It can be very difficult and costly to restructure a valuable enterprise once it leaves the startup phase, so it is important to have the right structure from the start.
The purpose of this article is to assist founders in avoiding a costly restructure of a startup after the business starts generating revenue, or the consequences of business failure.
There are two main reasons why founders need to start with the right structure:
- Protecting intellectual property from creditors and insolvency
With the right planning, founders should be able to set up a business structure which will be effective in the event of a business sale, public listing and/or litigation.
This article is general in nature, but here are a few principles which might guide founders when working out the right structure.
What is the IP?
Firstly, you need to be clear what the IP consists of. A patent is a simple example, but keep in mind that IP can extend to copyright, confidential information, trade secrets and trademarks. The ‘owner’ of this IP needs to be clear on paper and it is always helpful to be able to show a ‘chain of ownership’. Understanding how IP is generated is also critical.
Keep IP separate from day to day operations
Once you have established what IP the business holds, it usually preferential to isolate the IP in an entity which does not engage in trade, such as an ‘IP holding company’. For instance, if it holds IP, a company should not employ anyone. Likewise, an IP holding company should probably not trade with consumers.
A transfer of the IP to a holding company can be effected with a simple agreement. It will also be necessary to setup an IP licence structure to enable the main business to use the IP and for newly generated IP to revert to the IP holding company.
Keep in mind, every business operates differently and an IP holding company might not be the best strategy for you. It is important to get advice about the best structure for your circumstances.
Employees can be a risk to your IP. Depending on the culture of the startup, it may be prudent not to offer direct shares to employees as incentives. Shareholders have rights under the Corporations Act which can be enforced. Instead, consider setting up a unit trust and offering units to employees. A unit trust can give employees an entitlement to dividends and underlying value in the business but, importantly, acts as a buffer when it comes to ultimate control of the company. It is also easier to cancel units in the event an employee leaves the business for any reason.
It cannot be emphasised enough how important it is to have an agreement in place between shareholders and/or unit holders.
Moving IP around at a late stage may have tax consequences. The taxation consequences of any change to a business can be varied. It is always useful to plan to pay tax and in what circumstances. Tax planning should be done in sync with the development of the commercialisation strategy of the startup.
In principle, you should plan for capital assets to remain in once place until sold. Transfers of capital assets (such as shares or goodwill) can create capital gains tax liabilities.
Situations which may give rise to taxation events can include:
- payment of dividends
- transfers of shares or units
- sale of business goodwill
Understanding some of the basic principles of taxation can also be invaluable for founders such as, for instance, the difference between income and capital.
Startups do not always go according to plan and, according to some commentators, the startup failure rate in Australia is on the rise. Founders must be realistic and sensible about this fact and plan for possible insolvency.
It is possible to keep IP rights intact even if the main enterprise faces insolvency. The worst case would be for valuable IP to be sold in a fire sale.
Creditors who commonly place startups into administration include co-founders/partners, consumers, suppliers, employees, landlords or the Australian Tax Office.
As well as protecting IP, proper planning can protect directors from claims by liquidators. See also our article on
Foulsham and Geddes notes that this article is written for the purpose of providing generalised information and not to provide specialised legal advice. If you require qualified legal advice on anything mentioned in this article, our experienced team of solicitors at Foulsham and Geddes are here to help. Please get in touch with us on 02 9232 8033 today to make an enquiry.