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Growth Enterprises Market (GEM) in Hong Kong
Product Liability

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.