HomeCorporate LawThe Common Legal Mistakes Made by Start-Ups

The Common Legal Mistakes Made by Start-Ups

In order to thoroughly comprehend the daily complexities and legal tangle that startups are witnessing, let us primarily understand the legal connotation of startups. In India, the term ‘startup’ is defined by the Department for Promotion of Industry and Internal Trade (DPIIT)which is regulated by the Ministry of Commerce and Industry. In accordance with the definition provided by DPIIT, a startup shall be eligible for ‘DPIIT startup recognition’ if it meets the understated criteria:

Type of company

The company should be incorporated as a Private Limited company, a Registered Partnership Firm, or a Limited Liability Partnership (LLP).

Age of the company

The period of existence and operations of the company should not exceed 10 years from the Date of Incorporation.

Annual Turnover of the company

The company should have an annual turnover not exceeding Rs. 100 crores for any of the financial years since its incorporation.

Originality of the existence of the company

It is imperative that the company should not have been formed by splitting up or reconstructing an already existing company.

Creation of Wealth and Employment

The company shall advance towards the development and improvement of a product, process/es, or service/es and/or have a scalable business model with high potentiality for the creation of capital and employment opportunities.

Eligibility for DPIIT Startup Recognition

Startups face numerous legal difficulties and pitfalls that make it arduous for them to thrive in the ever-increasing competitive world, including but not limited to restricted influx of financial resources, complex code of practices, limited access to information and professional guidance attributable to the inadequate cash inflow, absence of legal recognition of Intellectual Property (IP) and negligence of taxation and other compliances.

Further, we shall now address the common legal hurdles that startups encounter and the hands-on solutions for avoiding legal mistakes as a startup:

Negligence in drafting comprehensive agreements

Incorporation documents including but not limited to Founder’s Agreement, Shareholder’s Agreement, Memorandum of Association, and Articles of Association, form the foundation of any business structure. It is vital for any business organization to have a robust foundation in order to flourish in the contemporary business world.

However, the limited access to knowledge and professional services, and leniency on the part of the founder/s to design comprehensive and well-defined agreements, steer the company towards the mesh of legal quarrels.

In order to avert the startup legal risks, startups shall follow the below-mentioned guidelines:

  1. Appoint an affordable legal professional to assist with the basic drafts of the documents (preferably a professional with less experience to avert the concern of limited cash inflow);
  2. Additionally, create a checklist of mandatory clauses of the requisite agreements to contain internal and external disputes.

Selection of a suitable business structure

Not all startups and their founders are cognizant of the various kinds of business structures. It is imperative for startups to thoroughly understand the various business structures, the relevant compliances, and tax liabilities, amongst other things. The numerous legal structures available for startups are private Companies, Partnership firms, or, LLPs, amongst others.

In order to ensure an appropriate legal business structure is being selected by the founders for their startup, the following steps can be followed:

  1. Solely conduct preliminary research on the kinds of business structures;
  2. Analyze the appropriate business structure for your startup basis the nature of business activities, capital, scale of operations, stability, degree of liability, division of investment and profits, etc.;
  • Conduct thorough research on the compliances, tax liability, etc. of the shortlisted business structure/s;
  1. Analyze the procedure and flexibility to convert the selected business structure to another type/s; and
  2. Lastly, understand the incorporation procedure and preliminary compliances of the selected business structure.

Ambiguous Founders’ Agreements

Founders’Agreement is a primary legal document that outlines the rights, obligations, scope of power, investment, etc. of the Founders. An ambiguous Founders Agreement can prompt disagreements about roles, responsibilities, apportionment of equity, capital investment, exit strategies, vesting timelines, confidentiality, and IP decision-making power, amongst the founders resulting in time-consuming court disputes.

The founders should undertake the following plan of action to avoid the aforesaid repercussions:

  1. Convene several rounds of discussion before concluding and finalizing the founder’s agreement and other agreements;
  2. Engage and procure professional legal assistance;
  • Define the roles, responsibilities, and obligations of the founders;
  1. Outline alternative dispute resolution procedures like mediation, arbitration, etc. to avoid resorting to court cases; and
  2. Focus on clauses pertaining to ownership, intellectual property, and related rights in the agreement/s.

Failure to obtain adequate professional legal assistance

Generally, startups employ their funds in various facets of their business, however, they fail to engage their funds in legal assistance. Typically, the founders believe that the incorporation of any business does not require experienced legal counselors. It is essential to procure legal guidance at the beginning and when disputes are erratic.

Obtaining professional guidance is as indispensable as devising a business plan. New organizations should manage numerous issues that will authentically affect the goodwill of the company, including but not limited to safeguarding intellectual property, incorporation as a legal entity, and drafting incorporation documents. Procuring legal advice for incorporation of your startup can be exceptionally gainful, for instance: drafting well-grounded agreements, professional legal advice, negotiation skills, etc.

Absence of Shareholder Agreements

The absence of Shareholder Agreements is a common legal error in startups. Shareholder Agreement is the fundamental document that defines the right, obligations, etc. of shareholders in startups wherein there are several shareholders and investors. This agreement is crucial for providing lucidity and safeguarding the interests of all the parties involved. Startups encounter various challenges due to the lack of these agreements, for instance:

  1. Decision-making procedures may be abstruse in the absence of a formal written agreement, resulting in inefficiencies and conflicts;
  2. In the absence of a shareholder agreement, it may be unclear how ownership percentages and voting rights are split among shareholders, resulting in arguments over decision-making and control;
  • Shareholders may disagree on important matters, and the lack of a formal agreement can make it difficult to settle disputes or overcome disagreements;
  1. In the absence of a shareholder agreement, there may be disagreements about how dividends or profits should be dispersed among shareholders;
  2. This agreement is imperative as it includes confidentiality and non-compete terms that protect critical corporate information and prohibit shareholders from competing with the business;

Companies can consider the following legal tips for startups to sail through the aforesaid issues and avoid hampering their business operations:

  1. Procure assistance from a knowledgeable attorney to create a comprehensive shareholder agreement that addresses all important areas of share ownership, governance, and rights;
  2. Ensure that the agreement addresses critical problems such as voting rights, ownership percentages, decision-making, share transfer, and dispute resolution processes;
  • Include provisions for exit possibilities including buyback options, etc.;
  1. Regularly review and update the shareholder agreement when the company evolves, new investors join, or the business plan gets altered.

Ignorance of regulatory compliances

Generally, industries are intensely regulated, and it is fundamental for startups to be vigilant about and conform to the requisite startup legal compliances cum regulatory guidelines to avoid penalties, legal challenges, and business disruptions, and maintain a proficient compliance track record. For instance, being wary of the licenses, taxation, data protection, privacy, employment laws, health and safety regulations, environment clearances, Intellectual Property laws, advertising, marketing, etc.

In order to steer clear of the consequences of disregarding regulatory compliances, new startups ought to put invest time and resources in understanding and adhering to the applicable regulations and guidelines.

Failure to maintain precise records and documents

Appropriate documentation and maintenance of records are fundamental to ensure transparency, uphold the goodwill of the company, and uplift the interests of the company. Neglecting to keep precise and exhaustive records can prompt different issues and justifiable difficulties in the longer run. The outcomes of laxity in maintaining records include:

  1. The weakened position of the startups;
  2. Susceptibility to legal disputes;
  • Contractual disputes;
  1. Altered confidence of investors;
  2. Authenticity issues during Due Diligence and Audits;

In order to prevent the hurdles of not maintaining appropriate documentation and records, startups must implement robust record-keeping practices from the start. For instance, maintaining financial records, legal agreements, corporate documents, employment records, IP documentation, and any other relevant business-related information.

Startups can employ document management systems that can help restructure the documentation process and ensure the records and documents are protected and easily available whenever required. In addition, regular review and update of documentation is essential to stay updated with the ever-changing laws and regulatory compliances.

Negligence in obtaining requisite licenses and permits

Another legal mistake of startups is the failure to obtain the requisite licenses, permits, and regulatory approval/s for the company. This negligence on the part of the startups leads to damage in goodwill, shutdown of the company in certain cases, excessive penalties and fines, loss of IP protection, limited investment and financial opportunities, breach of contract, limited market expansion, etc.

The startup’s legal advice is to conduct an extensive study and determine all licenses and permits required for the industry, location, and operations.

Limited understanding of Tax liability

Startups have the privilege of getting certain tax exemptions in the initial years of business operations. Accordingly, it is vital for startups to meticulously understand the tax liabilities, tax exemptions, and breaks that the company can avail and benefit from.

However, it is widely observed that due to lack of resources and knowledge, startups fail to avail the benefits and timely comply with the tax regulations thereby leading to loss of resources and invitation to tax compliance disputes. For instance, incorrect tax classification, inadequate tax planning, missed tax deadlines, inaccurate classification of tax, negligence to collect and abate sales tax, etc.

Failure to comply with data privacy and data protection regulations

Compliance with data privacy and data protection regulatory guidelines is of utmost importance for all companies irrespective of their size, age, and business type. Data privacy and data protection have become a sensitive facet of business in the contemporary globalized world owing to the increase in awareness amongst consumers and increased vigilance by the regulatory authorities.

Negligence to comply with the relevant rules and regulations paves the path for privacy breaches, disbelief in the brand/company amongst the consumers, disparaged brand reputation, and legal disputes, amongst other things. Thus, startups shall take extra steps towards strengthening their compliance with the aforesaid rules and uphold their sensitivity towards consumers and their privacy.

Non-protection of Intellectual Property (IP)

IP is a comprehensive term used for the intangible assets of an individual or company. Alternatively, it means creations of mind or intellect including Trademarks, Copyrights, Patents, Trade Secrets, Logos, Designs, etc. which provide companies an economic advantage in the global world.

Typically, startups fail to understand the importance of the protection of IP in the contemporary globalized world which leads to weakened brand recognition, regular infringement claims, limited scope of business, inability to attract investors, and complications in licensing due to non-recognition of IP.

In order to strengthen the IP portfolio of the company, startups should undertake the following steps:

  1. Identify and create an IP portfolio;
  2. Engage IP lawyers;
  • Incorporate confidentiality agreements and rules;
  1. Educate the employees;
  2. Research on international protection of IP.

Conclusion

A brief insight into the legal difficulties faced by startups aids in a better understanding of the challenges, the consequences, and the proactive steps startups can undertake to safeguard the time, financial, and other resources of the company in the long haul. Concludingly, startups are highly advised by experienced practitioners and regulatory authorities that they seek legal assistance and support at the very beginning of their operations. Professional assistance, vigilance, and proactive approach of the startups shall aid the business in expanding the scope of business and in alleviating the anticipated risks that may arise due to con-compliances and the easy-going outlook of the startups.

 

Legal Geekz
Legal Geekz
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