareholders, the possibility for foreign citizens to establish a company, etc.

The type of legal entity is closely connected to the potential share transfer. As mentioned above, it is likely that you will eventually engage in fundraising.

Fundraising can have different forms, such as:

  1. SAFEs (Simple Agreement for Equity)

This means that the investor does not get the stock, but the investor gets a promise that the investor will obtain the same kind of stock that the company will issue in the next financing round. This is combined usually with discounts, MFNs and valuation caps.

  1. Convertible Notes

They are a type of debt instrument that allows investors to lend money to a startup with the expectation that the debt will convert into equity in the company at a later date, usually during a future funding round.

  1. Priced Rounds

Priced rounds refer to a type of fundraising round in which a startup sells equity in the company to investors at a pre-determined price per share. Unlike convertible notes or SAFEs which defer the valuation of the company until a future event, priced rounds establish a valuation for the company at the time of the investment.

For instance, Serbian regulation defines a clear and straightforward share transfer procedure. Upon signing the Share Transfer Agreement and filing the application for registration of the new shareholders to the Business Registry, the registration process will be finished within 5 working days.

For this purpose, important questions will be:

    • What type of documents are required for this purpose?
    • What is the form of the required documents?
    • How long does it take to register the new shareholder?
    • Are the KYC procedures for new shareholders reasonable?
    • Are there any additional steps that I should take?

 

3. Shareholders Agreement

When embarking on a startup journey, it’s vital to establish a strong foundation for collaboration between the founders. The shareholder’s agreement is a crucial document that defines the rights, obligations, responsibilities, and expectations of each founder. Even though it might sound unnecessary at the very beginning, it is important to define a decision-making framework, founders’ rights, obligations, and duties, as well as all other relevant questions.

It is important to consult with a qualified attorney when drafting your shareholder’s agreement. Each startup is unique, and an attorney can help you customize the agreement to meet the specific needs of your startup.

For example, if a startup has 3 founders each of whom will contribute to startup development in some manner, it is recommended to define their responsibilities in writing. For instance, Founder A will mostly provide funds, Founder B is an IT expert who will supervise the development process, and Founder 3 is a sales expert who will contribute to the product placement. For transparency purposes, their responsibilities can be defined in detail under the Shareholders Agreement.

In case you wish to learn more about the Shareholders Agreement, get in touch with us.

 

4. Common Stock Purchase Agreement and Vesting

In certain jurisdictions like Delaware, founders often enter into a Common Stock Purchase Agreement with their company, whereby the founder acquires a specific number of shares of the company’s common stock. At the company’s inception, its value is typically negligible, resulting in a nominal purchase price paid by the founder. The rationale behind the founder’s purchase of these stocks lies in the advantageous tax treatment they offer: while the initial investment is modest, subsequent gains in the case of selling the common stock are subject to capital gains tax rather than the higher rates applicable to ordinary income. Consequently, the disparity between the purchase and eventual sale prices forms the basis for the capital gains tax, a figure notably lower than that for ordinary income.

The right of repurchase, often included in agreements between startup founders and their companies, typically serves as a safeguard for the company’s interests in the event that a founder leaves the company prematurely or under certain specified circumstances.

In the context of startup founders, the right of repurchase is commonly applied to shares of stock issued to founders as part of their equity compensation package. This provision allows the company to repurchase a founder’s shares under certain conditions, such as if the founder leaves the company before a specified vesting period elapses or if they fail to meet certain obligations outlined in the agreement.

For example, let’s say a startup founder receives shares of company stock as part of their compensation package, subject to a four-year vesting schedule with a one-year cliff. This means that the founder must remain with the company for at least one year before any shares begin to vest, and thereafter, a portion of the shares vest incrementally over the remaining three years.

Now, if the founder were to leave the company voluntarily or be terminated for cause before the shares fully vest, the right of repurchase may be triggered. The company could then repurchase the unvested shares from the departing founder at the original purchase price or a predetermined formula specified in the agreement.

 

5. Tax Considerations

Understanding the tax obligations of a company is crucial for startup compliance and financial optimization.

It often happens that startups in the initial stage disregard the potential of tax incentives and benefits. However, this is something that should be considered before the establishment of a company.

Some countries offer a wide range of tax incentives such as R&D, IP boxes, incentives for employees, different tax exemptions, etc. To fully use tax incentives, it is useful to explore the options before starting the business. This proactive step will contribute to a well-structured business setup and efficient tax optimization.

To give an example, Serbia is one of the countries that offer many tax incentives, subsidies, and other benefits that could help your business grow.

 

6. Intellectual Property

From a legal perspective, one of the crucial things is to protect a startup’s IP. Often, the value of a startup is mostly determined based on its IP assets. IP is usually created by founders,  employees and contractors.

If the founders developed some IP before the company was founded (as it is often the case), the founders have to assign such IP to the company.

Additionallyit is essential to have a clear mechanism to assign IP from the employees to the company as well as from the contractors to the company. This will ensure that the company is a holder of all IP rights and that it can transfer it further. Additionally, it is paramount these persons are bound by confidentiality.

Also, it is important to choose a jurisdiction that offers adequate protection of trademarks, patents, trade secrets and proprietary information.

 

7. Data Protections Regulations

Personal data protection regulations should also be on the list of matters that you should consider before establishing a company. This is especially important if you intend to process personal data on a large scale.

If you are developing an app, it is almost certain that you will process personal data. For example, it will be probably necessary to sign up to use the app. This means that you will process personal data.

Above, we gave an example of an HR app targeting the EU market. Compared to the US, EU (and generally European) regulations concerning personal data protection are more restrictive. In this regard, if your target market is the European market, you should make sure that your business is set up in jurisdictions that can assure compliance with European data protection regulations.

However, a company’s targeted market can be the EU market, but the company can also export personal data to a third country. If this is your case, you should make sure that personal data is exported under the law.

 

8. Compliance Roadmap

Following the compliance roadmap is essential for a successful startup launch. On this road, the first step should be to understand the regulatory landscape and specific rules for the industry. In other words, you should check which obligations your company will have in terms of financial report submission, whether your business model requires specific licenses or permits, etc.

For instance, if your business model includes the development of an app in the field of FinTech, you should pay more attention to the financial regulations of the specific jurisdiction. Namely, such a business model may fall under a specific regime that requires licenses and approvals for the app.

Also, you should check if the chosen jurisdiction offers a possibility to reduce operating costs. For example, a virtual office could be a significant saving at the early stage of startup growth. Also, employees would probably be satisfied with the possibility of working from home.

 

9. Employment Regulations & ESOP

Employment regulations are essential in the jurisdictions where you plan to build your core team. In this regard, you should make sure that your company is compliant with all employment regulations.

Also, you should consider what is the best manner to keep your core team together. Therefore, potential benefits for your employees should not be discharged at any stage. For example, ESOP is one of the benefits that could encourage your top employees to stay with the company. Many times, we see startups decide to give stock options to employees in the parent company (usually the company in the US) under the Stock Options Plan, even though the employees are employed by the Serbian subsidiary and not by the US entity. In some cases, companies will opt for providing phantom stocks instead of stock options for employees. However, the company must understand the difference in taxation of Serbian employees in their country of residence before deciding on the model.

In the dynamic environment of startup ventures, sound legal structuring is the cornerstone of success. Even though it might sound unnecessary at the very beginning, proper legal structuring is essential for a successful startup. With the well-organized approach to legal structuring, you’re now ready to chart your startup’s course toward a successful startup story!

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