Contracting with technology start-ups (from the funder’s perspective)

Concluding deals (e.g. licence, supply of goods, provision of services, R&D agreements) with start-ups is far more complex than concluding similar deals with mature, consolidated companies. Often the early “investor” (which is essentially how start-ups view you) is the “early worm that gets caught by the bird”.

Whereas concluding an agreement with a mature company involves a (comparatively limited) due diligence, negotiation and contract drafting process, concluding deals with start-ups is far more complex. This article highlights a few of the problem areas and offers some advice on how to manage the process.

Financial considerations

Cash flow and financing is one of the main reasons that start-ups fail.

It is therefore critical that you review the financials carefully and ensure that the cash flow forecast is reasonable and sufficient to get you to the finish line. Focus on the liabilities section of the balance sheet. Funding is frequently extended by private equity funders and venture capitalists. This means that:

  • loans are often convertible into shares in the start-up;
  • the pressure on cash flow will increase as these “higher-interest” loans are ultimately repaid;
  • the financing arrangements typically include “kickers” in the form of warrants or other future benefits to the financier, which may impact your future plans or dilute any equity that you may obtain;
  • most of the assets (including future assets which you may be funding) have most probably been secured by funders; and
  • the start-up can be expected to survive liquidation while pushing you out into the cold.

Review the tax position of the start-up carefully – their tenuous cash-flow position may encourage the adoption of liberal auditing procedures to generate “tailwinds”. An unexpected tax claim could significantly impact on the start-up’s cash-flow. Anything that impacts on the start-up’s ability to reach your finish line becomes your problem as well.

Cash flow stress, onerous financing terms and tax risks combine to polish the slippery slope towards liquidation. Ensure that you have less to lose than the start-up and funders. Else, you could well find that you have unwittingly evolved into the start-up’s banker – which is the worst position you could possibly find yourself in. To prevent this, obtain and record proper security over relevant assets (which typically requires subordination of pre-existing securities) and embed “sticks” in your arrangements that, even though they may well come back to bite you, bark loudest at the start-up.

In a start-up environment, it is difficult to whittle practical, effective and enforceable “sticks”. An effective substitute is a stick that erodes the start-up’s balance sheet as it achieves a direct hit on managements’ pockets (e.g. provide for transfer of ownership of “high value assets” or reduce deferred income). A well fashioned stick effectively wielded seldom needs to be applied.

Change of direction

Always remember that new technology often has many potential applications. Although you may be excited about your application, investors are often less committed to your specific development plan and could easily redirect the business of the start-up towards another path of lesser resistance and highest returns. Effective veto rights over special resolutions that change the business of the start-up or dispose of a substantial portion of its assets are particularly relevant where some of your funding is injected as an equity subscription. Do not prepay for anticipated future benefits if the business of the start-up can be changed or its assets can freely be transferred in a buy-out.

The pseudopodial, permanently evolving nature of start-ups makes them sensitive to any provisions that restrict their options going forward.

Although employees and skills are important in all technology companies, skilled staff is particularly difficult for start-ups to retain. Often elaborate “kicker” structures are designed to tie them in during good times, but these structures (i.e. share options) could also have the opposite effect and disincentivise staff during darker periods (however transient they may be). Ensure that these arrangements: are effective; survive beyond your critical performance date; ensure proper transfer of IP rights from employees / contractors to the start-up; impose appropriate restraints of trade; and do not unduly dilute any equity that you may acquire in the start-up.

In addition, conduct background searches on key employees. They may previously have been employed by a competitor and accepted prior restraints / obligations of confidentiality. Patent searches in their names may also reveal relevant, parallel IP rights owned by previous employers.

Appetite for risk

Always bear in mind the ultimate objective of start-up directors – to grow the start-up quickly and trigger an exit strategy (i.e. buy-out or IPO). Their horizon is typically 3–5 years and risks that may arise thereafter are simply “someone else’s problems”. You may well be surprised at the comparatively low risk tolerance of start-ups during the short term, but this comparative position typically reverses dramatically as one compares medium and long term appetites for risk.

It is therefore important to conduct a proper infringement due diligence – potential infringement proceedings are generally beyond current management’s horizon; the risk of insufficient funding typically outranks the future potential infringement risk; and by the time infringement proceedings are ultimately instituted, you typically have more to lose than the start-up. Although intricate warrants and provisions can be included in your contracts, they are seldom of practical value. So, deal with this upfront. Conduct your own infringement and IP audits and do not rely blindly on information received from the start-up. Confirm it.

Critically review the practical enforceability of all warrants, guarantees and undertakings.

The same goes with licences. Ensure that relevant licences extended to the start-up are not breached by performance in terms of your agreement and that prior agreements do not legally prevent the start-up from extending contracted rights to you (e.g. in respect of sublicences granted, review the parent licence to confirm that the start-up is entitled to sublicense such rights). If licences / other documents are withheld due to confidentiality provisions contained therein, appoint an independent attorney to review the documents and provide an opinion regarding whether your arrangements conflict with the terms thereof. Do not rely on the start-up’s interpretation.

Negotiations

To retain flexibility, start-ups prefer to incorporate vague terms and broad principles into their contracts – legal certainty creates a box. In contrast, when dealing with start-ups, your need for legal certainty increases. This conflict must be dealt with early on. Middle ground is no man’s land and not much use to anyone.

Be careful not to fall into the “relationship trap”. Relationships are fine, but often abused. And, when a dispute arises and relationships falter, future disputes become personal. Retain a business relationship at all times. An extra Christmas card is nice to have, but a working contract that delivers is your main goal. Also, remember that relationships are transient with current management generally expected to be substituted within 3 to 5 years.

Clarify the degree of effort to be applied by the start-up. A natural tension exists between start-up’s preference for “reasonable commercial efforts” and yours for “best efforts”. The difference between the two is significant and deserves much attention.

Particularly in R&D contracts, clarify your position post success. Although success may be “far off” and uncertain, it is embarrassing to achieve your initial goal only to find that you subsequently pay normal commercial rates for use of the technology developed … and dressed up as a “meal ticket for life”. Also ensure proper checks and balances by substituting project managers and chief negotiators on a regular basis – mistakes are like mushrooms, if covered up and left unchecked, they tend to grow, and no-one finds past mistakes faster than a “new person in charge”.

Internal issues

Start-ups aim for high growth, which in turn encourages internal disputes and struggles for control. Despite being lobbied to wield your economic leverage, do not involve yourself in internal disputes unless you have a material equity exposure (i.e. a shareholding that provides a degree of control over the start-up) and fully understand the basis for the conflict. Rather remain neutral than be seen to have abused your power in backing a losing side.

Ringfence contributions

You do not wish to fund R&D for the benefit of your competitors. Ensure that: your “background IP” is properly protected; ownership and exclusive rights in your contributions are retained by you; and you continue to benefit from IP developed by you. Do not focus solely on the start-up. Also review the restraints and confidentiality provisions concluded between the start-up and its employees.

Always guard against the start-up being bought out by your competitor – a frequent occurrence.

In addition, provide that ownership in all tangibles acquired or developed using your funds is retained by you (accompanied by effective delivery clauses). You may wish to exit a R10 million project when it is forecast to be R5m over budget, but your competitor will most likely buy into a R10m project for a ticket price of R5m. Without encumbering assets funded by you, your contributions merely discount the “ticket price” of the next financier. Although incomplete, encumbered assets may be of little practical value to you, they are useful as bargaining tools to tap into future benefits that may potentially arise from subsequent, successful, third-party funded development.

Finally, insofar as is possible, record all rights (i.e. licences, securities, etc.) to convert them from personal into real rights … and enjoy the process.

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