“How many Startups are aware of compliances they need to adhere to?” a question posed recently by my colleague while conducting a Legal Due Diligence (LDD) exercise for an early-stage startup going for their pre-seed funding round.

He answered his own question quite briskly, “Very few, if any.”

Legal Due-Diligence is the exercise where investors get a complete legal audit of sorts done on their potential investment mostly through a professional legal team.

In preparing the LDD Report, information and documents provided by the Company, as well as assertions made by the Company under scrutiny are solely relied upon along with some online searches on the MCA website, Court websites, etc.

However, due to our client’s lack of knowledge regarding compliances, we faced several challenges, which are common blunders committed by many startups in their early stage.

Here are some of the major legal observations:

Incorrect Legal Entity or Structure for their Business

Many new businesses struggle to determine the best business structure for their venture because business structures differ, and what is good for one may be bad for another in terms of risk, the number of people involved, profit sharing, liability, taxation, annual meetings, and registration, among other things. While sole proprietorship, partnership, LLP or private limited company are all available for starting a new venture, only registered partnerships, LLPs or Private Limited Companies are eligible for being recognized as startups.

Out of these too, only private limited companies can raise capital through the equity route.  

Although our client’s Company has been structured properly but on a careful investigation, some startups which are structured as LLPs or Partnerships must convert into a Private Limited Company if they wish to raise funds by issuing equity shares or CCPS (Compulsorily Convertible Preference Shares), which is the most preferred instrument of investors these days.

(We shall cover the different instruments through which Companies can raise capital in a separate article)

Business activities in violation of their Memorandum of Association (MoA)

We raised our first BIG RED FLAG when we found out that the Company was engaging in a business which is not mentioned in the Objects Clause of its Memorandum of Association (MoA). The MOA is a document outlining a company’s constitution, serves as the foundation upon which the company’s structure is created. It includes sections that describe the scope of the company’s operations and its relationships with the outside world. The heart and soul of the MoA is its “objects clause”. Section 4(1)(c) of the Companies Act, 2013 mandates every business to include in its MoA, the objects for which the company is planned to be founded (the raison d’être of a company) as well as any matter deemed relevant in furtherance thereof (ancillary objects). The objects clause is basically a laundry list of all the businesses the Company wishes to engage in.

If a registered corporation fails to confine its operations to those specified in the Object Clause of its MoA, such operations are considered ultra vires. These acts are not only deemed null and void ab initio meaning that they shall have no effect or any rights arising out of such acts shall not be enforceable, but they also cannot be ratified by the entire body of shareholders. It is the directors’ duties to ensure that the Company’s capital is utilised solely for the company’s lawful activity, and if such capital is diverted to purposes contrary to the company’s MoA, the directors will be held personally liable. If the Company wishes to pursue a business not listed in its objects clause, it must first amend the objects clause by passing a special resolution to that effect. 

Absence of a Founders Agreement

The major reason why most start-ups fail is disputes between the co-founders. And the only way to avoid most disputes is by entering a co-founders agreement. A co-founders agreement governs the respective rights and obligations of the founders of a start-up and governs the relationship between them and the start-up Company.

Start-ups operate in a dynamic atmosphere where changes occur frequently and unpredictably. Therefore, having a properly drafted co-founders agreement in place which will help to avoid unnecessary confusion and disputes is critical. The agreement should outline the important duties and responsibilities of co-founders, as well as decision-making, intellectual property rights, equity distribution, vesting schedule of founders, salary, termination and exit conditions.

In the case of our Client, there was no Founders Agreement in place which we asked them to execute immediately.

Employment Agreement with all employees including Founders

It is critical that a Company executes a suitable employment agreement with all its employees, including its founders, so that the terms of the engagement are specified in writing. Furthermore, it is critical to secure the Company’s confidential information and intellectual property, thus the Company should tie its employees to confidentiality so that sensitive information related to the company is protected from unauthorized disclosure by a disgruntled founder quitting the Company. An important part of any Employment Agreement is the confidentiality, non-disclosure clause. Other important clauses include non-compete, non-solicit which prevent employees from working with the Company’s competitors while being in employment of the Company and from soliciting the employees and customers of the Company.

The Employment agreement must also clearly specify that the ownership of all Intellectual Property created by the Employee during his employment with the Company shall be owned by the Company.

The Directors were employed by the Company, but there was no documentation of the terms of their employment, nor was any information provided regarding their remuneration or other perks received from the Company.

We suggested to our client that their Company should enter into an agreement with all employees and co-founders which clearly mentions that all work performed/created by them during employment/in relation to the Company shall be owned by the Company and that they have no claim to such works.

Statutory and Regulatory Compliances

While pursuing profits and expanding business, start-ups frequently disregard mandatory statutory and regulatory compliances, which can have a negative impact on their organisation in the long term in terms of legal and regulatory action, fines, and sometimes even suspension of business.  

These compliances include corporate secretarial compliances, meaning holding of mandatory General Meetings, ROC filings, and other requirements stipulated by the Companies Act and other relevant laws and regulations.

Annual General Meeting (AGM)

According to Section 96 of the Companies Act, 2013, the AGM’s standard business agenda includes approval of financial accounts, declaration of dividends, the appointment of auditors, and other special business agendas. The AGM must be held within the jurisdiction of the company’s registered office. The first AGM must be convened within 9 months of the end of the first fiscal year. Subsequent AGMs must be held within 6 months after the end of the relevant fiscal year. There should be one AGM every year, with a maximum lapse of 15 months between AGMs.

Companies who do not hold their annual general meeting within the time frame specified in the act are in violation of Section 96 of the Act and are subject to pay a fine under Section 99 of the Companies Act, 2013. The violation of this section is a continuing offence until compliance is obtained.

While examining the Company’s registers, we observed that our client’s Company was supposed to distribute notice of AGM seven (7) days prior to the date of the meeting. However, the document for the Notice of AGM was erroneous and it was in contravention of the AoA and the Companies Act, 2013.

• Board Meetings

The first Board of Directors meeting should take place within 30 days of the company’s establishment. Aside from that, four board meetings are scheduled for each fiscal year, with no more than 120 days between two consecutive board meetings.

• Books of Accounts

The Income Tax Act specifies the books of accounts that must be kept for the purpose of Income Tax assessment. These are outlined in Section 44AA and Rule 6F. Failure to keep the books of accounts up to date could result in severe penalties, including imprisonment, for the managing director, full-time director, independent director, chief executive officer, or chief financial officer.

Absence of Formal Commercial Agreements

Contracts are the documentary backbone of all commercial transactions. They help to define and bring clarity about the nature of the transaction, rights, obligations of the Parties and dispute resolution mechanisms. Simply put, contracts bring predictability and certainty to transactions. A well drafted contract secures the rights and interests of all parties to the contract and a badly drafted one may lead to disputes and losses. Hence, contracts between a start-up, and its vendors, customers and employees must be carefully drafted. 

To begin with, every commercial transaction must be documented in a contract. A contract doesn’t necessarily mean one executed on a stamp paper. An exchange of emails detailing the

nature, rights and obligations of the transaction also suffices.

Considering that our client’s company has hired third-party contractors to provide certain services such as website development, the Company had not signed any agreements outlining the nature of the engagement, consideration, rights, responsibilities, intellectual property rights, and so on for either party. In the absence of a written contract, the Company has no recourse against the vendor in case of disputes.

Lack of Intellectual Property Rights Protection

Intellectual Property is the biggest asset of any start-up. Start-ups continuously strive toward the discovery, development, and commercialization of new innovative processes, services, or products that are powered by technology or intellectual property. Intellectual Property can be safeguarded by timely registration. If the IP is used by any third party, the start-up must assign their IP to such third party through deeds of assignment. Under the Start-up India initiative, start-ups can benefit from the ‘Scheme for Start-ups Intellectual Property Protection’ (SIPP).

Conclusion:

Start-ups are focused on product and business development and expansion. While doing so, they lose sight of critical legal compliances that can cause huge losses if ignored.

To avoid risks arising out of ignorance of legal issues start-ups should be diligent and alert. A fraction of the founder’s time spent on keeping their Company legally secure can save them from huge losses and even the risk of failure.