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Partner, Head of Corporate and M&A, Eterna Law
Associate, Eterna Law
How to Properly Set Up an IT Project, Make it Attractive to Investors and Increase its Capitalisation: Practical Advice
The start-up trend observed in recent years has spread all over the world, considerably changing the understanding of the mechanisms behind the development and operation of business projects. It is not uncommon for start-ups (that have just reached maturity and begun to generate operating gains) to face challenges, and sometimes crises, that result in substantial financial losses or lead to business failures. The reason for such adverse scenarios is usually disregard for actions taken by founders at different stages of project development because those actions, seemingly insignificant at first, prove to be very important.
Let us consider (a) a number of reasons that are likely to lead to adverse scenarios due to defects in corporate documents, pitfalls in website regulations and flaws in a company’s tax planning efforts, and (b) the ways to avoid adverse scenarios that came to life because of those reasons.
Start-up founders and investors usually sign a Term Sheet at the stage when agreements reached between the parties are being laid down. A Term Sheet is a rather standard document that sets out the key terms for investments and further cooperation. A Term Sheet, when executed, binds the parties to take specific actions on particular terms.
Subsequently, based on the provisions of the Term Sheet, and depending on the transaction structure, the main documents to govern the legal relationships between the investors, the founders and the start-up itself will, under Ukrainian law, be:
– an Incorporation Agreement (IA) describing the relationships between the parties in respect of the incorporation;
– a Shareholders Agreement (SHA) that will apply to the legal relationships between the start-up founders; and
– a Charter that will be a constitutional document on the start-up, setting out the key legal principles of its operation.
Start-up founders, seeking to obtain investor financing quickly, often fail to pay due attention when the documents mentioned above are being drafted and executed. Every so often, such a careless attitude towards the provisions of the documents that apply to legal relationships between the parties and govern the start-up operations leads to conflicts and crises.
As the IT project develops, no serious investor will invest in a company without an appropriate structure and well-built legal framework, which also includes matters regarding proper transfer of intellectual property rights (codes, TMs, and so on) to the start-up.
To mitigate potential adverse scenarios, it is necessary to determine and set out in detail (before the documents are executed) the provisions pertaining to, and addressing matters that arise in:
– the start-up’s incorporation: the parties may, in addition to the Term Sheet, use the IA to set out how the company will be incorporated, the terms of their joint activities related to the incorporation process, the amount of share capital, the amount of shares to be held by each of the founders, and the time limits and manner of making capital contributions;
– the application of finances and the distribution of profits: stages, purposes and plan for the application of the finances raised should be set out in the Term Sheet, while the terms and manner of paying out dividends should be specified in the Charter;
– the corporate governance of the start-up: the basis for its corporate structure (whether the company will be managed by a CEO or collective governing body and have a Supervisory Board) should be laid out in the Term Sheet, while the method of appointment of, and the matters reserved to, the said bodies should be set out in the SHA and the company’s Charter; and
– a founder’s withdrawal from the start-up: options for how the founders will deal with deadlock situations should be described in the SHA beforehand, setting out the terms (or way to determine the terms) under which a founder will have a right or obligation to purchase or sell his/her shares (or a fraction of his/her shares), and specifying when such right or obligation will arise.
A website, as the calling card for any start-up, gives the first impressions of the project and, depending on the project’s essence, offers various services and opportunities to users. Apart from the site’s stability and functionality, another important condition that allows a start-up to avoid adverse reputational effects is that website regulations be in line with national and international law.
The key documents that should be prepared and published on a start-up project’s website are:
– a Copyright Policy that specifies protection requirements for intellectual property available on the website.
Every so often companies fail to pay due attention to the sound drafting of the above-mentioned documents with a view to cutting costs when their start-up websites are being developed. Such a botched-up approach and the resulting non-compliance of those documents with legal requirements give rise to numerous complaints and legal actions brought by users and lead to penalties and fines imposed by government authorities.
In order to avoid adverse effects, at least the following should be done:
– the said documents should be drafted clearly and unambiguously, and describe the entire website functionality, as well as liability limitations and user rights and opportunities;
– the scope, purposes and reasons for processing personal data and their storage period should be set out, especially as far as sensitive personal data are concerned;
– it should be specified which classes of user cookies will be gathered and when such gathering will take place during website use; and
– rules should be set out in detail for how intellectual property available on the website (trademarks, material, algorithms and other elements that make the website unique) may be used.
Start-up tax planning is one of the integral components to be included in the business plan with a view to identifying the tax system that would, on the one hand, minimise costs and, on the other hand, mitigate the risks of penalties imposed by controlling authorities.
It should be noted that the conduct of business rules changed in Ukraine on 23 May 2020 — the effective date of Tax Administration Improvements and Technical and Logical Tax-Law Inconsistencies Elimination (Tax Code Amendments) Law No. 466-IX. Its novelties and provisions should be borne in mind for start-up tax planning purposes.
In view of the provisions of the Tax Administration Law that deal with the introduction of the Controlled Foreign Companies rules (which now require that controllers of foreign companies report the ownership of foreign companies in Ukraine and pay income tax assessed on such companies in Ukraine), the following should be done to mitigate potential risks:
– the best form of presence in Ukraine should be chosen;
– it should be determined whether or not the Ukrainian activities of several non-residents can be treated as a permanent establishment where such activities constitute, as a whole, the complementary functions of a cohesive business operation (because the chances are that the engagement of sole proprietor contractors may be a permanent establishment factor and, consequently, subject to taxation in Ukraine);
– it should be ensured that substance is in place at foreign company level (a series of measures should be taken to prove that the company has a physical presence in its country of incorporation); and
– relocation options should be considered for moving the business to European jurisdictions with acceptable tax burdens.
To sum up, it should be noted that the proper legal finalisation of agreements between founders and investors, as well as the subsequent proper preparation of constitutional documents, the sound and detailed drafting of website regulations and the building of the best tax model, are critical success drivers for a start-up as far as its development and normal operation are concerned.