Raising capital can be a challenging process for start-ups. Doing all you can to make yourself attractive to potential investors will maximise your chance of securing investment. Partner Chris Owen provides a summary of some of the key legal issues to cover off before approaching investors and the steps involved once negotiations begin.
Investors will usually expect you to have dealt with the following key issues:
A good business plan is crucial. You must demonstrate that your business is credible, likely to scale, when it is predicted to be revenue generating and cash positive, and that you have a thorough understanding of its competitive advantage in the market.
Investors will expect to see a realistic valuation of your business. This can be particularly problematic for early stage businesses. Look to comparables to assess value and factor in the time you need to become cash positive. The general rule is that the further you are from being cash positive, the more expensive the capital (and thus the lower the valuation). Be careful not to overvalue your business; this will only inflate investor expectations or risk creating a negative impression of your understanding of the market.
Recognise the value of your team to potential investors. The team are a key asset of the business. Investors will be keen to know that pivotal team members will not be leaving once the investment is made. Service agreements, or employment contracts, should be agreed with them to ensure necessary formalities are in place to retain them.
Investors will expect you to have taken adequate steps to safeguard the IP you need to operate your business and to protect it from abuse by potential competitors. Registrable IP (for example trademarks, domain names or patents relevant to the business) should be held in the name of the company (and not in the name of one the founders). Unregistrable IP (such as know-how and most software code) should, where possible, be protected by non-disclosure agreements before any confidential information is disclosed.
Investors may well expect an exit strategy where they can cash in their investment. You will need to be able to give a general overview of the likely exit mechanism through a trade sale or a new investor, for example.
Under UK financial services legislation, any oral or written communication to encourage an investor to invest in your business is considered a 'financial promotion'. Financial promotions should only be made by, or approved by, an FCA-authorised person, unless an exemption applies. However any financial promotions you make to an investment professional who is FCA authorised, a certified high net worth individual or self-certified sophisticated investor, are exempt. You will therefore need to make sure that you are dealing with exempt individuals as investors.
Once you have dealt with the issues discussed above, you should then be in a more favourable position to approach investors. The usual legal stages of the investment procedure are as follows:
This ensures that confidential information disclosed to investors remains confidential. Such an agreement should be signed with each party who will be receiving confidential information about your business.
This is usually a non-binding letter of intent to invest, setting out the key terms of the investment. Agreeing heads of terms is a useful exercise in flushing out any issues that may prove a deal breaker, before starting detailed due diligence and document drafting.
The process by which the investor will review the business to verify your valuation and business plan. This can be a frustrating and time consuming exercise for those unfamiliar with the process. It is important to remember that it is at this stage that you need to prove to the investor that you are a worthy investment. You should try to see the process from the viewpoint of the investor, as they will want to ensure that you are as safe an investment as possible before they part with their money. You must be thoroughly prepared so that you are able to back up assertions in your business plan with evidence. In particular, if the success of your business is underpinned by a number of key contracts, you should ensure that the contracts are in writing and the terms and obligations are clearly defined. If not, you should take steps to document the terms of the agreements. Investors will expect clarity and certainty.
The legally binding agreement that sets out the terms of the investment and the nature of the relationship between your business and the investor. This will normally give the investor the right to have access to financial information and in some circumstances the right to veto certain decisions not contemplated by the original business plan. It may also give the investor the right to have board representation. At the same time, the founders may be asked to undertake to protect the goodwill of the business by agreeing not to compete with the business in the event that they decide to leave within a specified period after completion.
This article was published in Disrupts magazine in April 2015.