Technology start ups: what are the legal challenges?

Connie Carnabuci, Stuart Grider and Chester Toh

Companies in the energy sector, ranging from oil majors to start-ups, have long been looking for clean, sustainable sources of energy. In this sector, a start-up can face particular challenges in its quest to develop the “next big thing”. Even if it succeeds, a long road awaits. Connie Carnabuci, Stuart Grider, and Chester Toh chart the legal course of a small renewable energy start-up.

If a company offering a new piece of technology seeks to bring its business into the next level, it should take note of a number of financial and legal issues over the course of its development.
The structuring phase

At the outset, consideration will need to be given to the place of establishment of the start-up, both from the perspective of the holding company and the operating company. This decision is driven by a number of factors including:

  • Tax efficiency;
  • Incentives offered for clean energy businesses;
  • Ease of capital raising;
  • Access to key markets and talent;
  • Business environment;
  • Level of development of the legal system (including the maturity of the local intellectual property (IP) regime);
  • Regulatory compliance costs;

Typically, during the structuring phase, companies may find it more efficient operationally to set up a holding company, with separate subsidiaries holding the operating assets. Operational contracts, such as lease agreements and employment agreements, can then be signed with the relevant operating companies.

It makes sense to set up a separate company (usually a subsidiary of the holding company) to hold the IP of the company, particularly when the company's business model contemplates global licensing of its technology. Ideally, this IP holding company should be established in a jurisdiction with strong IP laws and a sound enforcement record and should be a tax effective jurisdiction for the receipt of royalty revenues.

Beyond the holding company level, corporate structure planning extends to mapping out the operating territories. Typically, if it is anticipated that each operating territory will need to hold the necessary regulatory and operating licences for, amongst others, testing of the technology and commercial exploitation of the technology (including off-take), a separate project company for each territory would be required.

A clear and well thought-out group corporate structure is most effective with measures in place to ensure that intra-group dealings are documented so that the relationships between the group companies are transparent. A transparent corporate structure will make the company more attractive to investors down the road.
Protecting key intellectual property

If the technology is developed in-house, it is important to ensure that the company obtains full title to the IP rights underlying the technology. In most cases, an invention made by an employee will belong to the employer, for example, when the employee created the invention during the normal course of his employment duties and an invention might reasonably be expected to result from carrying on such duties. Some jurisdictions also require mandatory compensation of inventors, under relevant patent laws, which cannot be varied by agreement.

It is important to understand how these matters might effect valuation. Confidentiality agreements and IP assignment agreements should be put in place between the company and employees engaged in research and development. In most instances, it is also prudent to extend such agreements to key personnel and senior management, in particular, to safeguard trade secrets and other confidential information.

When the research and development is outsourced to a third party developer, written development agreements will need to be put in place so as to ensure that the company obtains the full benefit and title to the technology and IP developed by the third party developer. Similarly, if certain IP is developed by universities and the ownership over the IP is asserted by the institutions involved, the company will need to obtain an assignment or licence of the relevant IP or seek agreement from the universities that no claim will be asserted over such IP. To the extent that third party IP is required for the company to carry out its business, the company will have to develop a strategy of either acquiring such IP in future, securing long-term licences or developing its own proprietary substitutes.

As the initial core value of the business lies in the technology and the IP comprised in that technology, it is important to develop a clear IP strategy for raising the visibility of innovation and ensuring appropriate steps are taken to secure IP rights in that innovation. In particular, the IP strategy should be used to help identify key areas in which any IP is created is protected so that significant sums of money are not spent on IP registration and application fees for less critical items of IP and critical IP items are prioritised.

It is also strongly recommended to engage a patent attorney to assess the viability of proposed inventions and conduct prior art searches to ensure the invention is indeed novel and has not been anticipated.

If the idea has been disclosed and is in the public domain, its novelty has likely been compromised so maintaining strict confidentiality amongst the R&D team is key. Whilst such analysis can be a financial burden for a start-up, it will be money well spent and will yield dividends.

Any investor looking at the company will always undertake at least two fundamental due diligence enquiries on business critical IP. These are first, a chain of title analysis to verify ownership and second, a prior art search to test likely validity of the patents and patent applications in the portfolio. Subsequently, when the company is moving into the stage of commercial testing and deployment, a freedom to operate analysis is recommended in order to identify if any surrounding IP in relation to the technology owned by third parties could potentially restrict the commercial exploitation of the technology.
Seeking funding and investment

In this economic climate, it may be not easy for a start-up to secure trade financing. In addition to initial equity funding and shareholder loans, a start-up will need to secure venture capital funding, and then look to broaden the base of investors to include financial or strategic investors.

To the extent possible, the company will have to be selective in identifying investors with the right profile – like-minded investors who understand the business and the industry, and accept that it generally takes much longer for a technology-based renewable energy company to develop into a fully fledged viable business, given the need to develop and test the technology, seek third-party validation and ultimately achieve full commercial deployment. As such, it is vital that the company seek investors who hold a long term investment horizon and outlook and share a similar view of the company's development and prospects.

For early stage funding, rather than making a one-off investment, an investor may condition the various tranches of investment on the achievement of specific milestones for the development, verification and testing of the technology. This is to ensure that first, the company is focussed on attaining certain pre-defined performance benchmarks within a prescribed period of time and, secondly, that financial discipline is imposed on the company, given that the investment is intended to be utilised for development of the company's technology.

Sufficient flexibility will need to be built into the timeline for achievement of the milestones and the investor should only be allowed to walk away if the milestones are not achieved by a long-stop date. The company should also insist on the right to seek alternative investors if the original investor chooses to walk away if a particular milestone is not met.

Negotiating key investment terms

A typical equity structure in a venture capital investment may comprise ordinary shares and preference shares. The ordinary shares are generally held by the management and the founders while the investor may choose to hold both ordinary and preference shares. The rights of these different classes of shares will vary according to the financial and investment requirements of the investor. It is usual to seek warranties from the company and the scope of these warranties is often a subject of significant negotiation. In some cases, the investor may ask for restrictive or non-compete covenants from the management designed to protect the goodwill of the company.

These covenants ensure that should any members of the management team leave, they would not be able to set up competing businesses or solicit employees, customers and suppliers. Such restrictive or non-compete covenants may be granted in favour of the investor or, in most instances, these covenants would also be found in the respective employee's service agreement.

The investor will also want to ensure that the key technical talent is adequately incentivised under the terms of their employment arrangements, including through stock options.

Aside from the commercial terms of the equity investment, the key matters for negotiation relate primarily to the rights of the investor which would be documented in the shareholders agreement. These include:

  • Reserved matters: these are corporate matters of significant importance which will require the approval of the investor. They can range from customary minority protection matters such as consent to changes to the constitution of the company and winding-up. They might also involve operational vetoes in the form of approval of the business plan of the company or incurrence of debt beyond a pre-determined level, as well as more complex issues of IP strategy and enforcement;
  • Board seats: depending on the amount of investment, an investor can be expected to ask for board representation or, in some cases, the right to install an observer on the board if a board seat is not granted;
  • Anti-dilution and pre-emption rights: to safeguard its investment, the investor can be expected to ask for anti-dilution rights, that is, the right to approve the issue of new shares or a pro-rata entitlement to any issue of shares by the company;
  • Transfer restrictions: this can take the form of restrictions on the disposal of shares by the founders and management for a prescribed period as well as “drag” rights to enable the investor to “drag” the rest of the shareholders if the investor decides to exit the investment. Correspondingly, the company may require the investor to provide a similar lock-up undertaking on its shares and offer the shareholders “tag” rights if the investor, on its own or in conjunction with other shareholders, holding interest exceeding a pre-agreed percentage, were to exit the investment;
  • Information rights: these rights typically take the form of the rights to inspect the books and accounts of the company, monthly management accounts, management forecasts, etc.

In addition to the above, given that the company's IP rights will be critical and material assets, the investor may request that an IP sub-committee of the board is formed. Such a committee would be responsible for, amongst others, protection and maintenance of IP assets, enforcement and defence of the company's IP, as well as IP licensing. The investor can be expected in most instances to ask for representation on this committee.
Next phase, ready to take off?

Once the technology is ready for commercial deployment, it may be necessary for the company to seek another round of investment to fund the commercial deployment. At this stage, the company is in a better position to seek funding from strategic and financial investors. A financial adviser, usually an investment bank, will often be engaged to assist the company with preparing an information memorandum or teaser to be sent to prospective investors.

The company will also need to put in place confidentiality agreements with these investors before any meetings take place or materials are distributed. As part of this round of investment, the initial shareholders' agreement will need to be renegotiated alongside the new investment agreement and a new investor may ask for changes to the bundle of rights that the shareholders and the existing investor are entitled to under the existing shareholders' agreement.

The development course of a renewable energy start-up can be a long one. For every one that succeeds, many others may have failed. Nonetheless, there is no substitute for detailed planning at each stage of the development. As the prospects for this sector are extremely exciting, rewards await those with patience and verve.

About the authors:
Connie Carnabuci, Partner, Hong Kong (IP/IT Practice), Stuart Grider, Partner, London (US Corporate Practice), and Chester Toh, Associate, Beijing (Corporate/Anti-Trust Practice), all at Freshfields Bruckhaus Deringer.

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