We are frequently asked by our startup clients whether or not written contracts are strictly necessary, particularly during the early stages when their business may not be much more than a great idea about a product or a service. We are aware that founders frequently jump into building their businesses without any written contracts but doing so can prove to be a costly mistake.
Why bother with contracts at all?
Written contracts set out the rights and obligations of each party, thereby reducing uncertainties and helping to minimise the risk of disputes getting out of hand. Accordingly, embarking on a business arrangement without a signed written contract means that all of your rights and obligations are left uncertain, leaving your business in a weak position overall.
Regarding the kinds of business arrangements that startups and founders will find themselves in, there are few absolute rules but one is that you should use a written contract whenever you intend to enter into dealings with third parties (paid/unpaid workers, vendors, customers or investors) or with other founders. Employees are a special category because employment laws in Hong Kong actually require employers to provide written employment agreements.
So, what contracts does a startup really need and why?
The following is our Top Seven list of all contracts that founders are likely to need during the early phases of setting up and growing their businesses:
1. Employment contract
You will need at least one sturdy, reusable employment contract for your startup to be in compliance with Hong Kong employment laws but will also need to address confidentiality, non-solicitation, non-competition as well as several other key issues. If you intend to hire interns or other unpaid workers, you will also need a variation of an employment contract for them. For anyone who will be working for the business as a legitimate independent contractor you may also need a services agreement. You will also find that as a startup, these agreements and the business itself will probably need to incorporate a share incentive scheme of some sort to incentivise performance.
2. Co-Founders agreement/Collaboration Agreement/Founders’ Agreement
The function of this contract is to address the contributions of the respective founders, their entitlement to shares in the business (vested over what time period) as well as set out clear contingencies in case any of the founders withdraw. These are often put into place before the business has been incorporated so frequently, founders will ask to include simple administrative rules that will govern the founders’ conduct until a formal shareholders’ agreement is put in place which then replaces the Co-Founders Agreement.
3. IP assignment contract
This is the next most important contract on the list partly because it often is put in place before the business has been incorporated and before any employment contracts are needed. However, the main reason is that the technology developed by the founders is, more often than not, the lynchpin of the business but until the underlying IP has been legally assigned to the business, it consists of little more than ideas in the founders’ heads. Without that crucial step of assigning the IP, no investor will invest in the business for the simple reason that the business doesn’t own its IP. The founders own it. And unless that IP is assigned to the business, what will prevent the founders from leaving the business in 5 months to set up another business?
4. Non-disclosure agreement (NDA)
Everyone has heard of NDAs (aka confidentiality agreements) which primarily function as a means of protecting the business from unauthorised disclosure or use of confidential information. The general rule of thumb is that, as a business, you should not allow any individual or organisation to have access to any valuable confidential information until after they have signed a properly prepared NDA.
5. Investment agreement/Subscription agreement
This contract, often signed together with the shareholders’ agreement, governs the relationships between the company, the founders and new investors and can take many forms depending on the investors’ intended contribution. In Hong Kong, the investment will usually center around a subscription of either preference or ordinary shares in exchange for an agreed amount of cash (i.e.: an equity investment). Occasionally, investors will offer cash in exchange for a convertible note or other debt instrument. Regardless of how the investment is structured, at a bare minimum, the underlying contract must address details such as the amount, timing and conditions for the investment, and conditions that must be met before the investors can recover their investment. Regardless of who prepares the original agreement, the company and founders need to careful about the scope of representation and warranties as well as potential indemnity/liability provisions that investors will typically insist on inserting to protect their own interests.
7. Shareholders’ agreement
These are used to govern the relationship among shareholders once the business has been incorporated and, like the Investment Agreement, are usually quite detailed. Because they are so detailed and therefore costly to prepare, founders will normally wait until they start fundraising before paying to have a shareholders’ agreement prepared. The reason for that is because each investor will assert specific demands to protect their investment and these will need to be reflected in both the shareholders’ agreement and the Investment Agreement. Each new set of demands will entail changes being made to both agreements.
How can OLN help?
With the above list in mind, we hope you can appreciate why it is foolhardy to operate a startup without written contracts. So, how do you avoid that?
Although contracts are freely available online, the quality and suitability of these vary tremendously. Without substantial prior experience dealing with contracts, you will not know which ones to use and what changes need to be made. To avoid making a costly mistake, in most instances, you should seek advice from a lawyer before negotiating, preparing or signing any significant contract.
If you only require a few contracts at a time and some occasional legal advice, the most cost-effective option available in Hong Kong is to subscribe to OLN Online. OLN Online offers a huge library of contract templates for Hong Kong startups (including all of the ones listed above), as well as the basic advice you will need to get started, and is available through two subscription plans.
If you need more hands-on assistance with your contracts, we recommend that you contact one of us at OLN. We have decades of experience advising founders and investors about emerging businesses and can provide all of the advice you will need for your contracts and other arrangements.
If you have any questions regarding your contract needs or other legal issues, feel free to contact Cermain Cheung (email@example.com) for advice.