Startups are now the spotlight of the Government of India. With the launch of the Startup India initiative early this year, various incentives and strategies are being planned for establishment and growth of startups. While the Government’s action items are aimed at the general benefit of all startups, individual startups need to plan carefully for building and growing their business. One of the most critical but oft neglected areas remains the legal aspects of a startup’s operations. Let us look at some of the common or uncommon legal mistakes and how big their impact could be on the startup’s overall business.
Limited Focus on Statutory Compliances
There are multiple laws applicable to an entity. It is essential to have complete knowledge and understanding of these laws to ensure necessary compliances. The consequences of non-compliance can be levy of punitive fines, imprisonment for owners, cancellation of operating licenses and closure of business. While most startups are busy improving business delivery and operating revenues, they ignore the need to focus on compliance and internal control procedures. The author has come across numerous instances where startups have been slapped with show cause notices from concerned regulatory authorities leading to payment of fines or filing of compounding applications.
Absence of Legal Advisor
In a transaction some time back, the author was advising a PE firm which was investing in a technology startup. After the legal due diligence, the terms of the investment agreement were due to be negotiated between the investor and the startup. The startup’s advisor who attended the negotiation meetings turned out to be a chartered accountant. The startup had not engaged a lawyer and had faith in the CA. With no offence to the CA profession, it was observed that that individual was unable to give justifications to legal clauses in the agreement which the startup had objections to. In the end, after long drawn negotiations, which not only led to cost overruns but also significantly delayed the fund infusion, the startup had to accept the investor’s terms on major clauses. These terms were not in the startup’s favour and the author would have adequately addressed the startup’s concerns, had he been on the other side.
Wrong Choice of Entity
It is vital for a startup to understand the various entity forms and choose the one most suitable to its business. Options include sole proprietorship, partnership, one person company, limited liability partnership, private limited company etc. It is always advantageous to make a proper choice of entity so that the most effective benefits can be derived. The scale of operations and the complexity of compliances should be considered while finalizing the entity structure. Tax benefits and funding requirements also impact the choice. For example, funding institutions generally prefer to consider those entities whose accounts are audited.
Adherence to Transaction Specific Law
While it is essential to ensure regular compliance, specific transactions may bring in additional compliances. These need to be carefully understood before the transaction is undertaken. A case in point was with respect to some of India’s leading online retailers. These startups were established as Indian companies and hence laws from domestic business purposes were being complied with. However, when these companies obtained funding from foreign private equity investors, Indian foreign exchange laws became applicable. At that time foreign investment was not allowed in retail business. This non-compliance triggered an investigation by the Enforcement Directorate against one such online retailer.
Improper Charging of Tax
It is extremely important that taxes being charged to customers are correctly computed. While this may not seem as a major area of concern, the high implications can be understood from a case that was filed before the Hon’ble High Court at Delhi. A writ petition was filed alleging that an online food aggregator startup had been incorrectly charging VAT on the service tax component. The High Court directed the Government of Delhi to examine the complaint and take appropriate action against the entity. Non-adherence to the taxation laws can adversely affect a startup’s business.
Dispute with Investors
Dispute with investors, who are considered as a startup’s lifeline, can prove to be very detrimental. It can cost a startup its life. In separate cases, two leading Indian kids clothes retail entities were dragged to court by its PE investors over irregularities in accounts. A legal battle ensued which not only resulted in the exit of the investors but also put paid to the respective companies’ expansion plans. Gradually they were forced to scale down their existing operations and ultimately both the companies are now under liquidation. Eerie coincidence indeed!
The above are some of big mistakes made by startups which have led to severe implications. In some cases these mistakes have hit where it hurts most, the very existence of the startup. Further unwanted harassment and negative publicity can dent a startup’s image. Hence, it is imperative that legal aspects are given due attention and importance. It may be worthwhile for a startup to engage a consultant with the relevant experience to provide an overview of the applicable laws and the compliances therein. This will also help in identifying any gaps and plugging them in time. It is always better to be on the right side of the law than to endure the hardships of non-compliance. As the saying goes ‘Prevention is better than cure’.