Key topics in venture law
Recently, I had the privilege to spend a few hours with aspiring entrepreneurs at AUT. We covered a lot of topics in an intensive, interactive session on venture law. Here are the 6 topics we covered with a few bullet point summaries for each topic.
You can also check out the full recording of the course on Youtube (not-so-great audio quality) and download the PowerPoint slides.
1. New Zealand legal system
There are three branches of government, divided between the makers, the enforcers and the interpreters of the law. They are the Legislature (Parliament), the Executive, and the Judiciary, respectively.
Our legal system is underpinned by three constitutional principles – Parliamentary sovereignty, the rule of law, and separation of powers. Of the three, Parliamentary sovereignty has the most practical significance.
For businesses, another key principle is the freedom of contract. However, this principle is subject to legislative oversight (that is, Parliamentary sovereignty). This is the framework to understand various laws that apply to businesses.
2. Business structure
Three commonly discussed business structures for new businesses are sole trader, a company, and a partnership. Factors such as cost of set up and maintenance, the risk to personal assets, ability to raise funds and exit, and tax efficiency are relevant in determining which structure you should choose. Check out this Government tool to help guide you choose an appropriate structure.
In most instances, a company incorporated under the Companies Act 1991 will be the most suitable structure. A company is a separate legal person, managed and run by its board of directors and initially capitalised by its shareholders. It enjoys full capacity, powers and privileges as a natural person would.
The most significant benefit of a company is its limited liability. The general rule is that the shareholders’ liability is limited to the capital invested and no more, which is widely accepted as encouraging investment into ventures.
3. Co-founders and employees
Co-founder relationships can make or break ventures. Having a co-founder agreement is a risk management and contingency tool. It deals with scenarios where relationships sour, and disputes can arise.
For example, co-founder shares may be subject to a vesting schedule over an agreed period (of, say, 4 years). If one of the co-founders leaves, then their unvested shares can be subject to a buy-back. There is some equity to this arrangement and helps to keep the remaining founders motivated. For more info, read our article on shareholders’ agreement FAQs.
Hiring employees is laden with statutory requirements and minimum legal entitlements. For this reason, companies often hire independent contractors because this arrangement avoids many of the mandatory legal requirements. However, courts can and often declare that independent contractors are, in substance, employees. Check out MBIE’s summary of the differences between an employee and a contractor.
4. Intellectual property
Great ideas by themselves are not protected by law. They need to be expressed or recorded as intellectual property, which may then have some legal protection.
An intellectual property right is a statutory monopoly to reward innovation and creation. It gives its holder the exclusive right to some intangible assets. It is arguably the biggest asset class in the business world today, including for early-stage ventures.
Key intellectual property rights include patents, trade mark, copyright and trade secret. These have varying degrees of legal protection and duration of statutory monopoly. Trade secrets do not have any statutory protection, and must be guarded by businesses using tools such as confidentiality clauses in employment agreements or NDAs with third parties.
5. Capital raising
A capital raising process follows the broad pattern: preparation (including deciding on the investment amount, company valuation, and financial information), pitch to target investors, negotiation of the term sheet, due diligence by investors, and finally execution and payment. This process can take a few weeks to as long as a full year or longer.
Equity is the most expensive form of capital due to founder dilution. It is balanced with it being the funding option with the least cash flow impact. A balance between equity and debt funding is convertible instruments, such as convertible notes and simple-agreements-for-future-equity (or SAFEs). For more info, read our article on convertible instruments and capital raising.
The securities law regime requires an offer of securities to the public to have mandatory disclosures. This is cost-prohibitive for early-stage ventures and means that they rule out raising funds from the general public. To raise funds, companies need to rely on one or more of the “exemptions”. These include offers to wholesale investor categories, relatives and close business associates, small offers under $2 million, and raising funds via licensed intermediaries such as crowdfunding platforms.
6. Exits
The majority of businesses have a bad ending, running out of cash. On the other hand, good outcomes often result in private trade sales or, less often, in IPOs.
Private sales follow a similar process to capital raising. Parties typically execute a letter of intent setting out key deal terms such as purchase price, exclusivity and due diligence scope. The buyer then completes its due diligence on the business while the parties prepare the formal sale documentation. The sale may be subject to deal conditions, such as regulatory approvals. Smaller deals are brokered by business agents and follow a more streamlined process and documentation.
IPOs are much more complicated in terms of process and the parties’ involvement. It results in introducing the company to the stock exchange and for public trading. It also likely involves the founders being “escrowed” for some years and selling down their shares over time. For more background information, check out our article series on direct listing on the NZX.
This was necessarily a high-level overview of the key topics we advise on. If you are interested in attending the next public lecture, please stay in touch with us on Linkedin or with AUT Beta.
What next
If you have any questions regarding this article, get in touch with Joshua Woo.
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Disclaimer
This publication should not be construed as legal advice. It is necessarily brief and general in nature. Please seek professional advice before taking any action in relation to the matters discussed in this publication.
