You and your co-founders had a brilliant and solid business idea, you set up your business and it is going well. However, it is being held back by the need to inject more money to allow it to grow and develop to the next stage. Perhaps you also need the benefit of a third party with experience of taking start-ups to the next level in your sector to help with making your business really fly. What should you do?
There are several options you should consider. From taking out a bank loan (secured or unsecured) to you or your co-founders injecting more money in the form of share capital or as a loan (secured, unsecured or convertible to shares). However, you’ve found another person or a company who has the skill set that you need and wants to work with you to drive the business forward. They also want to invest in the share capital of the company or are willing to make you a loan.
This article looks at what you should do/think about next if the route you have chosen is to seek out investment in your private limited company from a third party such as a business angel or venture capital investor (“VC Investor”). Ideally, the earlier in your business cycle you look at these elements, the easier and quicker it will be to prepare the company for third party investment – a stitch in time really does save nine – and the more confidence you will inspire when seeking to attract that vital investment. So, even if you think external funding is a way off, and you have only just started your business you would do well to take note of the points discussed below as early on in your business’ journey as possible.
What type of investment are you looking for your business? How much are you looking for?
Most venture capital houses or VC investors would seek to initially invest £0.5-2million (seed) or £2-10million (as a series A follow on rounds) and take minority equity stakes (i.e. shares) although these can be supplemented by convertible loans (loans which can be converted, usually at the option of the lender, into shares in the company). Either way VC investors look to own part of the company rather than merely lend money to it. A typical investment cycle of venture capital is 5 – 12 years (depending on how quickly the VC investor makes the return on capital it needs for its fund) after which they would wish to exit either by selling their equity stake to another investor or taking the invested private company public through an initial public offering (“IPO”).
Of course, along the way, the initial funding rounds could well be supplemented by additional investments (follow on rounds know as Series B, C, etc). In these new rounds, new VC investors, as well as perhaps the exiting VC investors, may invest. The effect of this is often that the time it takes to sell the company privately or take it public can be extend by a number of years to allow for growth to return the new investors’ money.
Are all your co-founders and any existing investors (such as angel investors) on board with taking on a new investor? Taking on a VC investor means ceding some of the control co-founders have in “their” company. The VC investor will have their own processes and procedures that it will wish to impose and there will be more formality in the management of the company. A VC investor will not only be able to exert control through their shareholding (although as they typically take less than 50% of the equity the control tends to be negative control i.e. they can block things from happening rather than make things happen) but also through having a seat(s) on the board of directors. Clearly, there is a pay off on the one hand between the money/expertise which VC investors bring and the co-founders no longer having sole control of “their” company.
Before revealing your sparkling crown jewel of a business, before revealing any non-public information about your business, you need to get your potential VC investor(s) to sign a non-disclosure agreement (also known as a confidentiality agreement). This is what will protect your business sensitive information you will need to share with the VC investor between starting discussions with the VC investor and getting their funding into your bank account.
Heads of terms are typically discussed between the co-founders and the VC investor to ensure that they can broadly, subject to due diligence, find mutually agreeable terms for their future relationship. They avoid both sides spending time, effort and money trying to agree a fully termed deal only to find that they are not aligned on the key commercial terms.
A heads of terms will usually cover the following areas:
Once you have convinced a VC investor that your company is the one to invest in, the VC investor and their financial, sector, investment and legal teams will need to “kick the tyres”. They will need to see documentary evidence that not only backs up the sales pitch you have made to them as to how great your business is, and will become with their investment, but demonstrates that there are no skeletons in the cupboard and the company has been professionally run. This process is known as due diligence.
Typically, due diligence will cover:
Even in a company where everything has been properly documented throughout its life, due diligence is a very time-consuming process.
Accordingly, it is extremely important to consider:
When heads of terms are in place and due diligence is underway attention should turn to documenting the investment through drafting (usually undertaken by the VC investor’s legal advisors) of two key documents. The first of these documents is the Subscription Agreement and Shareholders’ Agreement (with Disclosure Letter).
This document will set out the terms on which the VC investor will subscribe for shares and regulates the relationship between the shareholders going forward once the investment is complete. It will typically cover the following areas:
The second document that you will need to consider are the Articles of Association. “But”, you may say, “my company already has articles of association?”. This is, of course, true but it is likely that your existing Articles of Association will not embed the rights that the VC investor will insist on to protect and regulate their investment. Whilst some of these protections will be in the Subscription Agreement and Shareholders’ Agreement, that agreement is private between the parties to it – it is not a public document so third parties will not have any notice of its terms and can only be enforced by the parties to it. Conversely, the articles of association is a public document (it has to be filed at Companies House) and, being the constitution of the company, is the rule book by which it must be run.
Typically, the Articles of Association will cover:
Provisions setting out how shareholders can make decisions and what decisions need to be taken by special resolution/ordinary resolution of the members.
Note that, by default, anything created for you by an employee (or contractor) will be owned by that person so you will need to include an assignment provision in the applicable contract to counter this presumption; this could be important, for example, if you engage a developer to write the code for your key business asset.
Our view is that there is always a significant quantity of ground to cover between a founder’s decision that investment is needed and actually having the funds in an early stage company’s bank account. Fund raising from start to finish is a time and resource consuming process with many aspects to consider and prepare for. Many founders of early stage company’s underestimate how involved it is and how it can take over from the “day job”.
Our view is that a well-advised company will have started the fund raising process long before those first tentative emails reaching out for interest from potential investors are sent. At Garfield Smith – Technology and Data Lawyers we have extensive experience of advising companies preparing for, negotiating and finalising investment. If you have any considering investment for your company or have any questions or comments on any of the issues covered by this briefing please do not hesitate to contact us.