Are you getting ready for an investment round? Are you due diligence ready? Do you know what investors will want in order for them to part with their money? What will they expect regarding ROI, control or management decisions?
Knowing what lies ahead on the road to investment and what legal steps need to be ticked off through each stage can prepare you and your business to make the process as seamless as possible.
Most early-stage businesses and start-ups simply don’t have the available budget for much legal support so should prioritise what’s absolutely necessary and use what budget you have for that.
Helen Goldberg, COO at LegalEdge shared her insights on this:
“Firstly, do make use of early-stage tax relief investment schemes: the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS). They are designed to encourage investment in start-ups and will make your business more attractive to angel investors (if they are UK taxpayers). There are ongoing rules for qualifying though, so be sure you don’t fall foul of them by accident, otherwise you may have some very unhappy investors.
Control share ownership carefully and get paperwork in place to manage founder agreements and tailored articles.
Time and again, we find this is overlooked until it’s too late, i.e. someone leaves (often in difficult circumstances, e.g. a falling-out, or someone’s underperforming) and it’s impossible to get their shares back. This can seriously disrupt, even prevent, a later-stage investment round or exit because it will affect an investor’s percentage ownership and therefore its return on investment (ROI). Even better, use a share option scheme (e.g. an Enterprise Management Incentive or EMI) so you can give staff options rather than shares. They are tax efficient and allow staff to participate in equity ownership while you retain control.
Third is to be sure the company owns its intellectual property (IP), particularly those building proprietary tech, because that’s where the value lies. It’s common in the early days for IP to be held by founders, contracted developers, etc., but it needs to be legally transferred into the company as soon as possible otherwise it may be difficult or even impossible to get hold of later on. And while many early-stage investors do little or no due diligence on this, it will affect the value of the company later on when it’s uncovered, so could well hinder further investment rounds or exit.”
Helen says: “By all means use free publicly available information and documents where you can, e.g. the gov.uk, ACAS, Companies House, HMRC websites. The important thing to consider is the risk, i.e. the likelihood and potential cost if you get something wrong or an agreement isn’t in place or doesn’t do what’s needed because you haven’t outsourced to someone who knows what they’re doing. Think about and prioritise what to spend a bit of money on to get it right from the start or what can wait. And when early-stage investors do want to invest, make sure you get simple but effective documents in place. Often, just a simple subscription letter and tailored articles will work fine. A full investment or shareholder agreement isn’t usually needed at this stage and could cause administrative problems later on.”
Series A and B
The basics are key as we’ve shown above. But for Series A and beyond, the legal requirements step up. Helen says:
Institutional investors will expect you to be ‘investment ready’.
"You'll need to have a package of information and documents ready to go and be ready for due diligence. The package usually includes a pitch deck, capitalisation (cap) table and term sheet setting out an overview of the investment terms being offered. Alternatively, investors at this stage may want to use their own term sheet or offer letter and will often insist on using their own template legal documents too (investment agreement, articles, executive service agreements, etc.) which will replace anything you have in place already. They will also usually have their own advisers and require you to cover their fees.
The legal documents at this stage are more complex and will give investors more rights and control over the business and its future. Investors may also want preferred share rights that give an enhanced ROI. They may require a board position or board observer rights, regular financial and other business information, veto rights over certain business decisions, etc. They will also, and this is key for founders to be aware of, want to take back all or some of the founders’ shares in certain circumstances (‘reverse vesting’), i.e. if they leave within a certain period or are terminated for cause or otherwise (‘early/good/bad leaver’). And founders will be required to give ‘warranties’, i.e. a series of statements backing up the due diligence and value of the company. If any are found to be incorrect later on, investors may look to recoup any loss (i.e. reduced value in their shareholding) from founders.
The due diligence process involves the investor’s financial, technical and legal advisers digging around to check there are no problems or hidden liabilities that might affect the value of the business. Legal due diligence includes looking at corporate filings and documents to check share ownership matches the cap table. It also includes reviewing commercial relationships and contracts with customers and suppliers, insurance policies, employment agreements, policies and incentive plans, data protection compliance, and intellectual property ownership, for example. So, it’s sensible to start organising this early on using a simple online filing system (Dropbox, Google Drive, etc.) that can be added to over time. Problems can delay or even prevent a fundraise from going ahead if they’re too difficult or costly to fix.“
Towards exit and beyond
Helen stresses, “As your business grows, be sure you continue to put key building blocks in place to support it with good sensible agreements, compliance programs, etc. That way you’ll have peace of mind when an exit is imminent.
For assessing and managing what legal support is needed as you grow, use a heatmap mentality – green, amber and red. For high-risk issues in the red zone, spend the money to get the legal side of things right. But don’t overspend on the small stuff in the green zone (e.g., the water cooler lease!). Make sure you use the right legal resources. One size never fits all. Specialist law firm lawyers (and their fees) should be saved for high cost/risk matters, like a big dispute, or a complex exit or deal. A good commercial in-house lawyer will prioritise, risk assess, and manage the legal work and budget. As an example, something we do a lot at LegalEdge is simplifying and speeding up contract closure in the sales cycle. By simplifying templates, giving training and playbooks, putting in place contract management tools and processes, you can really help sales teams to negotiate and complete sales quicker, which ultimately saves time and money and speeds up revenue generation.”
There’s a lot to consider when thinking about the legal side to your investment journey but with the right legal support and preparation, you will be ready to navigate the key points ahead in the fundraising process.
How well prepared are your legal requirements ahead of your next fundraise?