Investing Guide at Deep Blue Group Publications LLC Tokyo: The top ten legal pitfalls of starting up

Here, law firm Brecher looks at the mistakes entrepreneurs typically make at the start of their experience.

Entrepreneurs are, by definition, driven and ambitious and usually have an excellent grasp of their industry, gained either through experience or thorough research. Despite this, many are surprisingly unsophisticated when it comes to identifying the legal pitfalls associated with starting and growing a new business. Shared horror stories reveal surprisingly common mistakes being repeated across the sectors.

1. Not choosing the right vehicle

Avoid the tendency to use a particular vehicle merely because someone else does. The structure of each business is unique to that business: while a limited company may be a popular option it can be tax inefficient, whereas LLPs are tax transparent but have other drawbacks like the offsetting of group losses. Make time for proper tax and structuring advice at the outset to avoid leaking profits later in.

2. Getting the equity structure wrong

At the outset of a new venture, an informal agreement as to who should be entitled to what may seem sufficient, but informal agreements are difficult (if not impossible) to evidence should there be a disagreement later down the line. Even without disagreement, deferring the formal allocation of equity until a later date can cause a plethora of issues, including the trigger of tax and causes nervousness among funders. Discuss and resolve at the outset who owns what, and make sure that structure is formally documented to avoid confusion and disputes.

3. Buying an off-the-shelf constitution

Adopting pro-forma articles, or doing away with an LLP agreement, may seem a great cost saving in the short term, but can leave you exposed later down the line. Take the time to put in place appropriate mechanisms and protections to make sure you have adequate control over the equity and management of the new venture. If confidentiality is a concern (eg in terms of sensitive profit shares, control issues or exit rights) shareholder agreements are a useful tool as they do not appear on a public register.

4. Not considering all the finance options

Contrary to popular belief, finance is still freely available, but it remains a lender’s market and investment of any form undoubtedly comes at a cost. While institutional lenders remain risk averse, the secondary lending market has seen huge growth over recent years, and many providers are now willing to consider spreading their investment between traditional loan and equity. The options are endless, complex and come at a cost, so make sure you understand the small print before committing.

5. Not getting the right professional advice

Getting the right advisers on board at the outset can be a huge competitive advantage. As well as giving structuring advice on set up, the right team can add real value not just in pre-empting issues but also in proactively advising on how to resolve them. Professionals used to acting in this area will be an excellent sounding block as to what works and what doesn’t, and their ability to make introductions and open doors should not be underestimated. Where a business has no track record, entrepreneurs are often judged on the quality of their professional team so take time to shop around and find the right team for you.

6. Not protecting your crown jewels

It is surprising how often this ‘basic’ is overlooked, but the value of the business will be depend on the value of its assets. So protect them. If the business is reliant on intellectual property rights, register them. If it is contract based, document those contracts. If the information is reliant on information, make sure it is not released without robust non-disclosure agreements being put in place, and if it is dependent on key employees or consultants, ring fence their terms of employment with suitable non-complete obligations. Without these, the faster the business grows, the faster its inherent value will be eroded.

7. Using the wrong incentives

Don’t give away the equity too early or too lightly. Shareholders, however small a stake, acquire additional protections at law, and (if not structured correctly) can cause a real headache in terms of administration and decision making. If you do give away equity, consider creating a new class of share with limited voting rights, and consider ‘good leaver/bad leaver’ provisions that oblige an existing shareholder to sell his shares when he leaves, with the price he receives varying depending on the circumstances of exit. As an alternative to allotting shares immediately, why not grant options the exercise of which is dependent on performance related targets. Phantom share schemes can be a useful alternative, as they reward an employee by tracking the increase in value of the business without diluting the equity. There are a large number of alternatives, many of which have tax consequences, so take proper advice to make the most of these and avoid making a costly mistake.

8. Having unrealistic objectives

It is always tempting to present rosy figures to potential investors, but don’t promise more than you can achieve. Excessively optimistic statements can erode trust and credibility, and making a statement you know you can’t deliver is fraud. Investors can (and do) sue on that basis.

9. Getting lost in the here and now

Getting that first development, or that first contract, underway is critical and can be all consuming, but it mustn’t allow you to take your eye off the pipeline three, six or nine months down the line. If you don’t have resources, and cash flow, in place to fulfil the commitment, the business will fail. Run conservative projections, and keep an immaculate trail of outgoings at all times. If finance isn’t your forte then don’t be too proud to bring in someone with suitable expertise who can help you keep up to date and pre-empt issues before they arise.

10. Leaving the legals to the last minute

It’s really tempting when finance is tight to see lawyers’ fees as an unnecessary cost to be deferred. That view can often be short-sighted, as issues that would have taken an hour to address at the outset can take several days to unpick later on. Lawyers don’t have to cost the earth, and finding the right adviser at the outset will pay dividends in the long run.