Introduction
The African startup ecosystem has evolved in the past few years. Many startups have emerged, some thriving while others have struggled or shut down completely. Regardless of the industry or the nature of the products or services being offered by a startup, there are some common success factors applicable to startups on the continent; for instance, issues like traction, leadership, funding, marketing, and legal structure are common factors in the ecosystem.
It is not uncommon to find many technical founders prioritizing the product and business development aspects of their company while deprioritizing other aspects such as legal or overall corporate structure. This model is forgivable at the onset of the startup, and some founders usually get the chance to rectify any defects in their legal setup in the future. Unfortunately, some others do not get this chance, and these latent defects may cause a massive problem for a startup.
Based on our continuous interaction with startup founders and investors, we have been privy to the numerous legal issues that founders often neglect or overlook at the early stage of their operations. Accordingly, in this article, we discuss some of these issues and their potential implication for the growth or success of startups operating within and outside the continent.
Legal Considerations for Startup Founders
There are various legal issues that startups must consider to be attractive to investors and sustain business growth. The considerations discussed below are not exhaustive but highlight some of the most important ones.
- Corporate Structure
The earliest decision to make during the ideation process of a startup is determining the corporate structure of the startup. This often starts with choosing the proper corporate vehicle for the startup; as simple as this sounds, this is the first stage where many non-savvy founders get it wrong by choosing corporate vehicles that are not suitable for growth or investment. For instance, in Nigeria, it is not uncommon to see founders register a Sole Proprietorship/Business name; in the U.S. as well, some founders would erroneously or due to lack of sound advice register their corporate entity as a limited liability corporation (LLC). In the foregoing instances, a founder would have created an artificial problem that may make the company less suitable for growth or investment. The appropriate/default vehicles under Nigerian law would be a company limited by shares, which is the equivalent of a ‘C-corporation’ in Delaware, U.S.
Analogous to incorporation is also the issue of share ownership by the founder(s). At the initial stage, it is important to determine the share ownership structure amongst the founder(s), including whether such shares would be subject to any form of vesting. Importantly, this is not a simple issue as varying legal issues may be implicated in the country where the company is registered; for instance, does the company law (in the applicable jurisdiction) permit shares vesting, or is it mandatory that all the shares must be allotted at incorporation? Also, if the latter is the case, what other documents/instruments can the founders execute to demonstrate the vesting? What is the role of the founders’ or shareholders’ agreement, and how will it govern the relationship of the founders, either as a pre-incorporation or post-incorporation matter? What other internal approvals are required to give effect to any agreements executed by the founders before incorporation, etc.? The foregoing are some of the questions that the founders must seek guidance on during incorporation.
Lastly, the place of incorporation also matters; given the popularity of Delaware as a preferred destination for technology and venture capital (VC) backed companies, many African founders who are also looking to access such external funding (from the U.S. or other Western VCs) often set up parent companies in Delaware, U.S. However, this also presents its unique challenges, in that registering a company in Delaware also triggers certain initial and ongoing compliance obligations that must be complied with under applicable federal and state laws in the U.S. Also, since such offshore incorporation would potentially lead to the creation of a parent-subsidiary relationship between the offshore entity and the operating entity in Africa, it is important to seek adequate legal advice from both local and offshore counsel on regulatory and compliance implications related to such corporate structure and to ensure that the desired objectives of the founders are achieved per the applicable laws.
- Technology, IP, and Material Contracts:
When investors evaluate a startup, the technology and intellectual property (IP) of the startup form part of the valuable assets of the corporation. Without proper legal safeguards, a startup’s innovation and competitive advantage may be at risk, diminishing its appeal to potential investors. It is important to address IP ownership and protection from the outset, ensuring that the startup retains full control over its technological assets and any intellectual property created during business.
Founders must prioritize the legal protection of the startup’s technology and IP early in the business lifecycle, including securing patents, trademarks, copyrights, and trade secrets where applicable. For instance, patents protect inventions, trademarks safeguard brand identity, and copyrights cover original creative works. Startups should also ensure that all contracts, especially those involving technology licenses or employment agreements, contain clear provisions assigning IP rights to the company. These steps not only protect the startup’s interests but also position it for future investment.
Moreover, having contracts is necessary for managing relationships with customers, employees, and service providers. Contracts define the rights and obligations of all parties involved in a business relationship, mitigate risks, and protect the startup’s interests. Clear and comprehensive agreements help ensure that everyone understands their responsibilities, reducing the likelihood of misunderstandings that could lead to disputes. For example, a non-disclosure agreement should be used when discussing sensitive information with third parties. These agreements ensure that the startup’s proprietary information, such as business strategies, trade secrets, product designs, or customer data, remains confidential. Employment contracts are equally important, and they should clearly outline the terms of employment, including job responsibilities, compensation, benefits, and termination conditions. Additionally, it should address the ownership of any intellectual property created by employees during their tenure with the company which expectedly should be assigned to the company. By securing the company’s rights to these creations, the startup will avoid potential disputes over IP ownership in the future.
Customer contracts, particularly in B2B transactions, should be designed to protect the startup’s interests while meeting the needs of the client. These contracts should include terms related to the scope of services or products provided, payment schedules, warranties, and liability limitations. In cases where recurring services or subscriptions are involved, the contracts should also cover renewal terms, cancellation policies, and any automatic renewal provisions.
- Proper Documentation of Investments and Shareholding
As a startup raises capital, whether from family and friends, through SAFE notes, or in early-stage equity rounds, all transactions must be properly recorded. A capitalization table outlines the ownership structure of a company; it provides a clear and detailed breakdown of the company’s equity, including common shares, preferred shares, options, warrants, and convertible notes, as may be applicable. By accurately reflecting who owns what percentage of the company, the cap table allows investors to assess the distribution of equity and evaluate the potential impact of their investment.
In addition to the cap table, startups should also ensure that all fundraising activities are properly documented by leveraging the adequate support of their counsel. Regardless of the size of the cheque, startups are strongly advised that monies received from third-party investors (whether family and friends or other investors) are backed by relevant documentation reflecting the exact investment transaction.
The investment documentation would also be relevant during future fundraising activities where potential investors request to review the existing shareholding of the company. It is important to work closely with counsel about any investment transaction conducted by the company to ensure that the interests of the company are ultimately protected.
- Regulatory and Compliance:
Legal and regulatory compliance involves a company adhering to the rules, laws, and policies that govern business practices within a particular jurisdiction. For startups, compliance goes beyond merely avoiding penalties — it also establishes credibility with investors and other stakeholders. Regulations and legal requirements differ significantly based on the country and industry in which a startup operates. Startups with entities in multiple countries must be diligent in understanding and complying with the legal requirements in each jurisdiction.
Compliance spans the entire legal framework that governs a company’s operations. Broadly speaking, compliance can be divided into two categories: general legal compliance and industry-specific compliance. General legal compliance includes the fundamental laws and regulations that all companies within a jurisdiction must adhere to, such as company registration, tax obligations, and data protection laws. Industry regulations and standards are unique to the specific industry in which the startup operates. For example, fintech startups must comply with financial regulations like the substantive license requirements (as may be applicable), Anti-Money Laundering and Know Your Customer requirements, etc.
Startups operating in highly regulated sectors need to obtain specific licenses to operate legally. Securing these licenses is crucial to ensuring that the business can function without legal interruptions. Different industries have their own set of regulations and compliance requirements, making it essential for startups to proactively research and adhere to these laws. Doing so not only helps avoid legal repercussions but also increases the value of the company and strengthens the startup’s credibility within the industry.
- Investment Readiness and Organized Data Room
Due diligence is a process that allows investors to evaluate the strengths, weaknesses, uncertainties, and risks of a potential investment. This assessment helps investors minimize risk by getting a clear picture of the business’s assets and liabilities and its potential for success.
A key part of preparing for investment is organizing a well-structured data room. A data room is a secure, centralized repository where startups store all essential company documents. The nature and scope of information in a data room largely depend on the business stage and the size of the funding round. The legal documents that should be in a data room include incorporation documents, intellectual property details (patents, trademarks, copyrights), material contracts and agreements (partnerships, vendor agreements), employment contracts and confidentiality agreements, as well as any litigation history and pending legal issues.
Startups should start preparing for due diligence from day one by having the right documentation in place and keeping documents organized. Being organized from the start makes the due diligence process more efficient and smoother. Founders can establish a workflow to update and maintain the data room periodically. Having a data room ready before investor presentations improves investor confidence and expedites the investment decision process. A data room must have privacy and security measures in place, to protect against leakage or unauthorized disclosure of documents to third parties.
To assist startups in preparing for the due diligence process, we have a free Investment Readiness Checklist. This checklist is designed to help you ensure that all necessary documents and information are organized and ready to be shared with prospective investors. To request the Investment Readiness Checklist at no cost, please send an email to lawyers@credence-law.com.
Conclusion
In conclusion, the African startup ecosystem continues to be a fertile ground for innovation and growth despite the challenges startups face. The continued success of early-stage startups in Africa’s fast-paced business environment depends heavily on cursory navigation of the legal landscape.
To thrive, startups must prioritize getting their legal and compliance affairs in order. This includes choosing the right corporate structure, staying compliant with regulations, protecting intellectual property, and proper documentation of applicable documents. When startups tackle these issues head-on, they avoid potential setbacks and increase their attractiveness to investors.
For more information and requests for the investment readiness checklist, contact us at lawyers@credence-law.com.