Commercial

Are you a Start-up Founder or thinking of starting a business with friends or others? Here is a Checklist of legal documents that are critical to you and your business.

Question: What is the most common mistake that start-up founders make during early growth?

Answer: Not establishing a strong legal structure from the start.

While it’s tempting to step into the market and change the world, it is crucial that founders of a start-up pause and cover their legal bases to avoid needless and preventable legal battles. Or even losing their business altogether.

Below, we have highlighted twelve (12) legal documents that founders need to put in place to safeguard their businesses from sly co-founders or investors.

1. Term Sheets (aka “Heads of Terms” or “Heads of Agreement”)

A Term Sheet is a preliminary document that defines the type of investment that the investor wishes to engage in, the different classes of shares and their benefits, proposed capitalisation, and key legal and financial terms. It can be referred to as your starting gear.

Ideally, the execution of the term sheet by a potential investor is an indication that the investor is serious about investing in your company. It conveys the interest of the investor to invest in your company and your willingness to accept their investment.

However, a Term Sheet is not a legally binding document in itself as the investor can walk away from the intention to invest unless a Share Subscription Agreement (or an Investment Agreement) and subsequently, a Shareholders Agreement, are signed.  

The Term Sheet is essentially a roadmap that guides an investor in determining whether or not to make an investment in the business.

2. Share Subscription Agreement

The simplest explanation for what a Share Subscription Agreement is this: it is a promise by a potential investor (referred to as “subscriber”), to invests in a company, in an agreed number of instalments, in return for the company giving a certain number of shares at a certain price to the subscriber, such that the investor becomes a shareholder. 

The Share Subscription Agreement will set out the number of shares to be issued to the subscriber or shareholder, and the order and timing by which funds will be advanced by the subscriber or shareholder to the company.

3. Investment Agreement

Sometimes an investor may require that a legal document referred to as an Investment Agreement be signed in place of the Share Subscription Agreement.

So, what is an Investment Agreement, one would ask?

An Investment Agreement is a contract to formalize a transaction between an investor and a company whereby the investor invests in the company by giving funds to the company either in form of a loan (debt) or getting shares equivalent to his funds (equity) or both debt and equity. Where the investor gets shares in the company, he/she acquires an ownership interest in a company. This document sets out the terms and conditions of the investment transaction.

In simple terms, an Investment Agreement allows founders and their company to obtain capital from investors, and in exchange for the capital received, they give away a percentage of the ownership of the company to the investor.

4. Shareholders Agreement

A Shareholders Agreement is a critical document for any start-up to have. It is one of the key governance documents for the company. It is a private and confidential document that defines the relationship between the company, the founder-shareholders themselves and between the founders and the investors when investors come in to invest in the company.

It sets out the rights and duties of the shareholders in the company. It also sets out the framework for decision making in the company. Lastly, it provides a mechanism for the division of dividends, for exits by the shareholders among other critical issues. Simply put, it contains information on who owns what shares in the business and what is required of them.

If there is one document that is an absolute requirement for founders to have in place even before investors come in, it is the Shareholders Agreement. Also, since the Shareholders Agreements affects what rights investors will have when they become shareholders of the company, investors will be interested in what is contained in them.

5. Founders Agreement

If your start-up has more than one founder, it is highly beneficial that the founders have a written and signed Founders Agreement in place to govern their business relationship. Ideally, this Founders Agreement should be signed even before the start-up is registered.

The Founders Agreement stipulates the rights, responsibilities, liabilities, and obligations of each founder. It also generally covers matters that may not be addressed by the start-up’s Memorandum and Articles of Association such as, the strategy of the business; funding of the business; the ownership structure; roles of the founders; contribution of each founder (whether money, skills, intellectual property, physical effort etc.); the transfer of ownership; decision making and dispute resolution; confidentiality; representations and warranties.

6. Intellectual Property Assignment Agreement (or Licencing Agreement)

Intellectual property is broadly defined as something which is created, invented or designed as a result of one’s creativity, thus bestowing upon him or her trademark, copyright or patent rights that preclude others from using it without permission.

It is critical that from the founding phase of the start-up to the successful set up of its operations, the intellectual property rights of the business are secured and safeguarded.

The Intellectual Property Assignment Agreement facilitates the transfer of intellectual property rights that are critical to the start-up and are possessed by the founders, from them to the business. It transfers the ownership of intellectual property rights of an individual to the company (before one becomes a director, employee, or consultant in the company). The individual will no longer have any right to the intellectual property assigned.

On the other hand, a Licencing Agreement will allow crucial intellectual property rights to be licenced by the founders to the start-up.

It is important to note that these two agreements, discussed here allow founders to maintain ownership of their intellectual property rights while permitting the company to benefit from the rights.

It is also important that the founders register all their intellectual property (name of the business, name of the product or service, the software, the design of the website, design of the product etc.), be it as trademarks, copyright, patents or industrial design, with the relevant statutory bodies, as soon as possible to protect them.

7. Non-Disclosure Agreement (aka Confidentiality Agreement)

Founders get asked to share important non-public information all the time by potential investors, potential customers, among others. Such information they may be asked may include disclosing information proving why or how their product or service is unique, trading data, growth plans, key hires among other commercially sensitive information. Such information might be needed by the investors to help them determine whether to invest in the company or not.

A Non-Disclosure Agreement (also known in common parlance by its acronym “NDA”) is a legal “Great Wall” used to protect the trade secrets and confidential information of a business from third parties.

Basically, a Confidentiality Agreement prevents a person who has been granted access to privileged or confidential information of the business from divulging it to others for a limited or unlimited period.

Every business has some information and trade secrets that give it a competitive advantage in the market, which information must be kept confidential.

An NDA will protect such vital information from being shared, used or disseminated to the detriment of the owner of the information.

8. Time & Performance Share Option Agreement (and Share Vesting Agreement)

The Time and Performance Share Option Agreement is used in two ways. One way is to reward an exemplary employee by giving them the right to buy shares in the company at a specified price. A company can use it as a motivational tool to motivate its employees especially at an early stage when it does not have enough money to pay them well but really needs their skills to grow.

Offering such early-stage employees share option rights will motivate, and also serve as compensation for accepting a lower salary or the risk of working for a start-up business. The employees can later cash in the shares with a huge premium when the company is acquired or listed with a high valuation.

The other way a Time and Performance Share Option Agreement can be used is where the founders want to onboard a new co-founder who is bringing in non-monetary capital (or contribution). Such non-monetary capital can be, their time, or specialised IT skills (for a tech or tech-reliant start-up), or great management skills, or intellectual property or whatever skills or talent that the current founders do not have and are deemed critical to the company.

The performance criteria that trigger the grant of the options could nonetheless vary depending on the company.

9. Convertible Note Agreement

A Convertible Note Agreement is a legal document used where an investor has given a short-term loan to a start-up which loan may be converted into shares of the company on a specified date and upon certain agreed conditions being met.  

It is also known as “Convertible Note” or “Convertible Loan Note”.

Investment in a company via a Convertible Loan Note takes the form of a loan (short-term debt) to the company (at the onset) and later on the loan is converted into equity.

Convertible Notes can be secured (with the start-up assets such as shares, or current and future invoices or revenues, or intellectual property being collateral), or be unsecured.

10. Employment Agreement

Many start-ups are basically “fly by the seat of the pants” operations where the founders double up as founders, managers, accountants, salespersons etc. Many of them start life with perhaps one or two or three employees with the founders putting all of their focus on getting the start-up off the ground, on getting sales, or drumming publicity on their products and services.

As such, most early-stage start-ups do not have written employment contracts for their people. While this is understandable from a commercial point of view, in the eyes of the law, this is illegal. The founders should ensure that their employees have written contracts (even Fixed-Term Employment Agreement for short term employment which can be renewed or extended would suffice) to reduce the risk of getting into trouble with the labour laws.

The Employment Agreement will govern the relationship between the company and its employees and provide the terms of engagement of the employees and their deliverables. It will set out among others, the employment term, duties of the employee, salary and benefits available to the employee, working hours, the circumstances that will result in termination and any dispute resolution mechanisms available to the employer and the employee, and the job description, sick leave, maternity, paternity and adoptive leave.

Three (3) critical reasons why a start-up should have in place Employment Agreements

Employment Agreements of a start-up must have:

(a) confidentiality clauses to stop the employee from taking the start-up’s confidential information and trade secrets to their next employee or their own business;

(b) restraint clauses to stop the employee from enticing other employees to join them in their new workplace – who might be a competitor of the start-up; or joining a competitor of the start-up, for one year; and

(c) intellectual-property clauses that will enable the employer to claim ownership of any intellectual property created by an employee while the employee is on the payroll of the company.

11. Commercial Agreements (with Agents, Contractors and Suppliers)

If the start-up intends to engage sales agents to generate leads and close sales on a commission basis, then it should have Agency Agreements drawn up and signed. In law and taxation, agents are different from employees in that they are independent persons who determine how, where and when they will work and are responsible for paying their own taxes and statutory contributions to NHIF and NSSF.

Where a start-up relies on a supplier or service provider to provide or supply products or services to it which are integral to its business, then it ought to protect itself. One way to do this is to draw up a Service Level Agreement (“SLA”) between the company and the supplier or service provider.

The SLA will specify the targets and performance standards agreed by the supplier or service provider and expected by the start-up. It will help to define and secure your business-supplier relationship, it will determine the major responsibilities of the parties. It will generally cover such issues as problem management, compensation, warranties and remedies, resolution of disputes and legal compliance.

The SLA, the Agency Agreement and the Consultancy Agreement will be extremely useful if legal proceedings ensue.

12. Agreements With Customers (Terms and Conditions, Terms of Use, Privacy Policy)

Every start-up needs a written contract between it and its customers. The written contract will take different forms depending on the industry that the start-up is operating. A tech-based or online start-up will have a “Terms and Conditions” or “Terms of Use” on its website or mobile app. Others will have a Letter of Engagement or plain old written contract among others. A Privacy Policy also falls under the category of contracts between businesses and customers.

What is of importance is that all start-ups, as well as established businesses, must have a document, written or digital, that will govern their relationship with their customers or end-users.

In the case of “Terms and Conditions” or “Terms of Use,” the customers or users will have to agree or accept or decline to accept the terms and conditions before accessing the website or the service. The “Terms and Conditions” will inform the customers or the users of their rights and duties and sets conditions to use the website or the service.

A Privacy Policy (usually placed on a company’s website) on the other hand will tell the customer or the user how the company will collect and use their personal information. It establishes the guidelines the company must follow when collecting and using information from users.

The founders are advised that the information provided by customers is also subject to Data Protection laws and start-ups have to be careful and adhere to the provisions under the Data Protection Act of Kenya when handling customers’ information.

What next?

Quite a number of these documents are complex, and a founder will benefit immensely from seeking specialised legal advice before committing themselves to sign the documents.

You can contact vonyango@otadvocates.co.ke or etarus@otadvocates.co.ke for legal advice on any of the above and any legal issues concerning your business, whether a start-up or an established company.

Check out our experience in Private Equity, and Mergers and Acquisitions practice here.