Good Bones

February 2003

Their dream, it's easy to focus on getting the money and the marketing right, rather than discussing board structures, voting rights and intellectual property (IP) ownership.

I see the end results. My colleagues Getting your company structure right today saves legal tangles later, says commercial lawyer Wayne Hudson.

More start-up companies fail through bad business structures than through bad ideas.

As innovators begin to commercialise and I spend a lot of time helping fledgling technology companies untangle unyielding structures, shareholder disputes and lost IP.

To be honest, most start-ups come to me with about the same resources as those buying corner dairies. All the prospective dairy owner needs is a standard form sale-and-purchase agreement and a good stocktake.

To set itself up properly, a start-up company needs to work through complex technology law, commercial and corporate law, IP knowledge, and often some tax.

So, being a lawyer I'm likely to say such things. But skimping at the start costs later. Take these scenarios.

• A shareholder in a go-nowhere company lets his involvement lapse and is ostensibly not included in the action when a fellow shareholder starts to enjoy some success with the company's products. The first shareholder wants back in, but understandably, the active shareholder is reluctant. Yet the inactive partner can make a claim for breach of contract up to six years after he was first involved.
  
  
• A company starts to sell a product that includes software created by a software house. The software house was paid for the work and the company assumes that it now owns the software. In fact, not having read the fine print in the software house's contract, the company discovers it must share proceeds with the software house.
  
  
• A start-up company can't afford to pay a business consultant in cash but offers instead some shares in the company. In addition to the problem of calculating the value of those shares, there are tax implications. The consultant's fee attracts both GST and income tax, which could later be demanded, with penalties, by Inland Revenue.

One company that's getting it right from the start is func.nutrition, a developer and marketer of dairy products. Founder Neil Macintyre is no stranger to the start-up world.

Six years ago he launched Sun Latte, a reduced fat and lactose milk that can now be found in supermarkets across the North Island.

But Macintyre was eager to develop more added-value products. "New Zealand milk is fantastic, so clean, so free of pollutants. Instead of reducing this great product to powder and shipping it around the world, I believe we need to start creating added-value milk products."

Neil's vision is for a range of enhanced and functional milk drinks - products that can deliver supplements, vitamins or even have a natural health effect, such as lowering cholesterol or blood pressure.

This required a strategic shift and raising new capital by bringing in new partners. The original business partner did not want to be involved so in addition to finding new partners, Macintyre needed to organise an exit.

The solution that we helped come up with was to create an entirely new company, func.nutrition. To protect Macintyre's ideas and work to date, we transferred the existing trademarked brand and other IP assets into the new company. This had the added benefit of instantly giving the new company a value - extremely useful when you are going into the market to raise funds.

We also created a simple shareholders' agreement of a limited duration and a constitution that will grow with the company. The company now has the flexibility to raise capital and take on new investors without overcomplicating the decision-making process.

When it came to func.nutrition, we aimed for the most appropriate IP protection, not the most extensive. IP protection is like insurance; you can be unnecessarily over-insured.

First time around, Macintyre protected the Sun Latte trademark but not the process. "Our process is pretty complex, but you can buy the necessary technology off the shelf - it's how you use it that matters. That's not something that you can patent: you just keep quiet about the process," says Macintyre.

With the structure complete, Macintyre began to look for investment and succeeded. Industry New Zealand has agreed to support the company's R&D up to $100,000 over the next two years, while private dairy sector investors have added $600,000 to the start-up funds.

func.nutrition's model won't work for everyone. For instance, start-ups with an existing company or product that has a steady cashflow may not need many more investors to fund the innovation.

Innovators that need many rounds of funding to reach market - often the case with biotech or new technology developments - will need a flexible structure that will allow them to bring in new investors as and when they are needed, yet protect the core IP.

Whatever the needs of the company, good structure is a bit like good bones - without them you're likely to fold.

Setting up: the ground rules

1. Get the structure right before you start. The wrong structure will strangle your growth later on.

2. Get a structure appropriate for your idea or industry. One size doesn't fit all in this game.

3. Get the best advice you can. Skimping on legal, accounting and tax advice now can cost a fortune later.

4. Protect your ideas and investment upfront. These are your start-up's most valuable assets.

5. Concentrate on what you do best and buy/employ the rest. The jack-of-all-trades syndrome can be the death of start-ups.

First published in Biotech Unlimited March 2003, published quarterly with Unlimited, and sponsored by Bell Gully, Industry New Zealand and SolNet/Sun.