Take Time to Lay the Right Legal Foundation

Take Time to Lay the Right Legal Foundation

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Working at our practice can be very rewarding. Many of our clients are innovative start-ups and it is wonderful to see their entrepreneurial ideas in action. However, we always advise business that are starting out to lay the necessary legal foundations from the get go – failing to do so could end up costing them dearly in the long run.

A good starting point would be the drafting of thorough founding agreement(s), including a memorandum of incorporation and/or shareholders’ agreement. This often gets put off and delayed because it’s fairly tedious work, but it’s absolutely critical.

The memorandum of incorporation and/or the shareholders’ agreements are the documents that will likely regulate the main aspects of your relationship with the company and that of your fellow shareholders. There are no basic legal obligations attached to being a shareholder, generally speaking, so whatever you require of each other should be agreed and recorded in writing.

Getting the basics right

Founders all start out as optimistic and enthusiastic about their business and their partners – and their shares aren’t worth anything, so all of them are on equal footing, splitting the shares without considering the potential future value of such shares. But a few months down the line, those shares start becoming valuable, and some disillusionment sets in.

Perhaps there are founders who feel that they’ve worked harder than others, but the non-performing founder still holds the shares and is fully entitled to enjoy dividends, if any, in addition to the others.  Or perhaps, the founders of a start-up fall out, and one leaves to start a rival company doing very much the same thing.

But he refuses to sell his shares in the first company, entitling him to continue enjoying the rights attached to the shares in the original company while competing with the original company.

 

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These scenarios aren’t far-fetched – in fact, they are quite common – which is why shareholders in start-ups can’t afford to be passive. It’s important to thrash out what is expected of every single party involved – whether it’s funding, skills or expertise – as well as reasonably objective criteria for deciding whether those obligations were met.

Answering the right questions

Our advice would be to sit down and agree to the value of each contribution before you start. Ask important questions:

  • How much is my capital investment worth?
  • What is the value of any person providing expertise? How is this to be compensated?
  • What is the value of the services provided by any person running the daily operations? How is this to be compensated?
  • What will happen if someone does not meet their obligations?
  • What will happen if someone wishes to sell?
  • How will we value the firm?
  • What will the payment terms be?
  • What happens if there is no cash to pay sellers out with?

These are the questions that will be asked sooner or later and to avoid a lengthy legal battle, it’s best to answer them beforehand.

These legal documents rarely feature high on the priority list when you are busy setting up your business. But it is almost certainly guaranteed to become an issue at some point. Take the time to lay the right legal foundation before building your company – or it may come tumbling down.

Jody Doyle
Jody Doyle completed a BA LLB at the University of Cape Town and thereafter worked at Edward Nathan Sonnenbergs Inc., during which time he specialised in corporate and commercial law, with a particular focus on mergers and acquisitions and corporate finance. He subsequently joined Dommisse Attorneys, a niche corporate and commercial firm, and has developed an advisory practice focussed primarily on assisting tech-based startup companies.