Many founders jump into building a startup without considering important issues like contracts and agreements. Legal issues never seem to be a problem until they become one, and resolving conflicts become onerous and complex, with founders themselves facing possible liabilities.
So what are the key contracts and agreements that a new founder should look out for when starting up? What are the consequences of a poorly drafted agreement? And when should you hire a lawyer?
A shareholder agreement governs the relationship between shareholders. According to Samuel and Sean, “You [need to] be clear on the following points:
- Reserved matters (i.e. which matters of the company should be subject to shareholders’ approval or directors’ approval),
- Who should be on the board of directors and the quorum and approval thresholds,
- Veto rights for particular shareholders on certain important matters,
- Tag-along rights,
- Preemption rights,
- Drag-along rights,
- Deadlock provisions, and
- Dividends (the division of profits).”
According to Ted, a shareholders agreement is also known as a partnership or founders agreement. He adds that the agreement should also include the parties’ duties, decision-making powers, share issuance, share transfer restrictions, and liquidation rights.
Not having a shareholders agreement leads to many complications. As an example, he says:
“There are also common issues with [sequentially] unwanted persons on the company’s cap table who can potentially block decisions of the company. Always ensure that third parties like key employees are offered share options rather than straight up equity. People do fall out with each other after they start to work with each other, so treat share options like a trial period of dating before deciding to marry the person. Because there is no law to force a shareholder to sell his/her shares.”
Yingyu, on the other hand, highlights the failure of not having a properly written shareholder agreement. According to her:
“If the shareholder agreement is not properly drafted, the courts can decide that it has no binding effect. This was the case in Teo Chong Nghee Patrick v Han Cheng Fong  SGCA 29, where the Singapore Court of Appeal decided that a shareholders agreement drafted without legal input and which was riddled with problems was ‘a piece of legal nonsense devoid of any binding effect.’”
An employment contract outlines the rights and responsibilities between an employee and employer. The Ministry of Manpower in Singapore has provided an example for use.
Other than the basic ones, Ted advises that clauses should ensure that the company owns any IP created by the employee to prevent disputes.
According to Samuel and Sean:
“Special care has to be taken with respect to restraint of trade clauses. While [the] law recognizes the commercial importance of restraint of trade clauses, the court will only allow what is absolutely essential to protect the interests of the company. A restraint of trade clause that is drafted too widely will not be enforced. For example, if the employee is only engaged in administrative functions in a fintech company, a restraint of trade clause that prohibits him from being employed in any other fintech company is unlikely to be recognized. It is advised that restraint of trade clauses be bespoke to fit the role of the employee in the particular trade area.”
Despite the limitations, Yingyu still advises a proper non-compete clause, otherwise, the employees who have left a company may join competitors. In addition, companies should also preempt a wrongful dismissal suit. She suggests that the employment contract should state the conditions for termination of employment to prevent any costly lawsuits.
This is a contract which governs the relationship between the company and potential investors. Samuel and Sean do not encourage an overly complicated share structure which can restrict a founding team’s management powers. Instead, they provided simple structures that new entrepreneurs may want to consider.
- If the investors are passive ones, the company may propose different classes of shares, whereby the current management would have super shares (e.g. 10 votes per share), while the investors will have subordinate shares (e.g. one vote per share).
- If the investors are active ones, the company may have a different arrangement such that the voting rights are equal.
- It is also possible that the investors be restricted in their voting rights (i.e. they are able to vote only in relation to certain matters).
Ted adds his view as a founder saying, “Make sure the KPIs are clear, [with clauses on] share issue and share transfer restrictions, vesting schedule, representations, warranties made by the company to the investor, restrictions on the use of funds, [and] conditions on getting the proceeds.”
This contract outlines the confidential material or information that parties agree not to disclose to other third parties. Yingyu cites the main points that a founder should be aware of:
- The scope of the confidentiality obligations and the type of information it should cover.
- Nature of the obligation: A mutual obligation applies to both parties while a unilateral obligation just applies to one party.
Samuel and Sean caution that when the non-disclosure agreement is not properly drafted to apply even after the termination of the working relationship, former employees may use or disseminate sensitive information to the company’s detriment.
This contract governs the relationship between the client and the company in regards to tech platforms.
She adds that in Singapore, a company may find itself liable for breaches under the Personal Data Protection Act for not protecting the personal data of customers. The punishment for a breach may include a fine of up to US$705,000 (or S$1 million). The largest penalty imposed by the PDPC to date is US$35,000.
Constitution of the company
A copy of the model constitutions for companies is found under ACRA.
For Ted, some clauses in the shareholders agreement are sometimes so important that they are enshrined in the constitution.
To him, the main difference between the constitution and a shareholders agreement is “that the shareholders agreement is only enforceable on the parties who signed the agreement and will have to be amended if there are new shareholders. The constitution binds all future shareholders in the company and also requires 75 percent of the general meeting to amend. Basically, the constitution is much more difficult to amend and should be reserved for very important terms that the parties intend to bind future shareholders by.”
IP assignment contract
Ted observes that startups usually start before a legal entity is incorporated and before employment contracts are put in place. As such, the IP that is created will belong to the individual who developed it. The moment the legal entity is incorporated, it would be wise to have all the founders assign all the IP he/she has created for the startup to that legal entity with no strings attached. No investor will invest in the startup if it doesn’t even own or at least have a non-revocable exclusive license to the product it is selling.
Ted warns of the failure to clearly assign IP because it is often the whole value of the startup that the investors invest in. As mentioned, the startup’s position will be weak if someone else (especially if that someone is not part of the startup) owns the IP.
When to use a lawyer
With so many contracts and agreements to look out for, it may seem overwhelming to founders with little to no legal background.
Ted finds that the most simple contracts can be done personally. “Contrary to popular belief, good contracts are straight to the point and written in simple English,” he said. “Furthermore, there is a lot of free legal resources online to guide entrepreneurs as to important terms that should go into the contract and sample clauses to cut and paste.”
Having said that, he highlights two scenarios that require a lawyer:
“Once a third party is a [part] of the agreement, it is best to consult a lawyer. Even if [the] terms are not complex, it is good for the people involved to fully understand the terms they are agreeing to and any present/future implications that those terms would have. This is a good way for the parties involved to understand their position and to avoid any misalignment of interests and understanding.”
Another scenario would be high value or complex contracts:
“You won’t be able to detect whether an important clause is missing from the draft contract if you don’t even know that that particular clause should be included. This is one of the main purposes of lawyers: to tell you what should be included or excluded in the contract (and the reason why). This is especially important if the opposing side (or the opposing counsel) sneakily deleted an unfavorable clause that should be included. As such, for high value (e.g. high monetary amounts/important assets like IP) or complex contracts, it may be penny wise, pound foolish not to hire a lawyer.”
He also highlights the need to get a lawyer who specializes in corporate law.
For Samuel and Sean, drafting a shareholders agreement should involve a lawyer to flush out the necessary points. “It is unlikely that main points can be resolved by using templates,” they note. “These points will be the subject of much negotiations and you should pay attention [in drafting] them clearly, as it involves the management and future direction of your company.”
I’ll use Yingyu’s words to end this article:
“In general, you should engage a lawyer as early as possible because legal costs would only increase as the project or matter progresses. A lawyer would be able to identify the relevant legal issues at an earlier stage, saving you trouble in the future. A lawyer can ensure that the contract is tailored to the needs of your company.”
This article is for information purposes only and should not be considered as legal advice. Readers should consult legal professionals on their specific needs.
This is the sixteenth article of the “Startup Advisory Clinic” series.
Converted from Singapore dollars. Rate: US$1 = S$1.42.
This article first appeared on Tech in Asia.