Getting you and your business investment ready, and then venturing through the investment process is an exciting but nerve-racking time which takes drive and determination.
It is imperative that your business is well organised from the outset so that you can present your business as attractively as possible to investors and secure the best possible valuation.
Getting investment ready
To be in the best possible legal position to secure investment at the valuation you desire, it is important to demonstrate that the business is organised and that your structure, shares and documents are concise and all in order. Key areas to consider include:
· Ensuring that your business can receive investment. This may seem obvious but is often overlooked. If you are looking to receive an equity investment, you need to have a company with share capital. It is important that the share register is up to date and that all filings to Companies House have been completed properly.
· An investor will want evidence that you own what you say you do. It is important to ensure that you can demonstrate your ownership rights to an investor. Some problematic areas may include intellectual property such as website design and coding.
· Intellectual property rights can be extremely valuable and often form a significant part of a business. An investor will want to ensure that these are properly protected.Your business may have many forms of intellectual property and you should seek specialist advice to identify these and protect the same. You should compile an intellectual property portfolio so that you can clearly demonstrate your businesses’ intellectual property including, where possible, that you have register edits name and logo trademarks.
· You should have a founder’s agreement in place regulating the relationship between the founders and / or existing early stage investors and shareholders. It is important that the parties are aligned in respect of the future and direction of the business including exit plans. Without appropriate drag or tag along clauses you could be restricted in your pursuits.
· You should consider the need for a director’s service level agreement, which set out the duties, restrictions and liabilities of a director to the company. Importantly if they leave and own shares you can ensure these are returned to the company and restrictions for anti-competition is in place.
· If shares have been offered to anyone such as options (even those made informally) to a member of staff or contractor, the terms of such offer should be clearly documented including when such rights fall away.
· If you have suppliers, consultants and/or employees, you should ensure that you have written contracts in place with each of them clearly documenting what has been agreed.
· You should have in place proper written terms of business with your customers clearly documenting the goods and/or services to be provided.
· If you have a website, ensure that you have the necessary policies and notices displayed, such as privacy policies, cookie policies and disclaimers.
· GDPR is a key aspect for claims and complaints so a clear process and policies in place to show any investor is also key.
Identifying potential legal red flags in your business at an early stage and questioning how investors may respond to these (ensuring these are rectified before investors get involved) can give you the best possible opportunity of securing a favourable investment. Being prepared is key, and you should look to take advice from an experienced solicitor at an early stage to guide you through the process and protect your interests.
The investment processes
Whilst not all investment processes are the same, most take the following form:
Whilst it is not an absolute requirement, the first major milestone is likely to be the parties entering into Heads of Terms, often known as a ‘Term Sheet’. This document typically sets out the commercial terms of the deal. It is not usually a legally binding agreement and is used to later draw up the more detailed legal documents.
Sometimes an investor may ask for an exclusivity agreement, or there may be exclusivity clauses within a Term Sheet (which tend to be binding clauses). Such terms seek to restrict the business from entering into negotiations and / or investment agreements with another investor. You should always take legal advice on a TermSheet to ensure you are properly protected and that the terms of the deal as you understand them are accurately reflected.
The use of a non-disclosure agreement (NDA) is controversial within the investment context and ultimately the use of one typically becomes a commercial decision of the business weighing up the legal benefits against the commercial risks of trying to protect any sensitive or confidential information disclosed. There are specific issues and risks around disclosing aspects of something which is patentable and the decision whether to ask an investor to sign an NDA will always turn on its own facts of the detail being disclosed and to whom.
Typically, once a Term Sheet has been signed, you can expect enquires on behalf of the investor. The purpose of such due diligence is to help investors decide whether to proceed with the investment or not and to identify where the risks lie in the business.
Due diligence usually covers three main areas; financial, legal and technical / commercial.
The due diligence stage is often a painful process for the founders. It is prudent to carry out a full audit of your company prior to due diligence, in order to pick out any potential red flags and try to rectify them prior to an investor picking these up.
The key legal documents dealing with the incoming investment are the articles of association, subscription and shareholders’ agreement and disclosure letter.
Articles of Association
The articles govern the way your company is managed, regulated and operated from a constitutional perspective. Many investors will require the adoption of new articles safeguarding any protection afforded to them under the investment agreement. It is important that such document is carefully considered as it has a significant impact on the running and operation of your business.
Probably the most important document in any investment round is the ‘InvestmentAgreement’ otherwise known as a subscription and shareholders’ agreement. This may take the form of one agreement or two. An investment agreement is an agreement between the company, any existing shareholders, the investor and the founders.
An investment agreement will set out the terms on which the investor is purchasing(subscribing) the shares and how the relationship between all parties is to be governed. Typical terms include:
1. A series of warranties (promises) to be made by the company, and often the founders. You may also look to try and limit the amount which an investor will try and recover for a breach of warranty, such as to the amount invested for the company or for the founders their annual salary.
2. Minority protection rights such as areas where the consent of the investor is required (investor consents).
3. Drag along clauses, which enable majority shareholders to force the sale of the company.
4. Tagalong clauses, which prevent the majority shareholders from selling their shares unless the minority holders can exit on the same terms.
5. Reporting requirements, such as what information must be provided to investors and when and how frequently the Board should meet.
6. Bad leaver clauses, dealing with the circumstances when a founder can lose their shares.
It is important that advice is taken on such documents. Many in the industry speak of ‘standard documents’, but always remember it is your business, and the agreement (and restrictions on the business) have to work for your company and its founders, otherwise it is all just being set up to fail. Whilst it may end up being a commercial decision on whether to accept any proposed restrictions, weighing up the risks of the restrictions against the value and need for investment, you need to be fully advised of the long term implications and effects before you can make the decision.
The disclosure letter is prepared by those giving the warranties under the investment agreement (this may be the company and/or the founders). It sets out any issues which may be in breach of the warranties. It should be prepared with care to ensure it awards the protection it is designed to offer. It is specific to your business and should be crafted as such.
Consents and Approvals
Certain consents and approvals may be required prior to finalising the investment. This may include consent from existing shareholders or investors. You may also require advance assurance from HMRC for SEIS or EIS purposes. It is important that specialist advice is sought regarding such reliefs as there are many pitfalls and this is an area where there are regularly changes.
Finally, there are various ancillary documents to be prepared at completion to put into effect the investment, including Board Minutes, Shareholders Resolutions andHMRC & Companies House filings.
From the outset of your investment voyage you should engage specialists who can competently guide you. Taking time at the beginning to ensure that your company and documentation is in order will serve you well.
The investment process can be daunting and there are often considerable pressures, not least financially, on founders to just do the deal and secure the funding. However, it is important that appropriate advice is sought throughout so that you are fully aware of the long-term implications of your decisions and what alternatives may be available.
Written by Karen Holden Founder of A City Law Firm Ltd
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