Failure Tales for your Startup Lessons
By: Trisha Shreyashi
Tags: Startup, Startup Lessons, Entrepreneurship, Invest, Business

Hello great readers! I come across a lot of news related to startups and being a corporate law student, I quite try to delve into nitty gritties of both success and failures of the startups. Doubts would crop up and I’d dig into it. (Inquisitiveness is galling, you see.)

“What do you think kills startups in their infancy, in the inception stage itself? What are the factors that lead to issues within a startup establishment? What are the issues, pertaining to a startup that founders must know?”

As you know already, one of the biggest concerns of entrepreneurs is to raise money, because building a business without seed capital can be very difficult. Investors too pass on seemingly great businesses, at times. They offer great valuation to some and undervalue some others. This is flummoxing for promoters.

Generally, this is just another business decision, based on market factors, stock value, share prices, investor likeability, growth of the organization and some others like the depreciation, confidence, interest rates, market size, depth of your team, future outlook of a particular technology or market. A part of the reason is subtly concealed in legalities. There are aspects that aspiring entrepreneurs need to understand. There are red flag legal issues that emerge during due diligence processes, that can lead to an otherwise viable deal getting canned or the valuation getting pummelled.

Clearly, these are things need to be kept in loop, far earlier than raising funds, because these are not things one can fix, last moment.

So, what are these red flag legal issues that damage fundraising chances and decimate valuation of a startup?

Co-founder conflicts over equity sharing and other issues

Being successful masks the problem that is brewing underneath the wraps and flaps of a successful startup. Co founder conflicts are just one of the most common issues. The conflict maybe multi faceted. One major issue that crops up is ‘who owns what’ conflict as the founders lock horns regarding the compensation, leadership roles and responsibility, or equity distribution of the startup. In some startups, it becomes apparent that equity sharing is unfair and unjustifiable which leads to unhealthy and unfriendly working environment. Cofounders may even quit in such circumstances which makes the startup unstable.

There can be a variety of ways that an equity distribution is done. It is generally good to analyse the input of every founder to the business. There is no normal or a formal way of splitting in equity. There are various examples of how splitting can go way wrong. Equity distribution is how founders allocate the ownership within the founding team. The article argues the best way of equity distribution is when all co founders are equally unhappy. It is imperative that the founders discuss their potential exit and agree on the terms ahead of time. This needs to be a part of the co-founder’s agreement. Having this in place go a long way in giving a potential investor some comfort. However, note that even the slightest sign of cofounder conflict is enough to spook a lot of investors as this has always been the biggest cause of startup shut down.

Cofounder conflicts can often be easily resolved through negotiation, deliberation and mediation. Most importantly, if there is a sturdy co-founders agreement in place, a whole host of issues and problems will not arise in the first place and disputes can be put to rest fairly quickly through a strong internal dispute resolution mechanism. At other times, it is wisest to let go of cofounders who do not fit in with the rest of the team, due to their goals, aspirations, expectations, career growth, skill level, performance, personality etc. It is better to lose a cofounder than get damaged by sustained conflict.

Co-founders with reputation or integrity issues

The importance of honesty and integrity cannot be overstated in the business universe. It is of paramount significance to understand that, in a startup, the employees, customers, vendors, investors, and other stakeholders implicitly trust a cofounder. It is the cofounders who are almost always in leadership positions in a startup, at least during the inception.

However, “what if there are serious allegations regarding financial impropriety or other integrity issues against a co-founder? Is it viable to retain him? How does the reputational issue impact his or her ability to navigate the ship and help attract the right kind of people to the organization?” These become huge factors in deciding investment likeability.

Conflict of interest

Another determinant is conflict of interest. Imagine that your startup is into biotech and develops new therapeutic modules. What if you also work with another company in the same business side by side? Or what if you are 15% stakeholder in a competitor? These are conflict of interest situations where the cofounder’s personal interests are at odds with that of the startup’s. Cofounders ought to have their interests completely aligned with that of their startup organization. Sometimes related party transactions come under the scanner as well. So, is it ok if the CEO and promoter appoints his brother-in-law as a sole distributor or supplier of a certain product? It is again a conflict of interest situation. The same is true when promoters give more importance to family members in hiring or promotions within the business. It becomes a major red flag.

License issues

Ola and Uber ran into huge license issues in India, as there were no rules and regulations under which such services were regulated statutorily. So, here a question crops up, ‘Can you really operate the business you run?’

One way to look at the license issue of a startup is that we are doing a new thing that is not legally prohibited so it would be fine. ‘As long as there is no legal restriction of carrying out a business, we should be free to do so.’ This is how many disruptive startups work. However, the other way to look at it is that unless there is a specific permission or a license to carry out a business, it is always uncertain, especially in countries like India, as one would have seen in the case of Ola, Uber, Juul, Policybazaar etc.

Also, there is always a possibility that the government will make laws that will curtail the freedom of a business to operate, which was exactly what went down with Juul, recently in India. There was a time when due to lack of clarity a whole lot of internet based or e - based startups in India were almost shut down.

Any kind of threat to license to operate makes creditors nervous. It is again a red alert.

Public policy issues

As the startup space grows, there shall always be laws and regulations that the founders will have to navigate through. Few of the domains could be license related, regulatories, taxation, special facilities, protection from foreign competition, access to foreign capital and government subsidies. Some startups need favourable government policies to survive, and as such concessions, tax breaks or access to easy capital can make a huge difference. For instance, until recently, Indian Govt. allowed foreign capital in the space tech and exploration sector in India, and it would be a game changer. But, other times policy changes might be negative and hurt startups. If there are policy overtures from the government that show the possibility of adverse impact, investors hold back investments, despite all other factors triggering investment suitability. A good example might be crypto startups in India. The chatter among the governmental institutions deliberating on regulation of cryptocurrency in India has led to drying up of investments in the crypto industry in India. And, the scams across India like the Bitcoin Ponzi Scam, are adding up against digital currency in India. A lack of public policy expertise in a startup that falls under regulated sectors, depicts the myopic vision of the founders.

Potential liability arising out of legal violations

There are a lot of risks that a startup faces on a day to day basis. A legal risk in developing countries and other countries with slow paced procedural establishment, may consume a massive amount of time and money and choke the growth of an organization. These risks can sometimes be difficult to quantify or predict. This makes investors wary.

However, some common types of legal violations, that startups must keep in mind about, are:

Contractual violations

Contractual violations can create massive financial liabilities. Such liabilities arise out of unlimited warranties, open ended indemnity clauses and such other contractual provisions. Startups sign the dotted line often without properly understanding the risks they are getting into, especially during their infancy. This can lead to heavyweight liabilities that can smush their entire business.

Statutory violations and compliance issues

Developing countries like India has numerous laws that can possibly apply to a business, and violations often have serious consequences. A statutory violation can have very serious implications that impact the value of an investable asset, especially when the consequence is a massive fine (for instance, under competition law, FEMA or GDPR), or cancellation of licenses, or possibility of one or more directors going to jail (like, in case of failure to submit PF deductions of employees to the government).

Tax violations

Sometimes startups engage in shady practices to save on taxes, which later create hurdles in smooth running of the organization. If there have been a lot of unjustifiable practices to evade tax, it exposes a company to risks of colossal penalties, investors may backtrack or may ask promoters to provide personal guarantees to cover such liabilities.

Intellectual Property related issues

For most startups, IP assets and their protection is crucial. It could be patented technology, or even non-patented technology, apart from design and brand value. However, from an investor point of view, two things matter the most. “Are you infringing on someone else’s patent or copyright? And, is your IP secure?”

If you are a hardware startup, getting a patent is also crucial. If you are into software, then one needs to ensure that your software is not based on violation of an existing IP. Further, if you are in literary or art related business, then you need to ensure that your content is original and there are no large scale plagiarism or copyright violations of another content producer.

Also, not owning the brand name by way of a trademark comes as a cost, later and you might have to switch or drop brand names, like ‘Foodiebay’ had to switch to ‘Zomato’. Being forced to change or drop a brand name is not just tedious and costly but is a loss for the organization, as all the money spent on promoting the brand and the time taken to gain prominence is now lost down the drain and the IP may lose its value. Investors want to ensure that the IP profile of a company is rock solid and valued before they invest.

False claims about finances or product

Lots of startups make claims that they cannot establish that opens them up to product liability claims and investors find such founders untrustworthy. It depreciates the value of IP and not only turns away investors but also creates a malignant image. In recent times, many startups that claimed their product had AI capability were later exposed to not have any significant AI capability.

Another issue that creates a great trust deficit between investors and founders is to be caught while embellishing numbers and embezzling finances. Investors make outlays on basis of representations and warranties from founders about the veracity of your claims made with regard to books of accounts, and if those claims turn out to be false, there are serious repercussions including criminal liability for fraud, forgery or worse.

Litigations with open ended and unlimited liability

“What if the startup has been sued before or during the investment discussions? What if there are legacy issues and disputes from years before that can still be taken up in the court of law?” Investors know that very often the news of the investment itself triggers many people with valid cause of actions to approach the court, because now the startup has deeper pockets. I’d name it a white collar extortion. It is pertinent for a founder to understand that if there are pending or potential litigations ahead that can create craters in the coffers of the startup.

Not all litigations may be red flags, but some of them can be, especially if it looks like one may have to pay out big damages if one loses, or that there may be a huge cost of litigation over many years that’d drain resources of the business. In such cases, investors ask promoters to reach a settlement with such claimants or disputees before the investment can be made.

To conclude, the founders and all those professionals who are a part of startup establishments ought to understand the significance of aforementioned pointers. These must be kept in mind while running a startup business, so that it does not kill your organization.

Disclaimer: The article is a result of personal observation and analysis. Contradictory views are welcome. Rights for the images used, are also reserved by the author.