Advice of Counsel*: Avoid These 3 Classic Mistakes Getting Your Start-up off the Ground

by Thomas Chou *Because of the generality of this article, the information provided herein may not be applicable to all situations and should not be acted upon without specific legal advice based on particular situations. The views expressed herein shall not be attributed to Morrison & Foerster, its attorneys or clients.

I have had a unique and rare opportunity working with hundreds of startup companies from across the globe, from my days as a young associate in Silicon Valley advising the first generation of dot-com darlings and the subsequent Web 2.0 companies that rose from the ashes of Y2K crash, to now, working with the new wave of innovators in China and across Asia that have blossomed over the last decade. I have been consistently awestruck by these entrepreneurs’ consistent demonstration of energy, passion, commitment and a determination to succeed, despite their differences in geographies and market opportunities.   

However, when it comes to getting Hong Kong and China based companies properly organized as a platform for future debt and equity financings, strategic alliances and eventual IPO or M&A, I have been frustrated to see so many talented entrepreneurs making costly but avoidable mistakes – particularly since these mistakes tend to recur time and time again.  The following list highlights some of the most common mistakes that you are advised to note and avoid.

1. Poor Company Structuring
When Hong Kong based startups visit me for the first time, many of them have already incorporated into Hong Kong.  There are many reasons why a Hong Kong based entrepreneur should and must set up a Hong Kong entity –  to hire employees or take advantage of preferential tax treatment for dividends received from a China subsidiary.  However, there are also advantages of having a Cayman Islands or British Virgin Islands company structured as a parent holding company of a Hong Kong subsidiary:

– There are cumbersome procedures for a Hong Kong company to repurchase restricted (i.e., unvested) ordinary shares from founders and to repurchase preferred shares from investors; troubling, considering that VCs in Asia often demand a right to have their shares repurchased upon certain events;

– Transfers of shares of a Hong Kong company require a payment of a stamp duty and, typically, will also require presenting financial statements to the stamp duty office;

Hong Kong companies provide less flexibility for listing companies a US IPO.

While it is possible to restructure the Hong Kong company to be held by a parent company in a more flexible jurisdiction (such as the Cayman Islands), this requires going back to all your existing shareholders to explain why the restructuring is necessary; then redirecting your scarce funds from the rock star engineer you were about to hire to your reliable but decidedly less glamorous solicitor.

At these initial meetings, founder shares purchase agreements are often memorialized on a cocktail napkin, a WeChat/WhatsApp message (or a photo of a napkin sent via WeChat/Whatsapp).  Suffice it to say, the actual share register that evidence such ownership rarely match these initial founder share purchase agreements.  It is true many well-intentioned and passionate founders end up leaving the start-up earlier than expected (for reasons best left to another article).

What happens to the departing founders shares in that situation?  Can the company buy them back, and if so, how many shares and at what price?  It may be no surprise that these very basic terms are not often clearly set out on these ephemeral contracts.  Needless to say, it is critical to have well-constructed and legally binding founder share purchase agreements put in place; not only for the protection of the non-departing founder and the departing co-founder’s successor, but to the professional investors who will insist that the share capital of your startup be deployed to those who will drive the company forward after the departure of said founder.

2. Treating China as “just another big market”
5 of the top 10 unicorns by valuation currently call China their home.  It is no secret that China is an extremely attractive market for manufacturing hardware, as well as for distributing the domestic consumer market.  It is also no secret that non-Chinese founders have had no shortage of challenges to succeed in China.

There are significant restrictions on foreign investment in Chinese companies, particularly those engaged in the internet, mobile, entertainment and cloud-based services.  Moreover, the traditional structuring “toolkits” to address these restrictions are evolving, such as using variable interest entity (VIE) structures. New cybersecurity laws are expected to impose stringent requirements on data privacy and localization of data content.  While some aspects of foreign investment in China are liberalizing, like in certain areas of ecommerce, you should be realistic about the significant operational, financial, and legal resources you will need to set up meaningful operations in China.

3. Nothing is More Expensive than a Cheap Lawyer
Acting as a self-serving comment from a lawyer with a healthy billing rate, I cannot emphasize enough that hiring attorneys with low hourly rates does not cut down the overall cost of a project. In many cases, putting in a lower-cost inexperienced lawyer on your project may actually result in a higher final bill.

You should be looking for counsels experienced in the type of transactions that you will need and can help you prioritize the critical issues that you need to focus on – issues that present theoretical risks but are practically acceptable and are not applicable to your company. The right lawyer, hopefully, will not accept shares of the company, cocktails, or a delicious chicken burger in lieu of legal fees. But lawyers who do regularly work with startups may have special discounted or fee deferral arrangements that you can explore.

As an entrepreneur, the demand for your time is unrelenting and time lost fixing avoidable mistakes can be a startup’s death sentence.  I urge you to have the foresight to invest time upfront and get things done right, saving you time and unnecessary legal expenses down the road and giving you an unfair advantage over your competitors.

About the Author:
Thomas Chou is a partner in Morrison & Foerster LLP. He is co-head of the firm’s Asia private equity practice. Mr. Chou is also a leader in the firm’s China M&A group. Mr. Chou is consistently recognized as a leading lawyer in the areas of M&A, Private Equity and Venture Capital by major independent lawyer ranking organizations, including Chambers Global, Chambers Asia-Pacific, Legal 500 Asia-Pacific and IFLR1000.

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