At last, your startup is bringing you the first tangible something, which is actually expenses, instead of income. Now and again, you hear that someone has raised 200 000 USD in 15 minutes on Kickstarter or Indiegogo, or that some happy startup pitch competition winner gives thanks for a half a million check during some European event. Unfortunately, you don’t have enough expertise (or courage) to duplicate this success.

Here’s when you start thinking that it’s never too late to study, so you apply for participation in some startup incubator or accelerator.

As a lawyer, I’m going to try to get a boring, but a very important legal angle on incubation and acceleration and warn you against the hidden pitfalls in acceleration and/or incubation agreements. I’m going to be the happiest IT lawyer in the world if I find out that incubators complain about startup teams asking way too many questions about agreements, because “there was this article”.

Here is a very important disclaimer: if you’ve come across this article by accident, or you’re a lawyer of some other niche specialization and you’re a little bit out of our subject (which is fine, since as we know, there’s no such thing as a lawyer who can deal with all the areas of law), or you’re a startupper, but you are new to all this stuff, I am going to talk briefly about startup incubators, startup accelerators, and the difference between them. I’ve used this very long and compound sentence on purpose, since that’s how disclaimers usually look like.

However, if you are all well-versed in this subj, you may skip the next section of this article and go directly to the one that follows it.

Breaking Down the Concepts: Startup Incubators and Accelerators

According to law scholars, incubators and accelerators relate to each other like generic and specific concepts. Now let me try to put it in plain words.

In a nutshell, incubators are organizations that knit together investors, companies, funds, NGOs, governmental organizations and schools focused on providing infrastructure and information support to startups.

Let us say, you’ve got a startup idea: a smartphone application that will help air passengers quickly find out whether they can be reimbursed for late flights, generate reimbursement claims, and get their reimbursements (yeah, I know, I’m amazingly creative). So, you are a bunch of enthusiasts with a startup idea. The question is, where do you start? How to make your idea work?

So, you see the top list of Ukrainian and European startup incubators and apply to some of them. What a score! They find your idea good enough and say that your startup is just what Ukrainian airlines need.

Finally, your startup gets included into a program launched by some well-known incubator. It’s more than likely that they will offer you a place where you can work on your product. Maybe they will offer free dinners and accommodation on the premises. Sometimes, incubators only provide some certain benefits for startups at the initial stages of product development. However, in addition to delicious coffee and cozy chairs at coworkings, as a rule, traditional startup incubators have something more to offer.

In a decent traditional incubator you and your team will be treated with the utmost seriousness. You will be mentored by a specialist respected within the IT society, who will guide through the process you and introduce you to people, make a detailed development plan with stages and objectives, help you out with your business plan and marketing strategy, give you a lawyer, as well as a financial expert who will help you deal with the most boring stuff. In addition, you mentor will offer a lot of other useful things to encourage the development of your entrepreneurship skills. Incubators often invest money in startups in exchange to stakes in companies following their incorporation.

Now you finally understand how the market works, who your clients/customers/users are, see your prospects, and have a rough idea of how you are going to bring your product on the market. So, it’s time for you to go to the next stage, i.e. acceleration, during which you are going to create a successful company out of your startup and attract angel or venture investments, that is to say, accelerate the development of your startup (the word accelerate is of Latin origin and means to go faster). So, acceleration is the final stage of preparation of the most commercially viable startups that have passed incubation stages for the further investment.

Making Agreements with Incubators

Let us return to our startup that has been designed to help people get reimbursed for late flights (by the way, this right is provided by the laws of Ukraine, but only few of us know about it). If a certain incubator chooses your startup from a list of other applicants, you will be offered to make an incubation agreement. As I’ve already said, incubators invest in startups in exchange for equity stakes. Consequently, your incubator becomes a shareholder (yet, not the major one) and acquires the right to participate in company management and attract prospective investors.

But what if you find out that you won’t be able to bring your idea to life: airlines have refused to accept reimbursement claims in automatic mode, since such claims may be filed by claimants or their authorized representatives only in writing and should be duly signed. So, your idea goes to waste, and you rue the day when you’ve caused all this mess with Ukrainian airlines. Or maybe you are still enthusiastic about your startup, but your incubator thinks that it’s hopeless, and you would rather leave this incubator, but you’ve already signed the agreement, that is to say, pacta sunt servanda, and stuff like that. What is your next step? You finally get to carefully study your agreement that you have read with half an eye. You try to find the way out of it, but unfortunately, you fail. Well, you’re not the only one to find yourself in the hot seat. This is how legal instruments work. So what are the main traps and pitfalls of incubation agreements?

Incubation agreements may be multilateral. For example, your mentor may be the third party to an agreement, and consequently, may get the share in your company. Therefore, you have to find out as much as possible about your startup mentor, including the business profile and areas of expertise. You have to make sure that this mentor will be able to help develop your startup. If for some reason you’re not satisfied with your mentor, you may include a certain clause in your agreement to provide that in case of default, your mentor should be replaced. If a mentor is a party to an agreement and is entitled to the stake in a company, you may envisage that in case of default, the mentor should be replaced, and this mentor’s share should be assigned to startup founders (to the incubator).

Now let’s talk about the equity shares. The parties to incubator agreements agree on the term, within which a company should be incorporated, the jurisdiction of incorporation, and as well the main provisions of corporate bylaws and shareholder agreement. A shareholder agreement (in this case, the parties to an agreement are the incubator, i.e. the investor, startup founders, and eventually, the mentor) is an arrangement between a company’s shareholders defining how the shareholders will manage the company, appoint directors and other executives, pay dividends, etc. In other words, an incubation agreement is a preliminary shareholder agreement. Depending on the liability and termination clauses set forth in this agreement, you may or may not unilaterally terminate it.

Incubators don’t seek to acquire major shares in companies. As a rule, their shares ranges from 5 to 25% (incubators seeking for 25% shares in exchange for their services will probably promise you to make your startup the next Uber or Instagram, so before you agree, check how many unicorns they have already raised). In general, startup founders have to make sure that their stake is not going to be less than 50% at any round of financing, since it makes companies less attractive to prospective investors. This rule does not work for the soviet-style investors.

According to incubation agreements, startup founders undertake to transfer all intellectual rights in their project to the would-be company.

If there two founders in a team (developer and designer), each of them owns the rights in the software and design. In order to manage these rights, you have to gather them together and transfer to the other party. So, the founders undertake to transfer all IP rights to a company incorporated under the incubation agreement. This includes the situation when, let us say, a startup hires a photographer or a camera person to make a video: they have to sign the agreement on the transfer of rights to a company as well. For startup founders, their IDEA is all that matters, and all the red tape with the transfer of IP rights doesn’t seem so important. I can’t but agree with that. However, some seemingly insignificant paper may turn out to be a significant point of contention in any deal.

Startup founders should be actively involved in finalization and approval of their incubation programs and project plans defining the main stages of incubation and compliance criteria, which are included in incubation agreements or agreed upon in separate documents and are linked to the amount of funds invested in a startup on a certain stage of an incubation program. So, if you decide to terminate the incubation agreement at the second of the third stage of incubation, either you or your incubator will get the company, depending on what you have agreed on in writing.

In certain cases, it would be appropriate to include the clause in the incubation agreement that will specify how the startup founders may spend the money obtained from the incubator/accelerator/investor, in order to indemnify yourself from any penalties for inappropriate expenses. In this case, it is as well important to agree on the powers of the shareholder meeting and specify the matters that would require 100% quorum and unanimous consent.

You know, life may throw you a curveball at any time. So, imagine that you are intended to wind up your company after you have received a notice from the cyber police claiming that you may have hacked the public Wi-Fi at the airport. In this case, in addition to your sleep-deprived eyes and fear, you have another problem. Even provided that you own 50% of shares in the company, it may be wound up only if 100% of shares vote for it. The same goes for restrictions on transactions. For example, you are a startup founder with a majority shareholding, and you want to buy some datacenter for 1 million UAH. Unfortunately, you will not be able to do it, if the shareholder agreement contains the clause specifying that all transactions amounting to over 1000 UAH should be approved by the unanimous consent of all shareholders. Though, you can make sure that these details are spelled out in your incubation agreement.

NDA, Deadlock, Drag Along, Tag Along, and Some More Words that Sound Nice

When a poor startupper comes to a certain investor ready to describe his or her creation in all its glory, it is considered bad manners to even hint to an NDA. All experts keep saying that it does not work that way, since investors have to deal with lots of startuppers, and if they make NDAs with all of them, they will have to keep a special register. This does not work the same way for incubators and accelerators, taking into account that incubators eventually become the shareholders and get the access to all commercially valuable information. Therefore, it is important to decide which information may or may not be disclosed to prospective investors or partners and spell it out in the incubation agreement.

A ‘deadlock’ occurs when shareholders are unable to agree on some issues that require the unanimous consent or 100% quorum, where neither shareholder has a majority vote, during two or more meetings. There are numerous methods that can be used to resolve a ‘deadlock’. In the first place, it’s the purchase of shares of shareholders who refuse to agree on the resolution of the issue. The situation may turn out to be complicated if the votes spread evenly and it is unclear who has to buy the shares out – either those who have voted for, or those who have voted against.

If acceleration is at the stage when investors are searched for and investment agreements are made, in addition to all the above mentioned, it is important to include anti-dilution provisions in the said agreements and provide for the best possible option, i.e. when the value/amount of investor’s shares remain the same during all rounds of financing or are adjusted according to the ratio of change.

It is also important to take into account the drag-along and tag-along provisions. A drag-along right enables a majority shareholder who wants to sell the shares to a third party to require minority shareholders to sell their shares on the same conditions. A tag-along right enables a minority shareholder to join the transaction in which a majority shareholder wants to sell its stake in a company.

This article does not deal with convertible notes, stock options and other investment tools that can be used for incubation or acceleration. It sticks to the most widely spread and common investment practices used in startup incubators and covers the general legal aspects of incubation and acceleration. As your startup will grow, you will hire more employees, customers will recognize your products on the market, and legal aspects of your business will definitely become even more important. Sure enough, if all you can think about is how to make your startup idea work, you likely won’t bother to grasp the meaning of all the ands/ors you will come across in any agreement you sign, and won’t be preoccupied with how they may influence your rights and obligations. However, knowledge is power, and it can’t hurt to be more attentive to legal nuances.