MICHAEL DRYSDALE suggests some practical steps for startups that can provide solid building blocks for the business and help secure investment
Standardise templates and manage records
It isn’t always possible to contract on your own terms but, when you can, having some well-drafted standard templates can make a big difference – examples of agreements that work well here include non-disclosure agreements, employment contracts and consultancy agreements.
Starting from the same template helps to ensure consistency, minimises preparation and review time, and helps to keep costs to a minimum. Storing signed versions of agreements as you go will save a lot of time later, especially when it comes to populating your first data room for an investment, and using an electronic signing platform for this will help.
Own and protect intellectual property
After people, IP is often the most important asset of any startup and fundamental to value.
The position on ownership of IP created by employees is generally straightforward (in the UK, IP created by an employee in the course of their employment belongs to their employer), but when engaging contractors, consultants or other service providers to create IP, those parties will own the IP by default, and it is therefore necessary to make sure that ownership of the IP is transferred (assigned) to the company. This can be done in the relevant contract or by means of a separate agreement.
Some IP rights arise automatically in the UK, such as copyright, while other forms of IP require to be registered, for example patents, trade marks and domain names. All registered IP should be in the name of the company.
If considering applying for a patent to protect an invention, then it is important that any disclosure of the invention is limited and made subject to confidentiality obligations, as putting the information into the public domain could invalidate any subsequent application.
IP is a complex area and so it is not surprising that issues can arise or be picked up as part of IP audits or due diligence. Addressing issues proactively is usually better than facing a last-minute scramble to get the IP rights into a company so that the investment can happen.
Incentivise employees
A startup needs to find ways to attract in-demand candidates and retain skilled employees and it is unlikely to be able to compete with large organisations on salary alone.
Once a company has any kind of value, allotting shares to directors or employees can trigger tax consequences unless full value is paid for the shares. There are ways to address this, for example with growth shares, but many startups prefer Enterprise Management Incentive (EMI) options
EMI options offer a tax-advantaged way to grant employees a right to acquire shares and can be tailored so that exercise of the option is only allowed in certain circumstances or when certain conditions are met. The simple approach is “exit only” EMI options, typically exercisable on a share sale, asset sale or listing only. If an employee leaves, then their EMI option can be made to lapse.
To be eligible for EMI options, an employee must work at least 25 hours per week for the company or, if less than that, at least 75% of their working time for the company. A valuation should be agreed with HM Revenue & Customs as part of the process (getting advice from the company’s accountant or tax adviser is worthwhile), and the exercise price set by reference to that valuation to ensure that the tax advantages are obtained. The grant of EMI options must also be notified to HMRC online within 92 days.
While there is some cost and administrative overhead involved in EMI options, the benefits to the company and option holders can be significant. Also, investors are usually in favour of EMI options too, so long as there is an overall limit on how many EMI options can be granted.
Give yourself time to raise investment and find the right investors
Not every startup is interested in raising investment, but for those that are, the process can sometimes take longer than anticipated. So allowing enough time to raise investment is important.
We are seeing a trend of new clients who have raised initial investment, often from friends and family, using online platforms, turning to us for more specific legal advice as their funding requirements become more complex . These platforms work well where the founders and the company are able to set the terms, but less so when the company is looking for a larger amount of funding and a term sheet is received from investors who invest on their own terms.
While term sheets are usually expressed to be non-binding apart from certain clauses, it is important to review all of the terms and negotiate where necessary, because those terms will form the basis for the investment. Any terms which are unclear must be clarified.
Of course valuation is a key part of any offer of investment, but it may not be the be all and end all. Where a startup is in the fortunate position of having two of more offers, we have seen cases where a lower valuation is accepted because the other terms were considered to be more favourable (leaver provisions being a common sticking point) or because the investor concerned was considered to be a better fit for the company.
Many investors will be looking for Enterprise Investment Scheme (EIS) relief (or Seed Enterprise Investment Scheme (SEIS) relief if the company is at a very early stage). SEIS relief and EIS relief are both complicated, but having a general understanding of them, the process involved and why they are important to investors can really help when pitching or discussing investment.
Startups (as well as companies of all sizes) also need to be aware of the National Security and Investment Act 2021. The Act allows the UK Government to call-in transactions relating to certain entities or assets that could harm the UK’s national security.
Regulations made under the Act identify entities carrying on certain activities in 17 sensitive sectors: Advanced Materials, Advanced Robotics, Artificial Intelligence, Civil Nuclear, Communications, Computing Hardware, Critical Suppliers to Government, Cryptographic Authentication, Data Infrastructure, Defence, Energy, Military and Dual-Use, Quantum Technologies, Satellite and Space Technologies, Suppliers to the Emergency Services, Synthetic Biology, and Transport.
We are just beginning to see the effect of this Act in practice, but early indications suggest a major effect on investments and acquisitions given the breadth of activities covered and the consequences of not making a mandatory notification where required (which is a criminal offence, and the transaction will be void). While the Act places the responsibility on the investor/acquirer to determine if a mandatory notification is required, experience so far suggests that this is going to require detailed input from the company itself.
Startups are a key driver of the economy and, although it may seem an unnecessary distraction from the task of growing the business, it is important that these building blocks are put in place as soon as possible. As always, it is never too early to take the best advice and those advisers used to guiding startups will always be sensitive of the need to minimise cost to the company.
Vialex was itself a startup a little over a decade ago, and we remain excited by the many startups that we see and we are committed to supporting that entrepreneurial activity.
Michael Drysdale, a senior legal adviser at Vialex and a specialist in startup companies
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