Ask the Expert: Breakthrough Magazine
So, you’ve got a great idea for a new product or service within the construction or engineering sectors. But how do you protect your intellectual property or other value that you’ve built up within your business?
Antoine West, Partner at commercial solicitors Spencer West, gives his advice on how to make your innovation journey a success – from getting started to exit strategies
A possible solution is for the company itself to buy back the shares. This can provide a straightforward exit for the outgoing founder while also presenting good value to the existing shareholders whose equity in the business will have correspondingly increased.
You work with a lot of companies that innovate - why are you so interested in this area?
About 10 years ago I was working for one of the big City law firms and I assisted a client who was acquiring a shareholding in a modular build system. The system had been designed by one of the leading firms of consulting engineers, Buro Happold, and it was a highly engineered solution for constructing hotels. Each module comprised two rooms and a corridor and formed part of the structure of the building, so it was self-supporting. This lent itself to a de-risked project where the hotel could be built in far shorter time periods than would typically be possible. I was so impressed with the technology that I became involved with the build system and developed a business around that myself; I’ve also worked for other companies whose business was focused around technology and innovation.
If a business is trying to innovate, particularly in a sector like construction, what are the main challenges they face?
First and foremost, if it’s an early stage business, the focus should be on managing the cash. There’s a classic acronym, ‘DROOM’, which stands for ‘Don’t Run Out Of Money’. If the company has raised limited funds in a funding round, then it should be careful to ensure that it is not overloaded with excessive overheads. They should also ensure that remuneration for key workers is based on performance; typically, look to award those team members with shares or share incentive schemes, or other performance-based rewards. This will encourage greater engagement and make sure that their contributions to the business are aligned with the long-term interests of that business.
What about Intellectual property (IP)? At what point should a business think about securing the rights to it's innovation.
It’s important to consider any IP rights that are being developed by the company right from the outset. This will enable the company to protect the value in what it’s developing. Also, if the IP is properly safeguarded, that will assist the company to attract further investment. Maintaining the IP rights at a very early stage is critical, otherwise, the value of the business can simply disappear. Staff can leave and in effect take the innovation with them, and a rival can spring up very quickly, or if one is not careful, clients may acquire IP rights to the exclusion of the business. The IP could relate to a trademark, patents, copyright or know-how. Sometimes the IP rights are not capable of being registered if it’s a case of know-how, as the know-how may reside with the personnel of the business. In that case, protect the knowledge by ensuring that key staff members have long notice periods and that there are appropriate confidentiality provisions and non- compete clauses in employment and consultancy contracts. Also, in employment contracts, be clear that any IP that is developed during the course of those services belongs to the company. But equally, try to ensure that those employees’ interests are aligned with the long- term interests of the company.
Construction and engineering are notoriously high-risk sectors - How can a company protect itself from the financial pitfalls?
If the company has some valuable IP rights or holds high-value machinery or plant, it’s often sensible to have that in a separate business, perhaps a parent company, while the riskier activities – the construction and services activities – are carried out by, for example, a subsidiary. Then, if during the course of carrying out the services the company found itself in difficulty, it wouldn’t be putting its IP rights or assets at risk. If this is done at the outset, the matter is straightforward. Points to consider include how the value that is stored in the relevant company is being charged to other companies, so that it becomes a separate pro t centre. If the service is being delivered as a combined entity with the company that owns the IP, it may be worth separating the two. This can be done by creating a top company in what is known as a ‘share for share exchange’, whereby a new holding company is created to which the principal assets transfer. There are tax considerations around this and a requirement for board and shareholder approval.
How about exit strategies? How can shareholders prepare for the eventuality of a sale?
One of the key points to consider is having an up-to-date shareholders agreement. This is so that if a potential buyer approaches one of the shareholders, the larger shareholders can enable the buyer to acquire all the shares, because otherwise the buyer may not be willing to proceed. That’s known as ‘drag along rights’ and is necessary to preserve the value of the business for a prospective sale. But equally, the minority shareholders will want to have their rights protected so that they’re able to sell their shares in the same way and at the same price as the majority shareholders. That too will be protected in the shareholders agreement and is known as ‘tag along rights’. The sale should be structured in such a way as to ensure that the director shareholders retain their rights to Entrepreneurs’ Relief, because they will want the sale of their shares to be taxed at only 10%. The buyers will often be interested in one or more of the founders retaining an interest in the ongoing business and in that case, it’s worth structuring detailed earn-out arrangements so as to maximise the potential earn-out for the shareholders and reduce the risk of that value being eroded.
But what if one of the founders wants to retire before the business has grown to the point where it's appropriate to sell to a third party?
In that case we often advise on the company buying back the founder’s shares so the company in effect becomes a shareholder itself. As a result of a change in the Companies Act legislation a few years ago, the company once it has bought back the founder’s shares does not have to cancel those shares;: the company itself can remain as a shareholder (in the place of the founder), which is known as the shares being held “in treasury”, although the company as shareholder is not entitled to vote or to receive dividends. The reason why you might want to do that is that the company can then issue those shares to either existing or new shareholders. Also by holding the shares in treasury, the company is not having to reduce its share capital, which can provide comfort to the company’s bank; a reduction in share capital can sometimes trigger banking covenants.
Finally, what's the best piece of advice you can offer companies who want to innovate?
Consider the position of IP rights and preserving these from the outset, because that is where a large part of the value in your business resides. it is your competitive edge, which will excite investors and attract the growth capital you need. Look at potential exit strategies as you are developing the business. Is your innovation one that lends itself to tax advantageous investing, in which case legal and other advisors can introduce your business to growth capital from the investment community. Raise your pro le for instance by attending trade shows such as Ecobuild. Prove the concept. The construction and engineering sectors can be conservative in their outlook and there can be pressure from existing construction companies to apply traditional methods. Therefore, you need proof of concept. Persevere – bringing your innovation to market can be immensely satisfying, but you will encounter barriers to entry and I can say from personal experience that it can cost more and take longer than you think. It’s therefore really helpful to surround yourself with supporters, mentors and business-savvy advisors who get excited about your business and can provide advice and encouragement along the way.
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