15 Jul 2020 by JC Legal

Identifying and Navigating Legal Risks for Startups

Legal risks are inherent in the process of running a startup. Yet, for first-time entrepreneurs, it is often very difficult to be cognizant of potential legal pitfalls. It is nonetheless worthy to spend some time and resources to avoid legal complications that may lead to business disruptions in the future.

Due diligence is a critical step to safeguard companies from future contractual disputes. It enables you to identify financial, operational or legal issues of the new partner or vendor. While small businesses often do not possess resources to conduct thorough due diligence, companies are reminded that researching the company’s background is equally important as negotiating the terms of a contract. Thus, we recommend startups to take some basic steps of due diligence before committing to a transaction. These include:

1. To conduct a company particulars search

Corporate filings such as the Incorporation Form and Annual Return are publicly accessible in Hong Kong, i.e. through the Companies Registry’s Cyber Search Centre. A quick search would render company particulars such as its true corporate name, registered address, the names of shareholders and directors etc. These allow you to verify the information provided by the new partner or vendor and identify red flags of fraud.

Moreover, a company’s true corporate name comes into play when you start a legal action, as the failure to sue the party in the correct name would render a waste of time and legal fees, or even a risk of having your claim invalidated as the wrong entity is sued. For instance, there are reported cases of fraud where the contracting party is merely a trademark held by another company that operates behind the scene. Thus, it is important to take the time to ascertain the true party before serving the Writ.

When the sum involved is significant, it is more prudent to conduct a site visit to the registered office to verify whether the company has actual business operations as claimed. Some fraudsters merely use a secretarial company as their registered office but in fact no business is being carried out.

2. To conduct a search of civil and criminal litigation records of the company

Litigation history is another indicator of the company’s financial situation and business operation. For instance, having pending claims in the Labour Tribunal may well indicate problems of a limited cashflow and poor management. While ongoing court actions of a company are not publicly accessible, judgements previously rendered are available on legal databases and judiciary websites.

Apart from the above “buy-side due diligence” practices, startups also have to prepare for “sell-side due diligence” if they want to attract investment. A well-prepared due diligence process can enhance both the value of the company to the vendors and the probability of a successful transaction. To start with, companies need to have a due diligence checklist and organise all the expected documentation well. Examples of items on the checklist include Business Registration Certificate, product/service portfolio, board resolutions and reports, shareholder minutes and an intellectual property portfolio etc. For startups that do not have well-organised documents for due diligence, it is perhaps the time for you to create a checklist and carry out internal due diligence, which helps to identify the strengths, weaknesses and value of your business.

Lastly, companies are reminded of the importance of choosing appropriate governing law for their contracts, especially when their clients or business partners are not confined in Hong Kong. Contractual parties have the freedom to nominate the governing law of their choice in the contract. A governing law clause that declares which laws will apply can save the cost and hassle of having to determine the governing law when disputes arise later. In addition, the rules determining the governing law in cross-border transactions can be very complicated and may not render the results desired by the parties. Therefore, it is important for the companies to agree on the appropriate governing law before signing the contract.

This summary is for information purposes only. Its contents do not constitute legal advice and should not be regarded as a substitute for detailed advice in individual cases. Transmission of this information is not intended to create, and receipt does not constitute, a lawyer-client relationship between JC Legal and the user or browser. JC Legal is not responsible for any third-party content which can be accessed through the hyperlink provided in this summary.