Legal documents a startup needs before raising investment

Legal work at an early-stage company competes with product development, hiring and sales for limited money. Some legal documents cost little to put in place at the start and are difficult or expensive to add later, particularly once an investor or a buyer is involved. Others can wait until the company has grown or raised money. This article covers both, and the checks an investor's solicitors are likely to carry out before a funding round.

What to do now

Agree the founders' arrangements, including leaver terms

If the company has more than one founder, agree in writing who owns what, how decisions are made and what happens to a founder's shares if they leave. These terms usually sit in a shareholder agreement, the company's articles of association, or both. Founders often put this off because raising it can feel like a lack of trust, but it is much easier to agree while everyone is committed to the business than after someone has decided to go. The agreement should also record who owns any work a founder did before the company was formed, and how decisions are made if the founders disagree.

The provision that matters most is vesting. In UK companies, founders usually own their shares from the start, and vesting works through leaver provisions: if a founder leaves within a set period, they can be required to transfer some or all of their shares, with the unvested part often transferred at nominal value. A common arrangement is vesting over four years, with nothing vesting until the end of the first year and the remainder vesting monthly or quarterly after that. Without leaver provisions, a founder who leaves after a few months keeps their full shareholding in a company the other founders continue to build.

Shares that the holder can be required to transfer below market value on leaving are usually restricted securities for tax purposes. The company and a founder who is a director or employee can make a joint election under section 431 of the Income Tax (Earnings and Pensions) Act 2003 within 14 days of the founder acquiring the shares, which affects how any later increase in their value is taxed. Ask your accountant about the election when the shares are issued, because the deadline is short.

Make sure the company owns its intellectual property

The company should own the code, designs, brand and content it relies on. Paying a freelancer or an agency to create something does not by itself transfer the copyright, which stays with the person who created it unless it is assigned in writing. Copyright in work an employee creates in the course of their employment belongs to the employer, but a founder who wrote code before the company existed, or who is not an employee, may still own that work personally.

The solution is a short written assignment from each founder, employee and contractor who has contributed to the product, transferring their rights to the company. It takes little time to do early. Consider also registering the company's main brand as a trade mark with the UK Intellectual Property Office before you invest heavily in it. If assignments are missing when an investor or buyer carries out due diligence, putting them right can delay the transaction or become a point for the other side to negotiate on.

Put basic contracts in place

Customers need terms that cover payment, liability, ownership of the work and termination. Employees must receive a written statement of the main terms of their employment on or before their first day, and in practice a contract that also covers confidentiality, intellectual property and restrictions after they leave. Contractors need agreements that cover the same points and assign their work to the company. None of these needs to be elaborate at this stage, but each should be in writing and signed.

If your product handles personal data on behalf of your customers, your customer contracts also need data protection terms. Under the UK GDPR, a business that processes personal data on behalf of another must do so under a written contract that contains specified terms.

Keep the company's records up to date

Each time the company allots new shares, it must file a return of allotment at Companies House within one month. Keep the register of members, share certificates and board and shareholder resolutions up to date as well. Directors and people with significant control must also verify their identity with Companies House. An investor's solicitors will compare the company's records with its filings, and gaps are easier to fix as they arise than to reconstruct during a funding round.

What can usually wait

Some legal work is better left until the company has a reason for it. A group structure with a holding company and subsidiaries is rarely needed before a specific event calls for one, such as a funding round, an acquisition or a decision to separate different activities. An employee share scheme can usually wait until there are employees to include in it. A full set of workplace policies can wait until the company employs enough people for them to be needed, beyond what the law requires from the start. Arrangements made too early often have to be changed when the business changes, which means paying for the work twice.

Work that becomes harder the longer it waits

The work that should not be left is the work that becomes harder over time. Leaver provisions are straightforward to agree before any founder has left, and difficult once one has, because the departing founder then has no reason to agree to them. An intellectual property assignment is a routine document before a funding round, and a condition of completion during one, negotiated under time pressure with less room to refuse the other side's terms.

What an investor's solicitors will check

Before a funding round, the investor's solicitors will carry out due diligence on the company. Expect them to look for:

• a complete record of who owns which shares, consistent with the filings at Companies House;
• leaver provisions on the founders' shares;
• written intellectual property assignments from everyone who built the product;
• signed contracts with key customers, employees and contractors; and
• no unrecorded promises of shares or options to advisers, early employees or anyone else.

If these are in order, due diligence takes less time and raises fewer points for negotiation, and any gaps that remain have to be put right while the investor's timetable is running.

Summary

At the start, agree the founders' arrangements with leaver provisions, have intellectual property assigned to the company, put basic written contracts in place and keep the company's records current. Leave group structures, share schemes and extensive policies until the business needs them. If you are not sure which category something falls into, ask before you spend money on it.

If you would like to discuss what your company needs now, send us a short summary and we will arrange a call with one of our solicitors.

This article is one solicitor's view and general information, not legal advice — always take advice on your own situation before acting. AD Solicitors is a trading name of AD Solicitors Limited, a recognised body regulated by the SRA (no. 8011228).