by Steve Maarbani
In the early years of building a start-up, founders almost always overlook key corporate, legal, tax and financial hygiene matters (the boring stuff) in favour of developing their product, finding market fit and acquiring customers. It’s not an ideal approach to building a global business, but cash is tight and other things need to be prioritised, so I get it.
However, once a company has achieved the threshold milestones of technical validation and consumer validation, and you are ready to seek external capital for expansion, I’m afraid you just need to get serious about the boring stuff.
That means getting your corporate, financial and legal affairs in order. Doing so adds credibility to the founding team and helps increase your chances of a successful capital raise. After all, investors invest in the capability of the team, not just the market opportunity presented by the business.
In this second blog, I highlight the importance of having a clear corporate story and some of the key corporate hygiene matters that will matter most to investors (and which will impact on valuation).
1. What is your story?
Raising capital for your business is a highly competitive process.
Most early stage investors are presented with opportunities on a daily basis, so you need to make sure your business, your team and your operation are able to withstand scrutiny. Having a great idea is not enough.
Founders need to be able to articulate the customer problem they are solving or opportunity they are targeting, show validation of their business model, explain the likely size of the market, how their solution addresses the problem or opportunity better than the competition, what strategies they have in place to acquire market share and why their team is best placed to execute their strategy.
In short, founders need to know and sell their story.
So before you start pitching to investors, ask yourself:
- What is our story?
- Is that story compelling?
- Is everything that we do aligned with that story?
Once your team is clear about you story, making decisions about which milestones to prioritise in order to maximise your company’s value and the funding requirements necessary to achieve those milestones becomes much easier.
2. Is your offer document an asset or a liability?
Preparing a compelling information memorandum (IM) or pitch deck is an essential part of securing funding because it is often the first time investors read your story.
At the early stages of a company’s development, investors don’t want War and Peace, but they do want a document which concisely summarises the company’s story, includes key aspects of its model and value proposition, looks professional, and only includes representations that can withstand scrutiny during the due diligence process.
The look and feel of your IM is also important because it reflects the professionalism of your business and the credibility of your management team.
Since the IM is usually received by email, there’s no opportunity to explain inaccuracies, exaggerations or poor branding. So you need to get it right the first time.
So before you send an IM to an investor, send it to a trusted advisor for feedback and ask them to be brutal in their critique. You can guarantee that investors will be.
3. How much capital should you raise?
This is a question I am often asked by clients. It is important to have a firm answer to this and be able to support that answer with a clear rationale.
Generally, the amount being raised should reflect the forecast capital expenditure of the company over the next 18 months and be attached to measurable milestones that are expected to increase the value of the company’s equity (plus a contingency amount).
Often during the early expansion stages, the capital being raised is earmarked for the hire of additional team members, further product development, customer acquisition and sales and marketing initiatives. Investors will want to understand these initiatives (and their costings) in some detail and be convinced that they are a wise use of the capital they are investing.
So before going to the market with an arbitrary capital raise amount, ask yourself:
- What are the key value-adding milestones we can achieve in the next 18 months?
- What will we need to spend to execute that strategy?
- Can we support each line item of spending with reliable costings?
4. Is your IP protected?
Intellectual property is a startup’s key asset.
During the early years, it is not unusual for a number of people to have contributed to the business’ intellectual property, often without a clearly documented arrangement about intellectual property ownership. This relaxed approach leaves co-founders exposed to potential disputes which can compromise the company’s growth plans and poses a significant risk for investors.
Early stage investors will expect that uncontested intellectual property rights are owned by the corporate structure seeking the funding and that any intellectual property that can be protected has been, including the brand assets.
5. Is your corporate structure appropriate for external investors?
Your corporate structure should ensure that:
- any undocumented arrangements regarding equity have been addressed (often this is equity promised to key team members but never issued),
- the intellectual property and any other key assets are held by the correct entity,
- all team members have employment agreements or services contracts in place,
- asset protection has been considered, and
- it facilitates future expansion of the business or the sale/listing of the business.
Investors may also require a restructure of the shares such that the founder shares vest over time to address the situation where a co-founder leaves the business.
6. Have you considered the rights of existing shareholders?
The capital raising process is often as much an exercise in stakeholder management as it is a showcase for new investors.
Introducing new shareholders to a company can change its culture, potentially dilute existing shareholders and alter its management dynamics. Therefore, it is important that existing shareholders are aligned with the capital raise strategy before approaching external investors.
The company’s constitution and shareholders’ agreement should also be consulted to ensure the pre-emptive rights of existing shareholders are understood and addressed.
The more complicated your member register, the more time you will need to dedicate to internal stakeholder management. Without the support of existing shareholders, the capital raise program can be unnecessarily delayed or frustrated.
7. Does your capital raise comply with fundraising laws?
The Corporations Act (Cth) 2001 requires disclosure to investors when an offer of securities for issue is made, unless an exemption applies.
Disclosure is generally made by way of a prospectus, a short form prospectus or an offer information statement. Each type of disclosure document requires varying levels of regulated content which can be time consuming and costly to prepare.
It is important that the founders understand the fundraising rules and the details of the available exemptions to ensure the fundraising campaign is carried out in the most efficient and cost-effective way without contravening the corporations legislation.
8. What will you do with shareholder loans?
Seed stage funding contributed by the founders is often provided to the business in the form of shareholder loans. External investors coming on board during the expansion stages will generally see that capital as part of the founders’ sweat equity and not permit shareholder loans to be paid out of any new capital raised.
Before you speak to investors, ensure your shareholders are aligned regarding the likelihood of converting shareholder loans to equity or forgiving the loans as part of the fundraising.
9. Have you claimed all of your R&D tax incentive entitlement?
The R&D tax incentive provides a key opportunity to fund ongoing development and increase cash flows within the business, as well as leveraging the equity capital raised from private investors.
For companies with turnover of less than $20m, this program provides up to 45 cents cash back for every $1 spent on eligible R&D activities thus benefitting emerging companies the most (particularly those pre-revenue where tax losses are likely to be available). The process is self-assessment and non-discriminatory in regards to industry, with claims lodged on a yearly basis to access annual refunds.
Investors will expect that companies have maximised the opportunities available to them under the R&D Tax Incentive program and have utilised the additional cash available to their advantage.
10. Are you ready for due diligence?
Investors who are interested in investing in your company will want to conduct their own investigations of your business, known as due diligence.
Those investors will seek to test the key representations made in the IM and assess for themselves whether the claims that have been made are accurate. Due diligence will also focus on any aspects of the business which is critical to its value or is an area of risk.
This will include an assessment of your corporate structure, shareholders agreement, the terms of any outstanding or unissued equity (or instruments convertible to equity), intellectual property, material contracts, joint ventures, key supplier/customer agreements, the skills and experience of the management team and any other material aspect of your business that has an implication on its value.
To prepare for this, founders should undertake their own assessment of these matters and collate all relevant documentation to ensure an efficient due diligence process.
Before approaching external investors, ask yourself, are we ready to answer the tough questions about this business and provide all necessary supporting documentation.
The key to the fundraising process is preparation. Founders that approach investors too soon and without the right preparation waste time and energy working out the importance of the matters detailed above. So before your first pitch, prepare, prepare, prepare, because it’s almost impossible to make a second first impression.
In the next article, we look at the key aspects of deal term structuring.
Steven Maarbani – PwC, Partner, Venture Capital ; Private Equity
Posted on November 23, 2015