Legal Briefs, conversations about the tech and startup world with Máire Cunningham, a partner at Beauchamps Solicitors.
Tell us about company ownership and the difference between a person and the company they own?
The most important thing to understand is that a company is an entirely separate legal person from you, the owner. If you set up a company called Irina Limited, you Irina could have a number of relationships with the company. You could be a director and employee, as well as a shareholder; you could be a licensor of technology or consultant. If you lend money to the enterprise, you are its creditor. If the company doesn’t repay that loan when it should, you could sue it to get your money back. As an employee, you can bring an action against the company if it breaches employment law. By the same token, the company could sue you if you, violated a noncompete agreement.
It is critical to understand these different relationships and get the right agreements in place from the beginning. While there might be no issues in the early days, relationships can change, and a founder may end up in dispute with the company that they set up – things move on, ownership changes, people go in different directions.
Which are the most important aspects of ownership that founders should be aware of?
There are two levels to consider – first who owns the company and then what does the company own. For tech startups, the key asset is usually intellectual property (IP), and the company should be clear about who owns it. Let’s use an example: you have built a product based on your idea, and you have set up Irina Limited to develop it. You own 100% of the company. Who owns the IP, though, you or the company? Generally, a company owns all IP developed by its employees in the course of employment. However, if a contractor created the IP, unless there is an agreement transferring it to the company, it belongs to the contractor. As the founder, the IP you had developed before the company was set up, usually belongs to you. If you do not want to transfer ownership of IP outright, then you can license the technology to your company and create an income stream for yourself. Again, that’s a case in point of how the company is separate from you.
What do investors prefer when it comes to ownership of IP?
Most investors will require that the company owns the IP. It is safer from the investor point of view because even if you are no longer around, the IP stays with the company. The company can exploit and protect the IP as it sees fit – registering trademarks in other jurisdictions or taking action against someone who is infringing it. Having said that, the company does not have to own the IP to have the right to use it. In a couple of startups I work with, the founders still own certain intellectual property rights and have licensed them on an exclusive basis. I’ve also worked with founders who have licensed the intellectual property for use in a particular field. Their investors fund that particular use, leaving the founder free to use the IP in other instances.
Would an investor say no to an investment because the technology is licensed rather than owned?
Not necessarily, but they would look at the terms of the license – whether or not it’s exclusive, what the limits on its use are, circumstances for termination and possible effects on valuations. I think from an investor’s point of view ownership is always going to be more attractive than a licensing arrangement.
And from a founder perspective?
Licensing may seem more attractive because even if the company were to fail, you would still own the IP. However, you have to consider the impact on the value of your shares in the company and its ability to raise funds. If you have co-founders, it would be in your mutual interest that you each transfer the IP to the company. Regardless if the IP is licensed or transferred outright, it is important that ownership is properly documented. You want to avoid problems down the line: if a disgruntled founder was to leave and set up in competition or look to be paid a substantial sum for IP that should have been transferred to the company. We have seen disputes around ownership of IP which only became an issue when a company became very successful. It is best to get this sorted out at the beginning. It does not require a complex document, but it is worth getting legal advice on it.
What is important to look out for in relationship to company ownership and shares?
There has to be certainty on who owns what shares or who has a right to get shares and on what basis. At the very beginning, if there is more than one founder, they have to agree on the equity split between them. In agreeing such a split, they should also think about how it might change if circumstances change – what should happen to a founder’s shares if they leave the company after six months? It is also important in the early days to not give equity away too easily. Once the company takes on external investment, your ownership is invariably diluted. Employee share incentive arrangements will also dilute your stake. It’s a balance: a small stake in an extremely valuable company is worth a lot more than 100% of a company with no value.
What about giving away equity in exchange for advice?
It’s important to consider all options before giving an equity stake away in exchange for advice or services that you can pay for instead, particularly if there are a number of providers in the market. Naturally, there are circumstances where it makes sense but think about the long-term benefit to the company and the basis on which it is issuing the shares. Is it in recognition of something done or is there an expectation of further work? Should the shares be subject to reverse vesting or buyback? Should the consultant hold the shares in his name or should they be held by a founder as his nominee? I have worked with many founders who regretted giving shares to consultants and advisers in the very early days. It seems to be more of an issue for sole founders, which itself might be telling.
Aside from IP, what else is important to remember regarding the separate entities of the person and the company?
In a startup, the founders are usually directors of the company. Under company law, the company must take extra care before it enters into a contract with a director or a person connected with a director. For example, if a director makes a loan to the company, it must be documented as a loan, or otherwise, it is presumed (until the contrary is proven) to be a gift. If no interest rate is recorded, the loan is presumed to be interest-free. It doesn’t have to be a long, complicated agreement, but it does need to at least set out the key terms – the amount of the loan, when it is due and what, if any, interest is payable. A company generally cannot make a loan to a director or a person connected with a director (which would include another company controlled by such director), but there are some exceptions. There are consequences for the company and directors if an unlawful loan is made to a director or connected person.
Does that apply to loans only or does it cover other forms of transactions as well?
There are also laws around other kinds of transactions such as quasi-loans, guarantees, credit transactions or substantial property transactions. IP could be a substantial property transaction that raises a red flag and requires a shareholder approval.
Sounds like it’s important to understand the legal relationships and document them well?
Yes, and it is the foundation for good corporate governance. Putting the appropriate agreements in place from the beginning will reduce the risk of issues arising down the line and smooth the due diligence process on an investment round or sale.