In the rush to establish a new business it is common for founders to avoid, or at least deprioritise, legal documentation as an unnecessary expense. This can turn out to be an extremely costly mistake later on.
Why don’t founders put legal documentation in place from the outset?
At the outset of a commercial endeavour the founders are usually highly motivated to commercialise as soon as possible, perhaps to be the first to market in respect of their product or service, or in most instances simply to start generating revenue to keep the business afloat.
Spending money on legal fees is not high on the list of priorities for newly established businesses.
Moreover, there is usually a significant amount of positive energy and goodwill as everyone looks to a shared rosy future, high trust levels and the possibility of handshake agreements. Naturally people in this positive mindset don’t want to focus on conflict or failure.
It could also be that a friend of theirs told them that they didn’t do any of that when they started their business and everything’s worked out fine..
Why do you need legal documentation?
Primarily, for protection.
Putting in place the correct documentation at the outset provides protection: for your personal assets, for your business assets, against legal liability, and of your business’s reputation.
A large part of this protection comes down to new business owners not knowing what they don’t know.
Obviously most people aren’t expected to understand legislation and case law in any depth – that is the job of the lawyer – however, they might also be unaware of certain risks inherent in their industry. And of course, like everyone else, they cannot know the future: what economic, social and political issues lie around the corner, or how their personal relationships with other founders are going to develop.
Here are some of the documents you should be looking to put in place at the beginning of your business journey.
If there is more than one founder in your business, a shareholders agreement is essential. This is a contract executed by the shareholders of a company setting out their rights, interests and powers in the context of the business the company runs. It offers transparency and order between the shareholders of the company, its board of directors and employees and aims to negate any disputes that may arise between these parties, or at least provide a mechanism to resolve them.
A shareholders agreement is a document that is bespoke to the company’s business, and to this end should include some form of guiding statement along with a procedure for preparing annual business plans that address specific goals, objectives and KPIs. A company constitution, in contrast, is more of a ‘vanilla’ style document concerned with the fundamental mechanics of a company as may be specified in the Corporations Act.
Key provisions of a shareholders agreement include:
- the voting rights of shareholders
- how decisions are made, including whether any special percentage majorities are required for certain decisions
- how to deal with deadlock, which is particularly relevant where there are only two shareholders each holding 50% voting interests
- the funding framework for the business
- drag along and tag along clauses which give shareholders rights in the event of a purchase offer being received by one shareholder from a bona fide third party
- buy sell provisions which outline the process for dealing with shares of a shareholder who dies, or who suffers total and permanent disability or a traumatic event that prevents their further involvement in the business
- restraints on competing with the business if a shareholder leaves
- general dispute resolution provisions
Investing time preparing a shareholders agreement at the outset allows members to dedicate themselves to business operations knowing each of their roles is defined, the funding of the business has been set and they have put procedures in place for dealing with adverse events that might occur in the future.
Licensing and security documentation
Ideally a business will be structured as a dual company arrangement whereby a holding company owns all the valuable assets, including IP, and either leases or licenses this to a wholly owned subsidiary that operates as the trading entity which faces the public and is therefore exposed to risk. The benefit of this structure is that the assets of the business are protected by being quarantined in the holding company.
However, a key component of this structure is putting appropriate licensing and security documentation in place.
The assets will only be safe from the grasp of administrators or liquidators of the trading entity if the holding company has put in place a licence agreement and security agreement, and has registered its security interest on the Personal Property Securities Register (PPSR).
The licence agreement will define the asset and the extent of the licence – duration and (if applicable) physical area – express the obligations of the licensee, outline the fees, include a retention of title clause and provide the holding company licensor with rights to terminate the agreement in certain situations, including the insolvency of the licensee trading entity.
Flexibility is key in this document, as the holding company should be able to maximise revenue generation of the leased or licensed assets while also ensuring their protection.
The security document will create a security interest over the assets being leased or licensed, and its terms must comply with the requirements of the Personal Property Securities Act (PPSA), including:
- an express statement that the licensee has rights in the assets and value is being given for the security interest; and
- a description of the nature of the security interest.
This document should also define the rights of receivers, managers and administrators appointed by the secured party (licensor) in the event of breach of the licence agreement by the licensee.
The security interest should then be registered on the PPSR within the relevant timeframes to ensure enforceability against an appointed insolvency practitioner – usually this will be within 20 business days following the date of the agreement.
Of course, companies whose business involves the leasing or licensing of products to customers will need to have more stringent licence and security documentation in place given their dealings will be with unrelated third parties, and they should be aware of differing PPSA requirements if their lease/licence arrangements fall within the definition of a PPS lease.
Terms and conditions
The terms and conditions (T&Cs) of a business form the basis of its interactions with customers and, depending on its negotiating power, suppliers.
They should be drafted to protect the interests of the business but ensure they comply with relevant legislation.
Commercial terms will include the effect of quotations or estimates, scope of works or services, amount and timing of fees, method and timing of delivery, and imposition of GST.
Beyond the leasing/licensing, retention of title and security provisions already discussed above, legal terms will include defects, warranties and returns, and potentially other forms of security such as personal guarantees where the customer is a company.
Business owners should be very aware of the impact of the Australian Consumer Law (ACL), both in terms of the mandatory guarantees and warranties, and the unfair contract terms regime.
Where a business provides goods or services to a consumer, the ACL imposes implied guarantees – of due care and skill, fitness for purposes and reasonable time for supply – which cannot be contracted out of. Moreover, T&Cs:
- must reflect the requirements of the ACL regarding the provision of refunds and replacements;
- where a warranty is being provided, contain mandatory wording imposed by the ACL; and
- may not contain any blanket refusal of liability for defects.
The ACL also contains an unfair contract terms regime which prohibits a business from including certain terms in a standard form agreement when dealing with personal customers or small businesses.
Unfair terms are generally those that create a significant imbalance between the provider of the goods/services and the recipient and that would cause detriment to the recipient if relied upon.
Factors to be taken into account in determining whether a provision is unfair include:
- the negotiating positions of the parties
- whether a provision is reasonably necessary to protect the legitimate interest of the contract provider
- whether the document containing the provision is legible, clearly presented and uses plain English
Penalty provisions and a broader definition of ‘small business’ coming into effect in November 2023 significantly increase the importance of ensuring standard form contracts such as T&Cs contain no unfair contract terms.
A slew of high profile data breaches in Australia has brought privacy and data security into sharp focus in recent times, together with amendments to the Privacy Act in late 2022 which dramatically increased the penalty provisions for corporations and individuals who breach the Australian Privacy Principles.
If your business turns over more than $3 million annually then it must comply with the 13 Australian Privacy Principles that form the cornerstone of the privacy protection framework under the Privacy Act. They cover:
- collection, use and disclosure of personal information
- integrity and correction of personal information
- rights of individuals to access their personal information
- governance and accountability of organisations
While the recent amendments have strengthened the legislative framework, at an international level it is generally considered that Australia’s privacy regime is comparatively weak.
Commonly regarded as the gold standard of privacy law is the European Union’s General Data Protection Regulation (GDPR), which has an overarching principle that organisations should incorporate privacy of individuals into every aspect of their business operations.
The GDPR imposes strict obligations on any entity that obtains the data of an EU citizen, regardless of where the entity is located, and high profile prosecutions of entities such as Amazon, Google, Facebook and WhatsApp have led to the imposition of extremely large financial penalties by various national regulators.
Confidentiality / Non-Disclosure Agreement
When your business is trying to get its first customers there is a good chance you will need to show its valuable intellectual property, trade secrets or other confidential information in order to get the work.
Rather than just opening the books to the potential customer, you should put in place a confidentiality agreement or NDA that protects your business interests while imposing obligations on the recipient of the information in terms of security and liability.
Important terms to consider when drafting an NDA include:
- whether the agreement is to be only one-way, or mutual. While this may seem applicable only to the direction in which information is to flow, it can also be used as a negotiating point when seeking more stringent obligations.
- a definition of the proposed purpose for which the information may only be used
- a description of the security measures that the recipient must apply to the protection of the information
- exclusions for various employees and advisors, but with the obligation remaining on the recipient to ensure such individuals remain under the obligation of confidentiality
While it is understandable for the founders of a new business to avoid or deprioritise the effort and cost of legal documentation when starting out, this can lead to all sorts of problems down the track, including:
- greater chance of disputes between business partners
- uncertainty following death or incapacity of a business partner
- uncertainty of contractual obligations with customers
- increased likelihood of legislative breaches
- potential loss of protection of assets
The cost of not putting the right agreements in place at the beginning of your business journey can far exceed the savings.