I’m Mark Allen. We’re a law firm that specializes in representing entrepreneurs from the start of their entrepreneurial journey to the end of their journey.
Today, I’m going to talk about capital raising. Now this is capital raising where you are issuing shares, and this means that you will need to have agreed on a value with your investor, and therefore the price for the shares, and therefore the number of shares that the investor’s going to get for their investment.
I’m assuming that you’ve not raised capital before, but even if you have, I’m assuming that it might only have been from friends and family who were going to be investing based more on their emotional attachment to you than their attachment to the business. Nonetheless, even if you have done it before, all that happens as you raise more money and do it again is that the scale and intensity of the exercise increases, all of the things I’m going to talk about will still apply, and the key thing that I hope you will pick up from this presentation is the need to be prepared.
It is a very uncomfortable position to be dancing to the tune of the investor, where they’re asking you for things that you’ve not thought about, and indeed, it can come to a point where investors lose confidence in your ability to manage a company if you’re not prepared. So engage lawyers, accountants early, set up the due diligence materials, think about all the things that an investor may find to challenge you about the company and sort them out much better that you have presented a problem to an investor with a solution rather than the investor finding the problem and then you’re having to work out the solution on the back foot.
Completing your due diligence
This term due diligence is the shorthand phrase to describe the process that the investor will go through to get comfortable with your company, to make sure that the investor is satisfied with your ownership of intellectual property, with the arrangements you have made with your employees and your contractors, that contracts exist to substantiate the revenue that you say the company is earning, and obviously, the financial position of the company through its accounts.
Typically, you will provide this information to the investor in what’s called a data room, these days, this is done virtually by you setting up a Dropbox or some other electronic folder and making the information available to the investor that way. Also, if the investor asks any questions, both the question and the answer or response should be uploaded to this data room.
At the end, this means there is a complete record of all of the information that the investor’s seen and on which they’ve based their decision to complete their investment in your company, and it means that if some claim arises later on where the investor might say that they were not aware of a problem, and you say that you disclosed it, you will be able to prove that you disclosed it because you will have saved a copy of the electronic data room on a USB and kept it safely.
Now, just while the investor’s doing due diligence on you, it is also open to you to do due diligence on the investor, particularly those companies that conduct the business of investing. There’s no harm in you asking for introductions to other companies in which they have invested to see how the relationship has gone, because you need to remember that even though investors may try and seduce you by saying that they’re here to help you, investors, particularly those that are running funds where they’re looking after other people’s money.
Their business is to make money out of investing, and if that means that they need to move you on as a founder from your company, they will do so. So it is useful to make some enquiries, to find out how the investor has behaved, not only when things have gone well, but more importantly, when things haven’t gone as well and there’s been a problem. Have they been supportive? Have they been constructive in dealing with their problem? Or have they used it as a reason for exiting founders from a company? So always think about doing your own due diligence on the investor during this process.
Your shareholder agreement
This is perhaps the most fundamental document you are going to sign. You may already have a shareholder agreement regulating the relationship between you and your co-founder, but remember that with the investor, you’ve got someone who is going to be investing in the company and may not have the same passion that you do for the company and is certainly going to be much more unemotional when things go wrong.
So at this time in your relationship with the investor where optimism is at its highest, you want to use that positive energy to think about all the things that might go wrong and then record how you’re going to deal with that issue if and when it arises. So if the company needs more capital, how is that process going to be handled? Are you entitled to go out and raise money from anyone you want to, or is the rule going to be that you have to ask your existing shareholders first?
The shareholder agreement will also set out who gets to appoint directors and how they might vote on things at director meetings. But there may also be some decisions where shareholders who have not appointed a director to the board want to have a right of veto or indeed a right to approve actions that you are going to take. There is a fairly standard path to these discussions to take over shareholder agreements but every investor’s going to have their own particular requirements. It’s not worthwhile waiting for the investor to provide their shareholder agreement because as you would expect, it is going to be heavily weighted in their favour and then you will spend time undoing things that are designed to protect their interest at the expense of your interest. Most investors, and certainly the professional funds, will be very happy to work with your shareholder agreement, but you do need to have one that is investor ready. That’s the term we use to indicate a shareholder agreement that is ready to take in an investor.
So you need to think about the things investors are going to want and work out how you want to manage the areas where your interests and the investor’s interests may not always be aligned. One of the other things that you will find in a shareholder agreement is your reporting obligation. So under the corporations act, shareholders have very few rights to information from the company and so they will generally put an extensive provision in the agreement as to the monthly, or quarterly, and annual reports that they want, as well as their entitlement to get information from you when they want it. Now, many companies do struggle with this, particularly those that have not been in the practice of reporting on a monthly or quarterly basis. There’s not much you can do about it so investors will have obligations so that people that have invested in them, but you do need to understand what the obligations are and then make sure you’ve put systems in place to be able to comply with the agreement because investors will rapidly lose patients if you’re not complying with what you’ve promised to do.
Now, I’m assuming you all know what vesting is, this is the process where you might have some shares in a company, but you’ve agreed that if you leave the company before those shares are fully vested, you will have to hand some of the shares back, and this is a good way of regulating, particularly in the early days, between founders. What happens when a founder decides that they no longer want to be on the journey but the other founders want to continue? It does allow the departing founder to leave gracefully, perhaps keep some shares for what they’ve contributed already, but to hand back the shares that have not vested. Now, you will find when you raise capital that investors have the same viewpoint, they also want to make sure that you are going to be focused on running the company for the next two, three, four years, and the way they will ensure that is by re-vesting your shares so that when the investment comes in, you will find that you have to work for another two or three years before the shares are fully invested.
Oftentimes, investors will want it to start from a zero base, but usually through negotiation, you can get between a quarter and half your shares as vested and with the balance being unvested to vest over a two- or three-year period.
We think it is better to have the vesting in a separate contract, but it doesn’t matter where it’s located, the vesting agreement needs to make clear and as objectively as possible the vesting conditions that need to be satisfied in order for the shares to vest. Obviously, the easiest way to do this is just through the passage of time. If you are there for another three months, then other three months’ worth of shares vest, but be aware, from time to time, investors may seek to put other KPIs in there around outcomes that they will expect you to achieve for the company.
Your subscription agreement
This is probably the second most important document after the shareholder agreement. It is the agreement that essentially records the investor’s promise to invest an amount of money and your promise to give the investor a certain number of shares. That’s the easy mechanical bit, the hard part of a subscription agreement are what are called warranties. Now these are a series of promises that you and your company are going to make about the company, and its business, and its assets, and if any of those promises turn out not to be true or complete, then that is there is a risk of a claim being made against you.
Now with early stage companies, these warranties are generally limited, so the key things that the investor is worried about, but if you do take investment from a larger fund, particularly an international fund, you are going to find that there will be many questions about the business that you will have to think through and decide whether you can answer yes, I can give that warranty.
Now you’ve always got the opportunity if something in a warranty is not entirely correct to disclose against that warranty and often time is taken towards the end of the transaction to work out what disclosure should be made. It might be for example, that you have had a dispute with an employee or that there is some problem with a bit of the intellectual property that you are using. So if in doubt, it is better to disclose.
The other thing, in all subscription agreements there should be a clause that limits your liability if a claim is made. So whilst everything is done to make sure that the investor does not get to be able to make a claim, if they do, then you want to know that they can’t recover more than what they invested, and also we would normally put in a clause that would prevent them seeking recovery, say 12 months after they made their investment.
So you know that at a point in time you can tick that transaction off and there’ll be no residual liability under it. There may be some can conditions that the investor wants to satisfy before they will invest, these are called conditions precedent. Obviously better if you have no conditions precedent or as few as possible, but if you do have to have them, make sure they are clearly and objectively identified and that there is a date by which they have to be done, and after which, if you haven’t been able to satisfy, each party walks away. There’s no claim made against you for not achieving it, it is just a condition that needs to be satisfied before the investor will release their investment to you.
The other thing we often get asked, “Oh, can you do a term sheet?” Now, a term sheet, as the name suggests, is a short document, usually not binding, which sets out all the key deals of the investment that’s going to be made.
Now, in many cases, this is simply a waste of time because no sooner have we done the term sheet, then we prepare the longer form subscription agreement, and in fact, it would’ve been easier just to do the subscription agreement straight up and get that signed. But there are times when you may be haggling over conditions with the investor where having a term sheet keeps people focused on the negotiation, or you may be wrangling a large number of investors and you want them to get to sign up on all the same terms and conditions. So you get a term sheet that you then get signed off by all of your investors, and then only when they’ve all signed, you get the long form documents prepared.
Your employee stock ownership plan (ESOP)
There’s no great magic about these because even though investors will expect you to have an ESOP, and I’m assuming that you know what an ESOP is. It’s the share option plan that you will ultimately set up to help you reward your employees by giving them an interest in the company, that’s either to attract new staff, to retain staff, or to incentivise staff. And if you follow the tax office rules, this means that you can give your employees an interest in the company without giving them a tax burden when you do.
So it’s something that investors expect you to have, or to at least set up in the future, and even if you haven’t set it up, they will expect you to construct your cap table as if the shares that you’ve allocated for issue to your employees have been fully issued and are held by the employees. And investors are going to expect the dilutive effect of that share issue to be taken out of your shares rather than theirs.
So in your cap table, you will have a line item for ESOP, those shares won’t have been issued yet. Indeed, you may not have set up your ESOP, but we have to have this artificial construct of those shares having been issued when they haven’t been. This of course means that if for some reason those shares never get issued, the investor gets a slight benefit but it has now just become standard de facto practice that investors invest on the basis that that allocation of shares has been deducted from your shares and not the investor’s.
Key thing here is not to worry about it too much, don’t spend money on setting up the ESOP until you have to, and most importantly, agree a number of shares that you’ve set aside with the investor rather than a percentage of shares, which will obviously just increase as time goes on, and may further reduce your shareholding. So always agree a specific number of shares.
Your company register
The company register is a document that has fallen out of favour but is still very, very important and is going to be the first thing that the investors due diligence team is going to want to look at. The company register is a binder of documents, registers, and other consents and documents that keep a history of the company. So it’s going to tell the person who looks through the register, who has owned shares, who currently own shares, who were directors, who the current directors are, who were secretaries, who the current secretary is. And in any dispute between people who are arguing over their role in the company, the court is going to look at the company register as the sole source of truth to answer that question.
Now you might say, “I never got one,” because you can actually now incorporate a company without setting up a company register. Just because you can do that doesn’t mean that you can avoid having the company register.
Also, you might say, “Well, I keep my records at ASIC, why isn’t that enough?” Because ASIC does not maintain the company register. Your reporting to ASIC is a requirement again of the company’s act because you have to keep on the public record details of who the director’s offices and shareholders of the company are.
But if there is a dispute and there is a difference between what is on the ASIC record and on the company register, the court will always look at the company register. So get this in place, and it is always possible to backfill and complete a company register when you haven’t had one, but you are not going to get away without having one.
Documenting your existing funds
Last thing I want to talk about, and only because it comes up frequently, is making sure before you start the final engagement with an investor that you have dealt with money that has been contributed to the company prior to this investment round. Now by this, I mean money that you might have put in, money that family and friends might have put in, and money that may have come in from SAFE holders. Now, now with SAFE holders, it’s quite easy because they will have put money in and there will be a written document that records how they have put their money in and what are they expecting to get when you are doing a priced round.
But really what I want to focus on is the money that you may have contributed, and you may have decided to not treat that as share capital, but we do need to find out whether that is part of the share capital of the company, or whether in fact, you say it’s a loan that you’ve made to the company.
Now, the first thing is most investors will say, they do not want their investment going to pay a past debt, and so it is probably going to be up to you to write that off but if your books are showing that the company owes you money, you will need to address that and have it written off and perhaps even sign a release.
I have been involved in cases where deals have fallen apart because debts have emerged after the due diligence process has started and, all of a sudden, investors have become spooked that there may be other liabilities of the company. Now, there are times when, particularly if you put a large amount of money in, investors will be happy for you to get that paid back, but they will want you to get paid back only when the company is in profit and then probably over a period of time.
So if you have put a large amount of money in, it is best to get it properly documented and then it just becomes a negotiation with the investor as to whether they want you to write it off, and if not, when you can get it repaid. But again, preparation is the key, don’t wait for the investor to raise this, don’t raise it at the last minute, have it in the due diligence room with the solution, and then let the investor talk about it.