Legal Challenges faced by the Start-ups in India

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Starting your own work is in itself a huge thing to do. Start-ups comes with huge responsibility in all aspects, from fund raising to establishing itself in the market there are lot of risks. But when it comes to legal issues concerning start-ups, precaution is always better than cure.

Starting any new venture needs planning not only for marketing and growing the business but also to remove any legal risks that a start-up could face. Such risks can derail a start-up even before it starts successfully its business. Listed below are some of the legal challenges that a start-up could come across while setting up a commercial venture.

1. Incorrect Formation of a Company based on type of Entity:

Whenever you start your own business you are always worried with one thing i.e., Legal Registration and Documentation. The type of business selected has an influence on the funding options for the company, its tax responsibilities, and the personal liability of the owners. The right format can help save taxes as well as protect the personal assets of the proprietors in times of crisis. There are 5 categories of Legal Entity for business registration in India- 1. Sole Proprietorship Firm, 2. Partnership Firm, 3. Private Limited Company, 4. Limited Liability Partnership Firm (LLP), 5. One Person Company (OPC).

2. Not having a proper Co-Founder’s Agreement:

A co-founder’s agreement lays down all the terms and conditions between the co-founders of a start-up regarding how the business will be operated. The co-founder’s agreement is a written agreement which provides legal binding in case there is any dissonance between the co-founders.

A co-founder’s agreement must be drafted on the lines of the business and should state all the provisions relating to factors for which the co-founders are liable. The following provisions are the most important clauses of any co-founder’s agreement;

(i) Ownership Clause

(ii) Responsibilities of each member

(iii) Intellectual Property

(iv) Employment and Finances

(v) Withdrawal/Removal of Ownership

(vi) Conflict Resolution and Laws Applicable

(vii) Winding up of Business

3. Not doing proper due diligence before Fund raising:

A start-up goes through various stages of fundraising, including Angel funding, Seed Round funding and Growth/Early stage funding. After the Angel funding stage, start-ups go through further fundraising process, after having executed a term sheet, which is legal due diligence.

A legal due diligence exercise is conducted in the early stages of funding and identifies: (a) risks associated with the investment; (b) a risk mitigation plan; and (c) a list of items that would need to be introduced in the final documents in the nature of conditions precedent to funding, conditions subsequent, representations and warranties to be obtained from the founders, and indemnities.

4. Equity Distribution:

Equity is ownership. Equity represents the percentage of ownership interest in a given company. There is no right way to divide equity and it depends on the situations of each start-up. For the investors investing in a start-up, Equity means the percentage of the company’s shares that a start-up is willing to sell to investors for an amount of money.

5. Having Right knowledge of Employee Stock Option Plan (ESOPS):

ESOP (Employee Stock Ownership Plan) is an employee benefit plan which provides a way of ownership interest to an employee1. ESOPs are actively deployed by start-ups to achieve two objectives (a) hiring the best, and (b) retaining the best for long periods of time.

In an ESOP, the company first sets up a Trust Fund and contributes shares of its own stock to buy existing shares, into the Trust Fund. This transaction of the company is taxable. The shares in the Trust Fund are allotted to an employee’s account. As and when the employee reaches a higher level of seniority in the company, they get an increased right to the shares allotted to them. This process is called Vesting. Employees get taxed when they exercise their options and convert their ESOP to shares.

6. Annual Compliance:

The moment a start-up is incorporated, it is subjected to different statutory and regulatory compliances. A business registered in India is required to comply with the various annual legal compliances laid down by the Companies Act. Businesses. Registered as companies are many a times unable to keep track of their annual compliance requirements and fall under the scrutiny of the Ministry of Corporate Affairs (MCA).

The compulsory annual compliance requirements of a Private Limited Company include the following:

(i) Auditor Appointment

(ii) Board of Directors Meeting

(iii) Annual Return and Financial Statements

(iv) Maintenance of Company’s Registers and Records

(v) Company’s Income Tax Return

(vi) Event-Based Annual Compliance of Company. The Event-based compliances of a Private Limited company includes:

-Loans to other Companies.

-Loans to Directors

-Appointment of managing or full-time director.

-Change in Authorised or Paid-up Capital.

-Allotment of new shares or transfer of shares

-Opening or closing of a bank account or change in signatories of bank account.

-Appointment or change of the Statutory Auditors.

-Non-Compliance with Annual Compliance Requirements

7. Not having knowledge of Listing Requirements:

If a start-up wishes to list its securities in a stock exchange, it has to comply with the relevant SEBI regulations. These regulations pertain to the conditions that a start-up has to fulfil before it can list its securities, the disclosures that are to be made, the compliances to be followed to, etc.

8. Improper Documentation used for sale of Shares:

Start-ups sell their stock to the investors in return for funds. They require proper documentation of the agreements failing which they can get into some serious legal trouble. The Securities Laws guide the sale of securities to the investors which have their own disclosure and filing requirements. The Companies which do not follow these regulation land up in financial penalties. A properly drafted shareholder’s agreements by a legal expert covering all the necessary aspects of the sale is necessary to avoid any kind of risk.

9. Not having proper Business Licenses:

Starting any kind of business requires licenses. Depending on the nature and size of business, several licenses are applicable in India. Knowing the applicable licenses for your start-up and obtaining them is always the best way to start a business. Business licenses are the legal documents that allow a business to operate. The lack of relevant licenses can lead to costly lawsuits and unwanted legal battles.

10. Ignorance of Taxation Laws:

Taxes are part and parcel of every business. There is a broad variety of taxes, such as, central tax, state tax and even local taxes that may be applicable for certain businesses. Different business and operating sectors attract different taxes and knowing this beforehand is necessary.

The Government of India launched the ‘Start-up India’ initiative to promote start-ups, and introduced many exemptions and tax holidays for start-ups and new businesses. According to this initiative, the recognised start-ups that are granted an Inter-Ministerial Board Certificate are exempted from income-tax for a period of 3 consecutive years out of 7 years since incorporation.2

11. Proper acquaintance of Labour Laws:

It is very important to have proper knowledge of the Labour laws applicable for your company. Laws with regards to minimum wages, gratuity, PF payment, weekly holidays, maternity benefits, sexual harassment, and payment of bonus among others need to be complied with.

Start-ups registered under the ‘Start-up India’ initiative can complete a self-declaration (for nine labour laws) within one year from the date of incorporation in order and get an exemption from labour inspection. The nine labour laws applicable under this scheme are:

The Industrial Disputes Act, 1947

The Trade Unit Act, 1926

Building and Other Constructions Workers’ (Regulation of Employment and Conditions of Service) Act, 1996

The Industrial Employment (Standing Orders) Act, 1946

The Inter-State Migrant Workmen (Regulation of Employment and Conditions of Service) Act, 1979

The Payment of Gratuity Act, 1972

The Contract Labour (Regulation and Abolition) Act, 1970

The Employees’ Provident Funds and Miscellaneous Provisions Act,1952

The Employees’ State Insurance Act, 1948.

12. No Legal Protection for Intellectual Property Assets:

Another risk is no or improper protection of the Intellectual Property Rights of a company. A unique product or an idea must be shielded with a patent with the brand name, logo, etc. and must be secured with trademarks. Copyright laws must be used for obtaining the right to use original works of authorship like software or advertising content. Correctly obtained copyrights and authorship will help the organization safeguard its valuable assets from unauthorized usage and protect its right to commercially exploit the assets.

13. Contract management:

A Contract is required to ensure the smooth functioning of business and is a great mechanism to ensure recourse in case of non-fulfilment of work.

Employee contracts are one of the most crucial aspects to be looked into while starting a venture. Various provisions of the Indian Contract Act, 1872 are required to be looked into at various stages as and when required.

14. Proper Documentation of Non-Disclosure Agreements:

Non-Disclosure Agreements or NDAs need to be drafted and used by start-ups while discussing critical business information with people outside the organization as sometimes there is risks of theft of ideas or any information being shared that might be harmful for the goodwill of the company.

15. Winding up:

When a start-up decides to shut down, all the stakeholders needs to be informed about the whole process in advance. There are three ways to wind up a start-up from a legal point of view:

Fast Track Exit Mode

Court or Tribunal Route

Voluntary Closure

Conclusion

All entrepreneurs embarking on a start-up journey must search and go through all the legal factors involved and ensure that their commercial project begins smoothly and does not face any legal problems while running its operations. Most start-ups spend a lot of time developing their business and tend to neglect various legal and regulatory compliances. Therefore, it is important that the start-ups follow all the legal requirements which are necessary for the proper functioning of the Company.

[The author Niyati Sah, Advocate is Associate Partner of Rajesh Kumar and Associates. The author can be contacted on [email protected]]

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