The Series A round is the first major fundraising milestone for an early-stage company, which typically is when a startup goes through its first, institutional venture capital (VC) process. At this stage, companies would have developed their concept, created a credible business proposal and sourced the seed or early-stage capital (from angel or ‘friends and family’-type investors, or crowdfunding) to grow the business.
Arguably, Series A is one of the toughest stages of any startup journey, where greater scrutiny is placed on the business and the formal procedures required to obtain an investment become more thorough. Before seeking to secure Series A funding, startups must get their house in order and ensure that they have taken key legal steps and considerations that will give their business the best chance to succeed.
Below, we look at the key legal considerations for a company looking to progress to Series A.
Getting organised – preparation for due diligence
Every VC investor will do its due diligence before investing in any business. After all, they will be writing a substantial cheque, and therefore will need to ensure that the company matches the investment proposal presented to them. VCs also want to ensure that there are no issues that could undermine their pre-money valuation or the general viability of the business.
While VCs undertake different levels of due diligence, in nearly all cases, startups will need to disclose all key financial, legal and commercial documents to the investor. It may feel like unexciting housekeeping, but businesses must show that they are well organised (keeping documents updated and in a clear, logical system) before speaking with investors, which will make the process run smoothly.
Important documents to be retained include, incorporation and constitutional documents (that evidence legal ownership, such as the company’s register of members); annual and management accounts; cash flow forecasts; tax computations; commercial contracts; leases; IP licences or assignments (including development agreements; employment contracts and insurance documents.
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Getting organised early will help you stay on top as the business grows. Once the Series A round gets going, you’ll be in a great position to access the information needed so that you can focus on other aspects of the investment. This will also give you the chance to identify, address or explain any gaps or issues before you are in a process with a potential investor (at which point remedying those issues can become much more difficult). If you are unsure, you should be able to ask a lawyer or investor for a sample legal, due diligence questionnaire. It may not be exactly what the investor would use, but it would cover the same areas and requests.
Owning your IP
Although some successful businesses achieve success simply by taking an existing idea and doing it better than their competitors, most disruptive, tech-enabled startups have at least some form of a proprietary product, or unique software, that underpins their business proposal. However, it is not uncommon for early-stage companies not to adequately register and protect their Intellectual Property (IP) at the early stages of their business. This is often a huge issue for investors, as businesses that use systems that they don’t own could expose the startup to litigation risk, and such liabilities will only grow as the company scales. Therefore, investors will want to see evidence that the company has full ownership of the IP underpinning the business. If there are problems or claims around the IP used, the risk and cost will effectively fall on the founders and/or the company.
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Businesses must have a written assignment of all the IP created for the company. This can be through an IP assignment provision in an employment contract or a separate agreement. Do not make the mistake of assuming all IP you have created or commissioned for the business automatically will vest in the company. Further, due to the additional formalities around registered IP (e.g. trademarks, patents or domain names) or applications, you should make every effort to ensure that such IP is registered in the company’s name. It is much easier to resolve IP issues upfront (i.e. before employees or contractors may leave), and any formal fundraising process begins.
Testing your business plan
A credible business plan is a crucial part of an investment round. The founders will be asked to ‘stand behind’ it and demonstrate that it is realistic and has been prepared on accurate information.
Therefore, before approaching investors, make sure the business plan is robust and realistic and can be defended if challenged.
Planning for Share incentives and Founder Equity
Before a startup starts to engage with investors, it should determine how much equity is or will be available to incentivise employees, whether under an Enterprise Management Incentive (EMI) option or other schemes.
Investors usually require an option scheme to be included in the pre-money cap table when calculating the amount of equity (such that any dilutive effect is on the existing shareholders), and may want to increase the size of the pool if it does not provide enough headroom to incentivise key team members and future hires.
Investors are often happy for a new option scheme to be implemented after the investment round. However, they often will want to agree on key terms before they invest. The more equipped businesses are to discuss and agree the size, shape, allocations and conditions of the scheme with investors, the better.
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Depending on the time already committed to the business, an institutional investor may require the founders to “vest” or “re-vest” all or a part of their equity, and give up their vested equity, if they leave the company (albeit at a fair value if you are a “good leaver”). Similarly, an investor may not allow the founder to keep their board seat if their equity is diluted below a certain level. Be prepared to have these conversations.
Managing your existing stakeholders
Consents and approvals are required from existing shareholders to implement a fundraising round. This includes investor consents, authorities to allot shares, disapplication of pre-emption rights and resolutions to adopt new articles.
If the company has a small group of controlling shareholders, this can be straightforward (both in terms of getting buy-in for the investment and collecting signatures). However, if there is a diverse shareholder base (perhaps if there have been several seed investment rounds or a crowdfunding round) that can make achieving the necessary approval thresholds less straightforward. If you fall into the latter category, having a clear communication plan with shareholders (and being on top of practical matters, such as being aware of their availability at key times) is important.
Before approaching shareholders, make sure that investors, agree that you can disclose the proposed transaction, as businesses often have confidentiality obligations to the investors under the heads of terms signed with them.
Negotiating the term sheet
The first document startups will be asked to sign in connection with a Series A round is a term sheet. Typically, the term sheet will address the valuation of the company, the total investment commitment and the key legal terms of the investment.
Even though term sheets are generally stated to be ‘non-binding’ (save for provisions such as confidentiality and exclusivity), do not sign without a proper review. The term sheet will form the basis of the binding long-form documents you ultimately will enter. Although ‘non-binding’, it will be very difficult (and you could lose your investor as a result) if you try to retreat from any ‘agreed’ positions at a later stage. There is also a lot of terminology and market practice approaches you need to understand properly (such as liquidation preferences and anti-dilution ratchets), which will have a material economic effect on the company, and you will need to live with for some time.
As a result, unless you are experienced in VC fundraising processes, in order to understand everything in the term sheet (and what may have been excluded or is missing) you should obtain advice from a VC specialist advisor before signing.
Finally, and this is not just a sales pitch, in addition to the above, it is helpful to engage advisors – in particular, accountants and lawyers – early. There is a wealth of experience and market knowledge available. Having the right support will help you navigate the Series A funding process while also best preparing you for what is still to come.
Written by Ken Wilkinson, associate director at Osborne Clarke