For the past 7 years, Invest2Innovate (i2i) has been at the front and center when it comes to supporting the startup community in the country. This can be seen with the report called i2i Investor Toolkit that they released in 2016 which is their most downloaded one yet as it serves as the ultimate guide for investors in the startup world.
Therefore, in order to accommodate startups this time around they have released the Startup Toolkit, a 101 Guide for startups and founders on how to launch, build and operate their businesses in Pakistan.
The Pakistan Startup Toolkit has been designed in partnership with Mubariz Siddiqui, an independent legal practitioner and co-founder of Wukla, which aims to make the law easy and accessible for everyone.
The report answers some of the most important questions that the startups have when they set out on their journey in the world of entrepreneurship. The questions that the report answers are:
Why should I register my company? The report gives excellent reasons as why it is necessary for startups to register, raising investments and signing partnerships with payment providers being the top most reason.
Registering is complicated in Pakistan no doubt, and the report answers the queries on how to register in a simple and easy way in 2 steps and also provides the relevant links. The report also states the options for registering a company in Pakistan, such as partnerships, sole proprietorship, single member company, private limited company, limited liability partnership, Section 42 non-profit, trust, and societies. The report also explains each category in detail along with what is the best option for startups to register as keeping in mind funding and investments.
The toolkit also answers the question of what the new entity limited liability partnership that was introduced in 2017 by the National Assembly of Pakistan. According to the report, “The new Limited Liability Partnership (LLP) essentially merges the flexibility of a general partnership with the advantages of a limited liability company. Ultimately, what that means is that no partner in a partnership will be held accountable for another partner’s misdeed.”
The report also explains the common applicable taxes on businesses such as: withholding taxes, that are paid by clients on behalf of the vendors on every sale; Income tax that has to be paid on every invoice of the business; Sales tax that has to be paid on every transaction that is in the domain of the nature of the product/services being sold; Payroll tax and EOBI deductions need to paid on employee payroll; Consumption tax is also levied on businesses on the consumption of goods and services via sales taxes (General Sales Tax); Bank taxes are taxes levied by government and directly debited by banks from the bank accounts of companies which include but are not limited to Zakat deductions; and Excise taxes are levied on the import of goods.
Furthermore, regarding taxes i2i advises getting an accounting firm on board for a better understanding.
Answering the question of how to protect one’s idea and registering their IP, i2i states that the only way to do so is by registering your IP in Pakistan. They also state the types of IPs that can be registered such as: Trademark/brand name, or the name of the business. This can be registered with the Intellectual Property Organization of Pakistan (IPO Pakistan), which can take up to a year and a half to confirm the final trademark certificate, though the application can be filed in a week. Copyright, is another which includes all creative work, i.e. literary, artwork, source code, etc. Copyright registration takes two weeks with the IPO, and about six months for the final certification. Patents are unique/novel inventions of processes or products in any field of technology which is capable of industrial application, and can be filed in about a week’s time with the IPO.
For contracts, the toolkit suggests getting a lawyer to come up with a draft. Furthermore, Wukla, the startup co-founded by i2i’s partner Mubariz Siddiqui, currently offers free customizable templates that one can use, which includes confidentiality agreements, partnership agreements, power of attorney, agency agreements, and permanent & contractual employment agreements.
Regarding the question about sharing shares with the employees, the toolkit states that there are no clear ESOP (employee stock option program) provisions for private companies in Pakistan. However, an ESOP can be created if the founders of the company allocate shares to the employees as and when the shares have been earned as per their vesting schedule.
The due diligence process for investors is also an important topic that is covered by the report, and it states that due diligence can take a while depending on the investors, with good reason and it better to be prepared to showcase all financial documents, audits, legal documents, etc.
Regarding what the investors look into the due diligence process, the list is as follows: Business Organization: all formation documents and amendments, by-laws, articles of association and governing documents, organization structure charts, lists of all partners & shareholders, and copies of all SECP filings. Business Finances: all audited and unaudited financial statements, grant agreements, any documents that show lines of credit or loans, details of any personal guarantees, security interests, lenders, etc. Accounting: all accounting reports, any non-business related assets, and any and all income tax returns. Contracts: copies and proof of any contracts the business has entered into with other parties. Property and Equipment: any proof if the business owns any property, equipment or assets. Intellectual Property: any evidence and documents if the company has filed for or owns any intellectual property. Employees: a list of all employees, their contracts, shares in the company, organization charts, employee manuals/handbooks, benefit/compensation offered to employees, etc.
Moving on, there are two main vehicles for investment in Pakistan for privately held companies i.e. Equity, also known as the buying and holding of shares in a company; and debt, also known as a loan to a company, in which your profit is not directly related to the performance of that company.
The toolkit also explains what convertible notes are, i.e., they are a hybrid of the two vehicles noted above. Basically a convertible note is debt taken by the company from an investor which will convert into equity based on the valuation of a company upon occurrence of a mutually agreed event or milestone (aka, a “trigger event”). This type of investment is ideal for startups, since valuations can be tricky and abstract at such an early-stage. However, they are not a vehicle of investment recognized under Pakistani law.
Another option that the startups can opt for is a safe or a simple agreement for future equity, in which the money will be converted into equity at a certain trigger event. This type of investment was conceptualized by YCombinator. Unlike a convertible note, a safe is not a debt instrument; which, as pointed out above, have maturity dates, are subject to major regulations in the Pakistan context.
The overall language of the report is fairly simple and it can be seen in the way they have explained various terms and methods. Such as explaining valuation of a company the report reads that “A ‘valuation’ is simply the value of your company in monetary terms. It is the total present ‘price’ of your company based on the money it will earn in the future and the assets it currently possess or will possess in the future.”
Moreover, regarding valuation, it says that most organizations use a simple method called ‘Discounted Cash Flow’for valuation of a company. This method essentially looks at your projected income over a period of time and calculates the value of all future income for the present. There are approximately three methods most commonly used to value any company, i.e., DCF, comparable company analysis, and precedent transaction analysis.
The toolkit also talks about not giving up too much equity to the investors in the early stages of the startup. The report also mentions the four tiers of ownership that are: < 20% shares that give an investor no special rights in a company; A minimum of 20% that give an investor special minority shareholder rights in a company, i.e., the right to be able to petition company courts, etc. Between 26% and 50% shares gives an investor the right to block special resolutions within the company, (since someone would need at least 75% shares/ownership in order to pass a special resolution), and > 51% shares give an investor the majority of shares in a company.
The report also explains the term dilution in simple terms, and emphasizes on the importance of being careful how much of their company one gives up during investment. The report also explains what a term sheet is, which is essentially a nonbinding agreement that outlines the basic terms of an investment. Although it is not a legally binding document it does lay the ground work for the Shareholders Agreement (SHA). According to them, the two things that one should be careful while analyzing the term sheet is the economics and control.
They also state that signing to a term sheet is harmless as it isn’t legally bind but it is important that when you’re signing the SHA your term sheet is accurately represented in it.
A vesting schedule is also explained in simple terms, the toolkit states that it is a legal agreement that reads that everyone will fulfill their end of the bargain to ‘pay for’ their share of the company. The report states the various situations a vesting schedule is used in.
The report overall in short covers the questions that startups are overall concerned with in their early stages. The legal advice given and the language used is fairly simple and in layman’s terms that makes it easy to read and understand.
To read the report in detail you can access the i2i Startup Toolkit here.