04 June 2018

The life-cycle of a start-up

Every start-up is different, but most go through similar phases during their life-cycle.

The idea

It always starts with an idea, whether something new or an improvement to an existing product, service or way of doing things.

It's possible that someone else might be working on something similar, so it's important to record ideas and when, how and by whom they were created at the time, in a legible, permanent format.

Formalising the business

Entrepreneurs often start out on a small scale, without any formal structure for the business.  Whilst this is fine in the short-term, it's important to being to consider formalising the structure of the business early in its life.

Structure

It is often advisable to operate a business through a limited liability company.  This offers various advantages in terms of risk, bundling of assets and liabilities and flexibility around financing.

Intellectual property (IP)

IP can be a key element of a start-up and, where it's business-critical, ownership and licence terms will go to value, which can affect the ability to obtain funding to grow the business.

That original idea will almost certainly constitute some sort of IP.  If it was created by the entrepreneur, it will belong to them personally.  Consideration needs to be given to whether to transfer IP to the business, or whether to retain ownership and licence it.

Regulation

It's important to understand at an early stage what laws and regulations apply and whether any licences or consents are required.

A business that can show a continuous history of good compliance will always be more attractive to investors or buyers than one that cannot, and the costs of getting this wrong can be significant. In a worst-case scenario, the entrepreneur or the business may commit a criminal offence and could be fined and shut down, or even subject to imprisonment.

Initial development

As the business grows, it will inevitably have more dealings with third parties.

It's likely that the business will continue to generate IP, and it is important to ensure that the terms agreed with any relevant third parties (for example employees and third party contractors) transfer ownership of that IP to the business.  Names, logos, designs etc may be registrable as trademarks, designs or patents, which can give the business additional protection and can again go to value.

In other areas such as staffing, leases and supplier agreements, a fine balance is required between getting the best deal or the best people or services and binding the business into significant ongoing commitments that it might not be able to support.  What notice period should employees be on?  Can employees work on a commission or bonus basis to keep fixed employee costs to a manageable level?  Should property be leased on a longer-term basis, or is there an alternative such as a short-term licence?  Are there termination penalties under things like IT service agreements?

Financing and expansion

What happens next will depend on how the business grows, and in what direction.

Seed capital

The business might generate interest from early-stage investors who are willing to take an equity stake, meaning they benefit from upside if the value of the business increases, but are on-risk together with the entrepreneur if it decreases.

This will likely require the entrepreneur to cede some degree of control, as the investor will want to agree certain matters that require its consent to protect its investment.  It may also want to have the right to appoint a director or more generally be involved in the future direction of the business.  This can be an emotional struggle for entrepreneurs, and is it not uncommon that start-ups never pass this stage.

Debt

Another source of finance is through debt.  Debt finance generally allows the entrepreneur to retain more control over the business, but it is not without risk.  A bank or alternative lender may require the entrepreneur to provide a personal guarantee and/or take security over business assets, and the financial covenants for some types of debt can be restrictive and can limit growth.

It may also be more difficult to obtain any significant amount of debt financing than equity financing: a lender generally has no "upside", and is therefore less willing to take risk that an equity investor, although some alternative lenders are taking steps to provide more flexible ways of financing businesses.

Other sources of finance

Other sources of finance are becoming available such as crowd-funding and initial coin offerings (ICOs).  These can often offer advantages over traditional financing methods, although they remain a developing area.

Stakeholder incentives

The entrepreneur may want to incentivise key stakeholders in the business, such as senior employees.  This can be done by way of cash bonuses, but is often achieved through share option schemes.

Developing a business that can stand alone

Business are generally more valuable, and easier to sell, of they are not over-reliant on a particular person, product or service, customer or supplier.  Thought should go into succession planning, building a team and ensuring that both customer and supplier bases are resilient.

Exit

Most entrepreneurs want to achieve value for their business through some sort of total or partial exit.

The most common forms of exit are a trade sale (a sale to another business), an initial public offering (IPO) of shares on a stock exchange, or though a private equity (PE) investment, often involving a management buy-out (MBO), where the current management team buys the business, or a management buy-in (MBI), where the business is acquired by a new management team.

Most of these exit structures allow the entrepreneur to remain involved in the business if they wish.  In any event, purchasers or investors will often require the entrepreneur to remain for an agreed hand-over period, with the price paid being linked to post-completion performance.  PE investors will themselves be looking for an exit, so it is common that an entrepreneur uses PE as an interim step to achieve a total exit for a higher value.

 

An original version of this article was published in Connect (Jersey edition), June 2018.

© Carey Olsen 2018.