Not every startup can be bootstrapped. MICHAEL DRYSDALE considers some practical points for founders preparing to raise equity investment for the first time
It will take time and effort to arrange your first equity investment, but you don’t need to have an investor lined up to start preparing. Talk to founders of other companies who have been through the process. Start reading about EIS relief and SEIS relief and why they’re important to individual investors.
And consider your, and your co-founders’, links to potential investors. However, care needs to be taken here, because of the prohibition on financial promotions under the Financial Services and Markets Act 2000. This means that, before sharing any information with a potential investor, you must first make sure they come within an exemption that allows them to receive such a financial promotion (the most obvious one being that they are a high net worth individual).
Look for angel investment syndicates that are active in your area – the Angel Capital Scotland members directory is a good place to start. Or look for venture capital funders if the amounts you are seeking are more significant.
Once identified, your preferred investors will carry out due diligence on the company. You can prepare for this by starting to collate and keeping securely in one place, copies of key documents such as employment and consultancy contracts, agreements in relation to intellectual property, shareholders’ agreements, option agreements, insurance policies, and so on.
Work on a pitch deck, taking care with intellectual property and what you disclose, particularly if the IP in question may be patentable. Disclosing something now without the protection of a non-disclosure / confidentiality agreement may prevent a patent being obtained later, so speak to an IP lawyer or patent attorney about this.
And, if anyone who is creating IP for the company is not an employee, you must make sure there are arrangements in place to transfer ownership of that IP to the company. The same goes for the company’s domain name that your CTO perhaps paid for on their credit card, and which is still in their name.
Once you’ve pitched to, and have interest from, investors prepare a simple, clear share capital table to help investors understand who currently holds shares in the company (and who has been granted options, if any), and which will also help existing shareholders understand how the investment will dilute their shareholdings. Ask your adviser for an example cap table.
It goes without saying that valuation is important and there are pitfalls to avoid. Therefore, it is essential to agree the basis for the valuation as well as the figure itself. And be aware of investor shorthand terms such as “pre-money” (value before the investment is made), “post-money” (value after the investment is made), “non-diluted” (position reflecting existing shares only), and “fully diluted” (position reflecting existing shares plus new shares to be issued assuming all options and similar rights are exercised). There is scope for misunderstanding and an experienced adviser can guide you through these terms and their impact.
It’s exciting when a term sheet arrives in your inbox, but don’t be tempted to sign it straight away – read it over carefully and preferably seek advice on it.
Typically, only a few provisions in the term sheet will be binding and need to be considered in the circumstances. Look for these – they’re likely to relate to things like confidentiality, exclusivity and costs. If the company is to be responsible for costs, can these be capped?
While other terms may be expressed as non-binding, in reality it can be more difficult to argue for changes to terms that are accepted in the term sheet, so if you aren’t happy with something it is better to raise it before the term sheet is signed than press ahead and hope you can negotiate it later. The other advantage to negotiating at the term sheet stage is that it will provide insight into how the investors go about negotiation before significant costs are incurred on the main documents.
Don’t be afraid to ask for more detail where appropriate – if the term sheet says that your shares will be subject to “customary leaver provisions” what does the investor actually mean by that?
Getting the right investors is critical. If you’re in the fortunate position of receiving more than one offer of investment, weigh up the offers as a whole. As mentioned, valuation is important but there may be other factors, e.g. a particular investor who has contacts and experience that could open doors for the company.
Find out if your investors require advance assurance for SEIS/EIS relief. If so, you will need to apply to HMRC for this, and it is important to seek advice to make sure your application is right first time (since HMRC may not be willing to look at it again unless circumstances have changed).
The importance of SEIS/EIS relief to investors shouldn’t be underestimated. James Watt, co-founder of BrewDog, joked on social media about delaying his wedding for three years to avoid losing EIS relief on an investment in his fiancée’s company, but don’t expect your investors to forego it!
Once the term sheet is agreed, the investment agreement and new articles will be drafted on behalf of the investors, and you and your adviser can get to work on them and the other documentation that inevitably is required. There is still a lot of work to be done, but all that preparation you’ve been doing is about to pay off.
An experienced legal adviser will know what can be achieved in negotiation with investors and will help you avoid any unnecessary delays in securing funding, so choose wisely.
While preparing for investment and finding the suitable partner does not compare with polar exploration, save for occasional cold headwinds due to economic vagaries, the words of Roald Amundsen, who won the race to the South Pole, are apt:
“Victory awaits him who has everything in order, luck some people call it. Defeat is certain for him who has neglected to take necessary precautions in time; this is called bad luck.”
Good luck!
Michael Drysdale is a legal director at Vialex
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