23 May 2017

"Despite their scale and success, the majority of today’s leading corporates are built to operate, not to innovate. Acquiring innovation from new and nimble start-ups has become a powerful approach for leaders who want to stay ahead of disruption.”

Stephen Pierce, Partner and Head of Corporate

Our ground-breaking report Close Encounters: The Power of Collaborative Innovation identifies a significant market trend as large corporates increasingly look to start-ups for the agility and creativity that often struggles to find a place in corporate culture. Wary of outright acquisition or full corporate joint ventures, and not looking for passive investment, collaboration has become a key strategy for delivering corporate innovation.

It can be extremely difficult to strike the right balance between corporate control and creative freedom. Investments must be protected, and performance monitored. However, introducing a spreadsheet-heavy regime into a start-up culture risks inhibiting the creativity that prompted collaboration in the first place. Close Encounters suggests that taking a minority stake in a promising start-up has emerged as a favoured basis for collaboration, providing the larger party with a direct stake in the start-up's growing value while conferring only the ability to exercise "negative" controls, such as the ability to block special resolutions or other fundamental changes, rather than subjecting the start-up to day to day control over operational and other business decisions.

As well as protecting investment through shareholding, taking a minority stake may also carry the right to participate at board level. The right to appoint one or more directors to the start-up's board provides a significant degree of comfort in terms of corporate experience and expertise. It also offers the larger party an extremely useful window into the thought processes of the start-up's creative talents. Insights gained from placing a director onto the board of an innovative start-up can materially improve the larger party's own performance in terms of research, development and innovation.

There are, however, legal risks to be managed. Crucially, the parties must not lose sight of the nature of a director's duties, developed and refined through case law and codified by Companies Act 2006, Part 10, chapter 2. Those duties include, at s 172, each director's obligation to promote the success of the company, at s 173, to exercise independent judgment and at s 175 to avoid conflicts of interest.

Each director's duties are owed to the company, and not to any other group companies or individual shareholders. If a director appointed to the board of a start-up is also an employee of the larger company, then that director's duties to each company must be fully understood and addressed. For example, specific arrangements might be put in place to pre-authorise the routine sharing of information relating to the start-up with the larger company. However, the scope of any such pre-authorisation must be closely monitored as it is unlikely to extend to the passing of information properly regarded by the start-up as confidential or commercially sensitive.

It is the company itself which can take enforcement action against a director if there has been a breach of duty. The decision to start proceedings against a director would normally be made by the board. However, should the start-up fail then it is quite possible that such a decision could be made in an insolvency situation by a liquidator.

In certain circumstances and subject to certain hurdles, an individual shareholder or group of shareholders can also bring a derivative action or claim against a director for breach of duty on behalf of the company.  

It can be difficult, when the mood is positive at the start of any joint venture or collaboration, to focus on the risks that might flow from any future breakdown in the relationship. However, any corporate or contractual joint venture should begin with a clear view of potential exit strategies or triggers. Similarly, parties entering into a creative collaboration must recognise and address the risks and tensions that inevitably affect directors for whom the company's success is one factor among many.