Key issues start-ups face during equity financing

At some point in their life, startups usually need to raise money from outside investors. This article tries to point out a few things to keep in mind when you’re talking to potential investors about equity fundraising.

Get ready to raise

Start-ups need to be aware of certain key factors when arranging equity financing to grow.

Due diligence and the data room

Investors usually wish to carry out some level of commercial, financial and legal due diligence over the target company before making their investment.

Founders should have all the accounting and legal documents up to date to be able to populate a virtual data room to facilitate this due diligence exercise. This helps investors’ advisers to analyse the business and, if due diligence responses are not provided accurately and coherently, poor documentation or lack of information can lead to advisers producing less than positive reports for investors which may impact the fundraising.

Warranties and indemnities

Investors frequently request a set of warranties on several matters relating to the startup’s business (regarding key topics such as corporate structure, employment, compliance, real estate etc.). In many cases, the ability of the investor to bring claims for breaches of these warranties are subject to certain limitations (such as time limitations and a financial cap), and the scope and extent of these limitations are always an important point of negotiation between the parties.

If a significant issue emerges from the due diligence, investors can also seek specific indemnities, which are typically not subject to the same limitations as warranties, and therefore are a key point to be negotiated so that both sides are comfortable. When the issue is critical to the business, investors may seek further protection or walk away from the deal.

Information rights

Investors can request the right to receive certain financial and other information to monitor the progress of their investment – this will be particularly important to investors who do not have a director on the board of the start-up, so they do not have the same day-to-day visibility of the financial and commercial decision making. In this respect, start-ups should consider whether it is appropriate to limit which investors receive the company’s financial and commercial information and whether the amount of information available is proportionate to the size of the business.

Consent regimes

When investors acquire a minority stake in the business, they can negotiate negative controls over the company to ensure certain actions cannot take place by the founders without their consent. Founders should resist a long list of actions which might block business operations or hinder the agility of the business to make quick decisions on key commercial matters. For that reason, founders are advised to negotiate a position such that the restricted matters are limited to key points which might impact the investors’ investment (for instance, amending the articles of association).

On the other hand, when investors become majority shareholders and have a majority of the directors appointed to the board, the founders should negotiate negative controls over the company to ensure certain actions cannot be made without their consent.

Other provisions commonly included in investment documentation:

• Drag along – this allows the majority of the shareholders who wish to sell their shares to force the minority shareholders to also sell their shares.
• Tag along – this allows the minority shareholders to require the majority shareholders who want to sell to a third party to procure the same offer is made to them by a prospective third party.
• Good and bad leaver – “Leaver” provisions are often included to force founders to sell their shares if they leave the business. If they are “bad leavers” (for instance, when dismissed for gross misconducts), the price can be as little as the nominal value of each share. If they are “good leavers” (for example, they leave because of illness), the price can be the “fair market value” (which will need to be defined carefully in the documentation). Investors commonly ask for these provisions to incentive founders’ performance, and ensure they stay in the business to achieve a common goal (often a sale to a third party after significant growth).
• Liquidation preference – this gives investors their money back first, ahead of non-preference shares, in a liquidity event.
• Anti-dilution – this protects investors from their investment being diluted at a lower valuation.

The fundraising process

• Equity funding can take on average 6-8 weeks.
• If there is an immediate need for funds, it is possible for existing or incoming investors to invest capital in advance through an instrument, such as an advance subscription agreement or a convertible loan note.
• SEIS & EIS – it is best to know early whether there will be any SEIS or EIS investors as structural changes will need to be incorporated in the investment documents, and specialist tax advice should be obtained by all parties.
• Option pool dilution – this is where a percentage of fully diluted share capital includes shares and share options that have not yet been granted as well as shares and options already allocated. If the unallocated option pool is going to increase as part of the funding round, founders need to consider whether this increase will be counted in pre-fundraise valuation or post. If the increase is counted in the pre-fundraise value, dilution will affect the existing shareholders, whereas if it is in the post-fundraise value, new investors will also be diluted.
• Rolling closes – after the investment documents are negotiated, it may be the case that the fundraising round is not fully subscribed. To accommodate late or additional investors, a further round occurring within a period of 30 to 90 days from the initial round should be considered.

Speak to our Corporate and Commercial Specialists

Equity finance can be a tough path and getting the right legal advice is fundamental to succeed. To ensure a smooth process, founders thinking of raising money are recommended to seek legal advice in advance.

If you would like to discuss any issue relating to this blog, please do not hesitate to contact a member of the Corporate and Commercial Team on 0330 175 7609 or contact us via the enquiry form at the top of our Corporate and Commercial page.