The high cost of legal indifference for startups

26th May 2015
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Startups prefer to tackle problems when they arise, frequently postponing or underestimating legal requirements. It works out just fine most of the time, but it can really sting when it doesn't.

The future of a startup is so uncertain that legal compliances and other requirements can seem too decisive to bother with. What's a founders' agreement going to do for two guys with just an idea? Why spend money on a trademark now when you may shut down six months later?

The intention may be to change this attitude when stability is visible, but it tends to be the norm for much longer than expected. In the mean time, the legal requirements pile up. More often than not, startups get away unscathed. The trademarks get filed, the agreements get signed and the compliances are put in place before anything untoward occurs. But the few who do are impacted, get hit hard by their indifference. Here's what can go wrong, with examples.


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Trademark Filing

There's no need to register your trademark. You came up with your name, slogan and logo, so why do you need confirmation from a government department that it's yours? Because someone else might have the same flash of brilliance, of course. And under the first-to-file rule, the trademark will belong to the person or business that first registered the trademark.

This is unlikely to happen, you may say, but it has, even to companies with unique names. The most recent high-profile example involves the unicorn Pinterest, a little-known media startup named Premium Interest and the trademarks registry in Europe.

It seems that Pinterest, even two years after starting operations in 2010, was unsure of its prospects, as it only filed for trademark registration in March 2012 in the US. What it didn't know, at this time, was that, in London, a full two months earlier, Premium Interest had filed to trademark the name in Europe (it was first to file in Australia, too). Consequently, Pinterest cannot use the name in Europe, as pointed out by Premium Interest's lawyers in early 2014, unless they somehow convince the company's founder to approve of its use. How will this small matter of trademark registration affect Pinterest's international expansion plans (for which it raised a whopping USD 225 million in 2013)?

In India, you can complete the trademark process in just three days. Given the trouble you could be put through if another business – or worse still, a competitor – trademarks what you think you have a right to, it's perhaps worth the effort several times over.

Business Registration

Startup founders prefer to put off legal registration of their business until they're ready to go looking for investment. Spending that extra bit of money and effort before a strong indication of interest from VCs seems unwise. But watch out, for such a step could lead you into tax trouble.

For example, let's say you register your company a month before you raise funding, when you issue the founders stock at Rs. 10 a share, and, 30 days later, this rises to Rs. 150 a share. How would this appear to the Income Tax Department? Could this not be treated as compensation to the founders? So, while you may not want to incorporate your company well before you're looking for investment, you should certainly do so a few months before you begin pitching VCs.

Another benefit of registration is that it brings disclipline. The accounts are more likely to be in order, talent is more likely to be hired upon signing an employment agreement and registrations (sales and service tax, for example) are likely to be done.

Also, do note that with the introduction of form INC-29, the process has also been simplified. So the effort involved has also been reduced.

Non-compete Agreements

If you think you have an idea upon which a scalable business can be built, why would you tell all about it to co-founders or employees without putting in place a non-compete agreement? Yet, it's common for startup founders to ignore such requirements because only their friends are involved. But such an attitude often causes people to forget to draw a line at all, just as the Winkelvoss twins did with Mark Zuckerberg.

Had Zuckerberg signed a non-compete agreement with the Winkelvosses, how far could he have gone with thefacebook.com? If he did, the settlement, rumoured at USD 65 million, would surely have been much larger. Sure, The Social Network would have been a lot less fun, but the twins, at least, would not mind that.

You may think that non-compete agreements are of no use if none of those you interact with ever try to compete with you, but you're forgetting the impact of simply having such an agreement has on the minds of those who might think of pulling such a stunt. Particularly with your early employees and partners, make sure you have one.

Copyright Ownership

The laws of India and, indeed, the world, could do with some tweaking now that the Internet has redefined the way we consume. But startups looking to get past copyright laws inevitably fail to do so. The free music service Grooveshark, if you've been following the news, shut down two weeks ago admitting its wrongdoing on its website.

Closer to home, Bluegape shut down its fan merchandising store in December last year after hitting monthly revenues of INR 1 crore after a slew of legal notices were sent to Flipkart, Amazon and Snapdeal by owners of the content on which the art was based.

The company addressed the matter as follows: “Indian copyright act is very unclear on the sale of fan art. Fan art is like creation of something from the inspiration from somewhere. All our 500+ designers were making crazy stuff with us, and we were proud of that.” Given that fan art is considered derivative of the original the world over, it's unlikely that our Indian laws would ever treat it with leniency.

The only way out for Bluegape would have been to ink deals with the owners of the content to permit the sale of the art in exchange for royalty payments, as had been stated when it raised funding. Unfortunately, these were not in place, and, with infringement so easy to find online, this proved to be the wrong move.

On the other hand, startups also tend to be lax about copyrighting their own original work. Website design should, of course, be top priority, but you can also copyright your source code, instruction manual, product literature and user guides.

Founders' Agreement

Individuals can disagree on a broad range of issues even without the set of challenges startups bring with them. Should any of these difficulties result in one founder leaving the company, what are the consequences? These can be solved by a founders' agreement, which most directors don't seem to want to have in place. The most probable reason is that they would rather postpone having the uncomfortable conversations the drafting of the agreement would raise to a less complicated time. But the founders' agreement is most essential when times are complicated.

It should have answers to all that's on the co-founders' minds, and leave room for the other complicated questions. Broadly, it should cover the roles and responsibilities of the co-founders, the shareholding pattern, vesting period, exit clauses and the vision of the product or service being built.

Housing has had several of its 12 co-founders leave, the same with the seven who had started Redbus, and, of course, you remember what happened to Eduardo Saverin. How much easier would a simple founders' agreement have made that time for all those involved?

Such an agreement not only clears any doubt among co-founders, it provides a clear roadmap for all those involved – a key requirement when people are working towards a common goal. While having a founders' agreement drafted may seem like you're getting ahead of yourself while working out of your bedroom, it's best to get this done before success and money complicate matters.


You may get in touch with the author on his website Vakilsearch and get more information.

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