A Day in the Legal Life of a Startup

Art Dicker, Parkwyn Legal

· General Blog

Welcome everyone to another edition of the China Tech Law Newsletter.

Over my time here in China, I’ve had the pleasure to work directly with some amazing founders of companies as they’ve built their businesses. In all honesty (and selfishly), I can't say they are the best clients in the sense that they are extremely fee conscious! But I love them and they are certainly the most fun. I’m going to share some of the things I’ve noticed in working with them, the issues they worry about, and the issues I worry about for them.

As you can probably imagine, founders typically come together and start working before settling on the precise details for how their business will be setup under a company structure, how much each founder will own of the company, and what each founder’s exact responsibilities are. That’s human nature. If you worried about all those details right off the bat, you’re putting the cart before the horse.

In the US entrepreneur community, people instead have gotten accustomed in the last few years to this concept of a “Lean Startup”, based on the book by Eric Ries - to get a Minimum Viable Product (MVP) up and running and make iterations from there based on real user feedback.

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I think its fair to say the lean startup concept has not really caught on here to the same extent - at least not for local Chinese founders. Most companies, especially B2C companies, need to fundraise from day 1 and keep fundraising to have enough to market their product through expensive online and offline channels. Particularly for online e-commerce portals, if you don’t spend on marketing, your product is buried. Viral, guerilla, word-of-mouth tactics here simply don’t work.

And as any founder can tell you, fundraising itself is a full-time and often frustrating job. Dozens and dozens of meetings may get you only a handful of follow-ups and one actual investor who you might be able to bring over the finish line. This is the same in China, the US, no doubt everywhere.

Practice Point #1 - Quick sidebar to bring my work into the picture here - on the legal side of fundraising. In the past, we typically saw full-fledged equity financings even at the early stage of about US$1 million. Where a company has a defined valuation (or “price”) with a relatively full suite of investment documents (SPA, SHA, M&A). We’ve seen more recently though startups - especially with foreign or returnee Chinese founders - using much simpler agreements where valuation is not yet hard set.

Convertible notes, and now more and more Simple Agreement for Future Equity (SAFE) investment agreements which punt on fully built out venture capital terms and hard valuations until the next round. Piggybacking off the US experience, especially the Y-Combinator SAFE model, these have become the preferred way to legally contract for an initial investment transaction. The idea that once you get investors in range of closing, the last thing you want to do is spend more time on lengthy, detailed legal deal documents. 

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Now back to the story of that poor frustrated founder working two jobs at once - CEO and Chief Fundraiser. For companies which don’t quite get the funding they need or otherwise are stuck in neutral, the first option is to operate lean to bridge to the next round. Reduce headcount to a skeleton team, etc., or delay paying your staff temporarily. It certainly goes against China’s Labor Contract Law, but its also done knowing employees are not likely to make an immediate complaint against a company with no cash to pay. Yes, the founders may even have to consider putting more of their own money in to keep the lights on. Its at this point where things can get “complicated” among the team and me and my legal hat are about to step back into the picture.

With the need to put in MORE of their own money or the need to keep slaving away doing work at either zero or way-below-market wages, some founders may start to question whether they would have a better use of their time just walking away and doing something else. You might think that there’s no way back from the dead after a failed business attempt. Not at all.

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What I’ve witnessed time and time again especially here in Shanghai is respect for one’s bravado and entrepreneurial thinking. If a founder had any success at all and is well spoken, you would be surprised to find they might get scooped up by a bigger, growing startup or even by a a multinational company here looking for out-of-the-box, innovative experience they can’t find in-house. For example, to build up their own in-house incubator or corporate innovation program and give its staff a chance to exercise their creative juices a bit in their “spare time”.

Practice Point #2: Now even in these “stuck-in-neutral” times you might see me pop-up again at this stage to help advise the company on finally putting a proper shareholders agreement in place. Locking down those elusive roles and responsibilities, some kind of pay-to-play requirements to keep existing equity amounts among the founding team at the status-quo, bringing in more direct non-compete or IP assignment obligations, or allowing one more committed founder to have voting control of matters going forward.

Now for sure, its a bad problem when a startup needs the founders to put in more money to press on with the venture. Then there are the good problems to have - on team fit and capabilities. Typically to get a company up and running and to any point of escape velocity, you need to have a certain determination - a willingness to put up with and learn with failure and rejection. But once you get to a certain level of development and funding stage (for example a Series C round), you will be owning less and less of a percentage of the company as you get diluted with new investors coming in at each round. While your investors will have tried to put your original equity on a vesting schedule to keep your “skin in the game”, there may also be a (mutual) recognition at some point between founder and investors that a new, more “professional” manager is needed to come in to replace the CTO, CFO, or even the CEO.

One founder I spoke with recently described how as they are approaching their Series C round, their company has evolved to be more and more of a tech company than when they first started several years back. And that someone with a proper tech background and training might be more appropriate to lead the company in its next stage of growth. Admittedly, this founder has been one hell of a fighter, taking his company from near collapse to back from the dead on at least three occasions counting. Investors love these founders - the ones that don’t quit when most people would have a long-time ago.

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And when they do (finally) quit, they feel like they failed you personally. As a small angel investor, I’ve had a couple founders apologize to me like this. My response is simple - you don’t owe me anything - any explanation or any apology. You gave up 5 years of your prime to do this. No investor expects the founders to keep working on the venture indefinitely. Life goes on and these founders’ experience only makes them stronger in the long-run.

Let’s stick with that back-from-the-dead-three-times founder approaching his Series C. I am an angel investor in that company as well and mid-way through the company’s life, they made a significant and radical change to their business model and target customer. The early co-founders had already left the business and new co-founders had come on board.

Practice Point #3: In theory, based on the terms in the investment documents, I’m supposed to make a return to the story in these moments as well, but it rarely happens. Most investor’s agreements with the founders and company require that they be given the chance to approve any pivot, any fundamental change in the business direction like this. In fact, often it is the investors themselves that are pushing for the change or at least not taken by surprise when the decision to pivot comes. For example, crossing over to be a more local company addressing the local Chinese mass consumer market or turning to a B2B instead of B2C model.

There is no official approval or “waiver” of the conditions in that investment contract. Investors are not as plugged into the business as founders and will almost always defer to their judgement. The only chance I pop-up in this part of the story is if one of the major founders wants that control over business direction hard-wired into the shareholders agreement with his co-founders. Not usually necessary, but you see the provision more often than you would think out here.

Practice Point #4: One other thing you find, especially for foreign founders of startups in China, is the concern with personal liability. If things really go south, there are some nuances in China versus other places that founders do need to be aware of while sorting through a lot of confusion in the startup community.

Generally speaking, you are liable for no more than the amount of capital you formally commit to contribute to the business when you register it with government regulators. That’s similar but not quite the same as other countries like the US.

What I mean by committed capital is related to this concept in China referred to as a “registered capital” amount. While there is no longer any fixed timeline to contribute the registered capital within a certain (previously it was 2 years) time frame, any unfunded amounts at the time of liquidation will have to be covered by the shareholders to cover obligations to creditors etc. In other words, there is a corporate veil for shareholders of a company (absent fraud, etc.) like in the US, but the veil extends out a bit to both already contributed capital (i.e. existing assets) of the company but also unfunded registered capital amounts.

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Conventional wisdom here and elsewhere is that a company has “made it” (although not really made it) when its gotten a proper Series A round of funding (perhaps at least US$5 million) from an established venture capital fund. This milestone usually brings with it a few housekeeping matters as investors start to do proper due diligence and dotting “i”s and crossing “t”s finally starts to matter a bit more.

(1) IP Ownership 

Your employees may incorporate ideas, code, or other IP from projects they worked on before this venture began. Are you capturing it all properly through employment and IP assignment agreements so there is no dispute later on? Did they incorporate anything into your product that they actually developed while at their previous employer? You probably brought them on board initially with not much more than a handshake. Now, as your investors are coming in, is the time for all this to get cleaned up.

(2) Noncompetes

Alluded to earlier and you would be surprised here as well. When the going gets bad, its a real test of the founders’ faith in each other. Perversely, when the going gets good, there can also be a tendency for in-fighting over how the new pot of money is spent, who should get the credit, and how roles are defined and expanded as the team size starts to grow exponentially. The last thing you want is in-fighting leading to the CTO leaving and taking half the team with him to start a competing business. Hey someone just gave us $5 million, it must be an idea worth something. Non-competes are always difficult to enforce, but its good to have for key founders and even some employees.

(3) ESOPs

A founder needs to continually hire new talent and keep existing talent fully engaged and motivated when taking below market salaries. For some relatively straightforward businesses, stock and stock options for junior employees are simply too far over their head. Cash bonuses are preferred and more effective.

Practice Point #5: For more senior employees, the trend has also been away from directly issuing equity, especially given the complications of registering shares for PRC nationals at the offshore Cayman, BVI, HK level in a holding structure. Instead, more recently the trend is to give employees “phantom” shares which mimic the economic rights of shares but are not actually issued equity shares in the company registry. The employees “phantom shares” do not clog up the company’s cap table as small shareholders, and from a PRC perspective this arrangement arguably reduces the obvious requirement for PRC nationals to register offshore shares with the State Administration of Foreign Exchange. Phantom shares also will not dilute founders’ voting rights vis-a-vis investors over the long-run.

Employees are not given the shares (or phantom shares) outright. They are subject to a vesting schedule (i.e. forfeiting some or all your shares if you leave before certain dates), with accelerated vesting if the company is bought (to encourage cooperation in the diligence and closing) or leading up to an IPO. Of course employees will usually know quickly whether the company has legs or not. Nevertheless many founders still insist on low buy back prices for employees leaving even with shares already vested.

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I’ve found, in fact, that founders are really getting wise on ESOPs. It used to be the first time a startup would engage me was when they had an investment term sheet presented to them by an investor. With SAFEs, that’s changed. Now the first engagement usually happens when a company is putting together its ESOP.

In the past, funds would almost routinely require founders to set aside and formally setup a 10% ESOP pool as a condition to closing (the shares coming out of the founders’ holdings prior to the investors coming in… of course!). With the rise of micro-seed funds and super angels delaying the need to reach out to larger funds, founders have recognized the value of ESOPs to motivate employees, knowing they’ll have to put it in place anyway, and are setting these ESOPs up themselves before demanding investors come in and ask for it on their terms. This also gives them the pre-emptive chance to keep voting control over ESOP shares for important decisions later on where again, they may disagree with investors.

And that trend pretty much sums up the entire story here. Founders in China both foreigner and Chinese are much wiser and more sophisticated about term sheets, ESOPs, IP protection, shareholder agreements, and how to prep for and deal with investors in the fundraising and post-honeymoon stage of their marriage. The point of this post was to show how founders have gotten so much more ahead of the curve in my 15 years here. They ask smart questions that are personally relevant to them (their business is their baby) and really value the advice you give.

Speaking of startup investors, we'll get into that in my next post coming up in two weeks. A discussion of how venture capital funds have evolved over the years on legal terms and general approach.