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  • Writer's pictureruth322

Many startup founders underestimate the need for legal risk mitigation

In danger of incurring crippling legal expenses while defending lawsuits and regulatory investigations, startup founders need to be conscious of the risks they face.

Most founders embark on their entrepreneurial journey being acutely aware that 90% of startups fail. What’s less known is that among these failures, one in ten funded startups flame out as a result of legal challenges.

As we’ve observed in recent cases involving several prominent Southeast Asian startups, clashes with co-founders, employees, investors, regulators, and customers can quickly escalate into full-blown legal battles. If named individually in a lawsuit, it’s not the company that is under siege—founders can be personally liable for legal fees, fines, settlement payments, or damages.

Founders too often think it’s only the company that faces legal risks, when in fact they can be personally targeted for actions they’ve taken in the course of their management duties. Entrepreneurs also frequently operate under the belief that they’ll only need to guard against legal threats when their startup has grown beyond a certain size. In truth, from the moment a startup is incorporated, its management can be sued individually and personally for all manner of missteps.

Legal fees incurred in countering a lawsuit often well exceed the sums paid out in settlements. Innocence of wrongdoing is no guarantee of safety. Whether they win or lose the case, a founder can be forced into crippling debt or bankruptcy when obliged to cover expenses from their own pocket.

Directors and officers (D&O) or management liability insurance helps mitigate this risk. It provides a company’s key personnel with protection if they’re sued for matters relating to mismanagement, breach of fiduciary duty, occupational health and safety, unfair dismissals and discrimination, negligence, error, or a serious omission in the course of executing their role at the company.

It also covers the legal expenses for responses to an official investigation. In Hong Kong, regulatory investigations account for a staggering 90% of D&O claims. Startups operating in strictly regulated fields such as fintech need to be particularly conscious of the likelihood of experiencing an investigation, no matter how unblemished their record is.

When considering investing in a startup, venture capitalists carefully assess the risks that company faces. They examine risks related to funding, viability of its technology, market size, timing and adoption, the business model, capitalization structure, team vulnerabilities, and manageability. Furthermore, VCs look at a startup’s exposure to potential legal action.

Despite the dangers and the relatively low cost of hedging against them, most early-stage founders remain oblivious to the need for legal risk mitigation. In dealing with founders, says Cocoon Capital managing partner Michael Blakey, “We often find that D&O insurance is an afterthought and something that they are not aware of.”

Cocoon is a Singapore-based venture capital firm that funds early-stage technology companies. Like many VCs, before investing, Cocoon requires a startup to maintain protections against legal actions. “It is a condition for investment, but we don’t expect them to have the insurance prior to us joining, especially if it’s their first institutional round. If so, it will be a post-closing requirement,” Blakey says.

“Lawsuits from past employees, problems arising from previous investors, especially around ownership and warrants, can distract founders in the most crucial early days,” says Blakey. Of the potential legal difficulties an entrepreneur might encounter, “legal action brought towards the company by large customers is the most damaging that can happen to a small startup.”

Indeed, major customers can quickly transform from a startup’s lifeline into a hangman’s noose. As soon as a startup commences selling something, as soon as the company secures its first customers and ships a product, that’s when it becomes vulnerable to potential legal action. The dangers increase when a startup conducts tests for a product-market fit and attempts to ramp up traction.

It is at this point that founders often take the most risks, potentially making mistakes in pursuit of greatness. A startup’s founders need to be free to try different things, to pivot, to iterate. They need to be able to make certain decisions that could go wrong. And ideally, they need to have safeguards established in case things backfire.

Occupational health and safety have always been a precarious area for business owners. Now, new legal threats are materializing due to the COVID-19 crisis. For example, in the immediate future, members of a company’s management team could be held liable for lapses in screening or social distancing that result in employees becoming infected.

Work from home is another fraught subject. As staff crouch in front of laptops all day in less than ideal settings—sitting on their couch or at a kitchen table, for example—back, neck, and wrist problems are becoming widespread. It could be argued that employers have failed in their duty of care by not providing the correct furniture or equipment, resulting in physical ailments—leading to occupational health and safety lawsuits.

The potential legal vulnerabilities stemming from COVID-19 are numerous. Errors made in relief claims for furloughed workers could bring legal action from the authorities. Meanwhile, furloughed employees may sue their employer, arguing that they should have been made redundant, and staff made redundant may sue for not having been furloughed. Fairness is in the eye of the beholder.

Budding entrepreneurs are kept awake at night, fearing that their startup will crash and burn due to a faulty business model, lack of funding, poor market fit, ill timing, inability to secure customers or users, and any number of other pitfalls. But the fact is, when a startup fails, the founders can usually pick up and start again. It’s the risk of being sued individually and brought to ruin that should really give founders nightmares.

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