@eLaw.com.hk by yip tse & tang, solicitors + notaries 葉謝鄧律師行

Choice of Legal Structure by Technology and Internet Start-ups

Q: Why the liability risk of a technology start-up is a significant consideration?

A: The liability risk of a business can be divided into insurable and uninsurable risks. Insurable risk is like employee's injury in the course of his work. An employee's compensation policy can cover this area of liability. Some risks are uninsurable. This includes the economic risk of technology start-up which business or business model is likely to be adventurous and innovative. For example, a voice over IP telecommunication business is highly subject to such type of risk.

Q: In what situation a technology or Internet start-up may not need a separate legal structure in operating its business?

A: A 'garage-stage' start-up may be in its primitive stage and does not easily attract outside liability, as transaction volume is pretty small. Therefore, choosing a limited company as a business vehicle may not be necessary. Such a garage business can thus be operated in the form of sole proprietorship or partnership.

Q: How is business risk related to legal structure?

A: Insurable risk can be covered by insurance. The exposure to uninsurable risk is covered, inter alia, by choice of a suitable legal structure. A limited company is a typical choice of vehicle to minimize the risk exposure of the personal liability of the shareholders.

Q: Under what circumstances personal liability of the shareholders or directors will arise?

A: Shareholders who do not take part in the business operation will not be exposed to any further liability risk beyond or over their capital agreed to be paid-up. A limited company serves the purpose of limiting the economic risk of the shareholders. Directors take part in business decision and management. The law imposes obligation on them that they have to exercise reasonable skill and care in operating the business of the company. They also owe to the company the fiduciary duty. This includes the duty not to make secret profit.

Q: What legal structure is preferred if equity financing is required from venture capitalists?

A: A technology start-up aims at obtaining equity financing from parties (like venture capitalist) not currently principals of the business must consider adopting limited company as a legal entity. A legal entity separate from the shareholders and the management provides greater flexibility in dividing its equity. If the business is financed by the principals' own savings or through conventional bank financing such as loans secured on fixed assets, having a separate legal entity is less of a concern. This is because when the borrower is a limited company, a bank requires the directors to enter into personal guarantees in any event.

Q: Should a technology or Internet business always use limited company as its legal structure in operating its business?

A: A business is not necessarily limited to one business entity or one type of legal structure. It can benefit optimally by having a combination of legal structures. For example, its author or inventor can personally own the copyright or patent of a technology start-up. The author or inventor may for a price license the intellectual property rights to a limited company which is owned by the author or inventor in equity. The company then uses the granted rights to have the intellectual property rights commercialised and marketed for profit.

Growth Enterprises Market (GEM) in Hong Kong

Growth Enterprises Market (GEM) in Hong Kong
(Source: GEM, HKSE)

As a gateway to Mainland China and with close trading and business links to other Asian economies, Hong Kong is strategically placed in a high growth region. Over the years, Hong Kong has developed into an internationally recognised financial centre and has provided many Asian and multinational companies with fund-raising opportunities. Growth enterprises particularly those emerging ones, i.e. enterprises that have good business ideas and growth potential, however, may not always be able to take advantage of these opportunities. A great number of them do not fulfil the profitability/track record requirements of the existing market of the Stock Exchange of Hong Kong ( i.e. main board of the Exchange ) and are therefore unable to obtain a listing. The Growth Enterprise Market (GEM) is designed to bridge this gap.

GEM offers growth enterprises an avenue to raise capital. The Growth Enterprise Market does not require growth companies to have achieved a record of profitability as a condition of listing. This removal of entry barrier enables growth enterprises to capitalise on the growth opportunities of the region by raising expansion capital under a well-established market and regulatory infrastructure. Besides the listing of local and regional enterprises, international growth enterprises can enhance their business presence and raise their product profile in China and Asia by listing on GEM.

GEM offers investors an alternative of investing in "high growth, high risk" businesses. The future performance of growth companies particularly those without a profit track record is susceptible to great uncertainty. Because of the higher risks involved, GEM is designed for professional and informed investors. It works on the basis of caveat emptor or buyers beware.

GEM provides a fund raising venue and a strong identity to foster the development of technology industries in Hong Kong and the region. GEM is opened to growth companies big and small engaged in all industries. Technology companies in particular should find it attractive to align themselves with the strong growth theme of the market. In providing a fund raising venue and a strong identity to technology companies, GEM complements and supports the HKSAR Government's initiative to promote the development of technology industries in Hong Kong.

GEM promotes the development of venture capital investments. GEM provides both an exit ground and a venue for further fund raising for investments made by venture capitalists. This facilitates more and earlier investments to be made by the venture capitalists in support of the growth of the industry.

(Source: GEM, HKSE)

NASDAQ in USA

Since its inception in 1971, The NASDAQ Stock Market has been the industry innovator. Introduced as the world's first electronic stock market, Nasdaq long ago set a precedent for technological trading innovation that is unrivaled.

Now poised to become the world's first truly global market, The Nasdaq Stock Market is the market of choice for business industry leaders worldwide. By providing an efficient environment for raising capital, Nasdaq has helped thousands of companies achieve their desired growth and successfully make the leap into public ownership.

www.NASDAQ.COM

Exclusive Rights

Exclusivity

Frequently, distributors, wholesalers, sales representatives and others in the product distribution chain will request an "exclusive" territory or "exclusive distributorship" from a manufacturer or supplier. In this type of arrangement, the manufacturer or seller agrees not to appoint or sell to another dealer in the same area. This greatly assists the distributor or sales representative because it need not then worry about competition in the sale of the same products.

Exclusive Distributorships

In Hong Kong, the grant of an exclusive distributorship is generally permissible. Although these arrangements could result in a "refusal to deal" by the manufacturer with other distributors, they are not prohibited by the laws as Hong Kong does not have any anti-trust or anti-competition legislations. The Consumer Council has been strongly advocating to outlaw certain restrictive trade practices but the Hong Kong Government is not responsive on that; nor the business enterprises in Hong Kong would like to witness that to happen.

Exclusive Dealings

The term "exclusive dealing" is generally used to refer to the agreement between a supplier or manufacturer and its customer ( such as a distributor or wholesaler) where the customer is restrained from dealing with any of the supplier's competitors. The term generally includes express agreements, and also arrangements that the have the same exclusionary effect on competitors. For example, some manufacturers use "tie-ins", a requirement that a customer purchase all its needs from the manufacturer, forcing the customer to purchase the manufacturer's "full line." Competitors of the manufacturer then may be foreclosed from selling the customer all of the "tied-in" products.

Arrangements Restricting Competition

There is no general law in Hong Kong outlawing anti-competition practices. There are legislations or regulations restricting anti-competition measures. The best example is the telecommunication services in Hong Kong. The regulating body, the Telecommunication Authority regulates restrictive trade practices of telecommunication licencees through the powers given to him under the Telecommunications Ordinance and also through licensing conditions.

Refusing to Sell

The law does not outright condemn a supplier's refusal to sell or lease a product. This subject area is governed by the market rather than through the law. Henceforth, exclusive purchase right of a party can legitimately happen by virtue of a exclusive right provision under a contract. But care must be given to specific industry like telecommunication services.

Franchise

Franchising is a system of distributing a product or delivering a service in return for a fee. The company that manufactures the product or originally developed the service and that appoints others to use its name and sell the products or service is called the "franchisor". The person that contracts with the franchisor and is granted the right to market the goods or services, according to the franchisor's established practices and upon paying franchise fees, is called the "franchisee".

Franchising can be an attractive alternative if you are interested in starting a business. If you are a small business owner interested in expanding your distribution, franchising may also be a valuable option. There are advantages and disadvantages for both franchisors and franchisees using this system.

Advantages and Disadvantages of Franchises

For franchisors, the advantage is gaining additional outlets for the distribution of products and services without many costs associated in establishing new facilities, such as hiring employees and acquiring facilities and equipment. Also, a franchisor may require the payment of an up front franchise fee, providing immediate revenue. The disadvantages for the franchisor include compliance with complex and time consuming federal and state regulations. To establish a franchise operation, it is important to seek out a lawyer who is familiar with this area. Most importantly, the franchisor must disclose much historical and financial information about the franchise business.

There are many benefits for franchisees. Buying a franchise allows you to acquire an interest in an established business, usually with a recognised name and the benefit of national or local advertising. Franchisors usually provide training and purchasing benefits not normally available to independent small businesses. Often, the franchisor will grant the franchisee the right to use a recognized trademark and will advertise it nationally or locally. On the other hand, a franchise business takes a high degree of personal involvement by the franchisee. The franchisee is also restricted in many ways because he will be subject to the dictates of the franchisor in terms of many facets of the operation of the business. The franchisee may define opening and closing times, product standards, service standards, warranty standards and place restrictions on the franchisee's territory and ability to sell the business. While success will depend in large part upon the abilities of the franchisee, the most important factor is usually the size of the market or value of the service developed by the franchisor.

Considerations for Franchisees

If you are considering buying a franchise, use great caution. Make sure that you carefully read the circular provided by the franchisor. Also, carefully review the proposed franchise agreement.

Are you provided a territory exclusively so that new franchises can't take your business?

Must you participate actively in the business or can you be an "absentee owner"?

Can you transfer the franchise to someone else?

What are the conditions for terminating and renewing the agreement?

Does the franchisor have a recognised, protected trademark that you can use?

Talk to other franchisees about the pros and cons of the business and what it is like to deal with the franchisor. Be particularly wary of promises of great earnings.

Product Marketing

Product marketing is to establish and maintain the most cost effective, efficient and profitable method of distributing products to customers. Determining the best channel of distribution for a product involves an analysis of start-up costs, size of the potential customer base, potential sales volume, cost of shipping and size of the geographic territory. Finding the best method may involve a process of trial and error, or modeling the method of distribution after an industry leader.

Sales Force

The simplest method for selling products to customers is to employ a sales force that deals directly with the ultimate customer, and then to ship the goods and bill directly to that customer. Unfortunately, this method involves a substantial investment in a direct sales force. If there are many potential customers, the large geographic area and/or broad product lines, a direct sales force may not be possible. When involving in direct marketing , the relevant provisions namely S.34 under the Personal Data (Privacy) Ordinance has to be observed.

Distributors and Independent Sales Representatives

Many small businesses instead elect to market their products through independent firms. These independent firms can roughly be divided into two groups: A distributor is an individual or company that purchases goods from a manufacturer and then resells them to another company in the chain of distribution, such as a dealer or retailer. The other channel is through an independent sales representative (sometimes called a sales agent or manufacturer's representative). Unlike the distributor, the sales representative does not purchase the manufacturer's product. Instead, the sales representative calls on customers, solicits orders, and is paid a commission when the sale is completed.

Because a distributor actually purchases the goods from the manufacturer and carries an inventory, the credit worthiness of the distributor is extremely important. An independent representative, on the other hand, does not purchase the goods or maintain an inventory. Because the sales representative simply solicits the orders from the ultimate customer, the customer's ability to pay becomes more important than the sales representative's.

There are many variations on these two basic methods of product marketing. Most commonly, there are often additional parties involved in the chain of distribution. Many manufacturers of consumer goods sell to distributors, who in turn sell to dealers or retailers. In some cases, particularly with high tech hardware and software products, a distributor may modify or enhance the product before resale. Dealings with these "value-added resellers" can become complicated, as issues of protection of intellectual property and responsibility for defective products come into play.

Restrictions on Resale of Goods

Restricting Distributors

Frequently, a manufacturer or supplier desires to place restrictions on its distributor's ability to freely resell the manufacturer's or supplier's goods. For example, a manufacturer may insist that a distributor sell or not sell to certain customers, in certain areas, at certain locations, or in a "primary area of responsibility". These restrictions can be enforced by the manufacturer through cutting off supplies of goods, terminating the distributor or dealing more favourably with other distributors.

Like exclusive distributorships, the law generally permits restrictions on the distributor's ability to resell the products.

Resale Price Maintenance is not Prohibited

"Resale price maintenance" is not unlawful in Hong Kong. Resale price maintenance involves the direct or indirect requirement by a manufacturer that its distributor or dealer resell the goods at a minimum set price or price level.

Restrictive Trade Practices in General

The management of whatever scale and nature of business has to be minded about the legal aspects in respect of the operation of the business.

Several legal concepts are particularly relevant to technology oriented enterprises, such as Internet platform solutions providers, supplier of proprietary contents. A valuable part of the business of a technology enterprise is based on its intellectual capital. Intellectual capital is characterised by its intangible nature. Protection of such intellectual capital requires a clear understanding of various trade or business protection concepts. These concepts are like exclusive dealings, exclusive rights underlying exclusivity and matters on business arrangement like franchising.

Enquiries and Complaints to Equal Opportunities Commission

The Equal Opportunities Commission (EOC) is a statutory body established under the Equal Opportunities Ordinance.

Its operation is funded by the Government. Businesses are entitled to seek advice and consultation with the EOC regarding matters arising from observance or compliance of the discriminatory legislations. 'Prevention is better than Medication' is the best motto when handling discrimination legislations. Looking for advice from the EOC is not subject to any payment of a fee.