Top 5 legal considerations every tech entrepreneur should know

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Entrepreneurs and startups - Top 5 legal considerations every tech entrepreneur should know

As an entrepreneur trying to get your business off the ground, there are many factors to think about and the legal "stuff" may easily be forgotten. In this article, we touch on the top 5 considerations entrepreneurs need to think about when starting out.

Term Sheets

Once you have structured your business, you will have your idea tested (hopefully) and you will need capital. One typical way is to look for parties that will invest in start-ups such as angel or venture capital investors ("VC"). At this point, you will hear the term "Term Sheet" a lot.

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At its simplest form a term sheet is a summary big picture document of key terms agreed upon between the entrepreneur and the VC in contemplation of a financing and will cover, at a minimum, "economics issues" (valuation of the company, i.e. how much money for what percentage of the company) and "control issues" (who will run the company). The term sheet is an important document, as it signals that the VC is serious about an investment and will serve as a roadmap for the relationship between the parties.

Provisions included in a term sheet are typically non-binding and at least subject to due diligence, other than confidentiality and exclusivity provisions which require the parties to keep the information disclosed VC between them confidential and only negotiate with each other for a specified agreed upon period of time (typically 30-60 days), which are usually binding on the parties.

Shareholders Agreements

Following the execution of a non-binding term sheet, the VC will typically work with the entrepreneur to complete its due diligence and prepare definitive legal documents, which typically includes a shareholders agreement.

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A shareholders agreement is a contract between all of the shareholders of a company and the company itself. It attempts to: (i) structure the relationship between the shareholders of a company, (ii) create certainty and set the expectations between the parties, and (iii) anticipate and address many of the potential future disputes. A shareholders agreement can also be an effective way to set out the details of how a business will be run. It is important to think about the business and the shareholders and their specific needs when drafting this document and anticipate what is needed in each case. This document, while containing certain typical provisions, can be tailored to the specific needs of each group (i.e. there is no "simple standard shareholders agreement).

Rights that VC or major investors look for when investing in a business

So what are these rights that are negotiated in a term sheet and then ironed out in a shareholders agreement?

Other than terms relating to economics (valuation of the company) and control (who will make decisions and run the company), the following are some of the rights VC and major investors look for when investing in a new company:

Liquidation preference - preference in getting paid out first in the event of liquidation of the company;

Participation rights - right to participate in future financings to maintain percentage ownership;

Veto rights - right to prohibit certain material or significant changes for the company;

Anti-dilution rights - protection against the company issuing shares at a valuation lower than the valuation represented by the VC investment;

Vesting - a VC will want to make sure that the founders are motivated to stay and grow the company, as a result, they will likely request that shares owned by the founders become subject to vesting based on continued employment (and then become "earned") over a period of time. Typical vesting for founders is monthly vesting over a 36 to 48-month period, with the first 12 months of vesting delayed until 12 months of service are completed. A form of vesting that is usually acceptable to VCs is the so-called "double trigger" acceleration vesting, where vesting accelerates and shares are considered "earned" if the company is acquired and if the buyer terminates the founder's employment without cause after such acquisition;

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Drag along and tag along - a drag-along provision is a clause that allows majority shareholders to force the minority shareholders to join in on a sale of their shares. This prevents small shareholders from creating a roadblock to an acquisition by objecting or exercising appraisal or dissenters rights under applicable law. Tag-along rights on the other hand allow minority shareholders to sell their stakes in a company if a majority shareholder wishes to sell its stake in a company. Tag-along rights are usually good for minority shareholders because they allow the shareholders to capitalize on a deal that another shareholder is able to strike. These clauses (tag-along and drag-along) balance each other out and are typically either both included or left out of a shareholders agreement; and

Information rights - right to obtain certain information such as financial information.

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