How to prepare for an early-stage start up funding round: an Australian legal perspective

The internet is awash with articles as to how start ups should prepare for an early-stage funding round, which predominantly focus on the more commercial aspects.

Whilst the commercial aspects are important, there are some simple things that start ups can do from a legal perspective to prepare for an early-stage funding round, which will put them in good (legal) stead to conduct an efficient and successful fundraising process.

Get your house in order

Cap table

The most important document that a start up can get in order prior to commencing any funding round is the capitalisation table (or cap table). The cap table is a document (typically a spreadsheet) that shows the ownership of the company – it normally sets out the company’s securities (e.g. shares, options, convertible securities, etc.), who holds those securities, how much each holder paid for its securities, and each holder’s percentage ownership of the company. The price per share under a funding round is ordinarily determined by dividing the pre-money valuation by the number of shares on issue (either on an undiluted or fully-diluted basis), so it is critical for both the start up and its potential investors that the start up has a credible cap table.

If you have convertible securities that will convert into shares upon completion of the funding round (e.g. SAFEs, convertible notes, etc.), you should ensure that they are properly reflected in your cap table, including on a post-conversion basis once the terms of the funding round are known. Particular care should be taken where there are different types of convertible securities on issue with different conversion terms.

To make the investors’ ownership percentages after the funding round and the price per share under the funding round manageable, you may need to conduct a share split, or share subdivision. A share split increases the number of shares that a company has on issue by dividing its existing shares; each individual share is worth less, but each shareholder holds more shares. Accordingly, it does not change the total value of the company’s securities.

Finalising the cap table may also involve putting in place an employee share option plan (ESOP) and granting securities, for example options, to an employee or contractor under the ESOP. If you have promised to grant securities to employees or contractors but are yet to do so, it is best to clean this up prior to completing the funding round – not only does this make your cap table easier to follow, but if you are relying upon the start-up tax concession for ESOPs, this typically results in a more advantageous position for the employee or contractor.

Members register

Many start ups think that the cap table and the members register are the same thing, but generally they are not – section 168 of the Corporations Act 2001 (Cth) (Corporations Act) requires each company to have a “register of members” that sets out specific information in relation to current and former shareholders of the company, and most cap tables do not technically fulfil this requirement.

As the members register is evidence of title to the shares in a company (unless proved otherwise), it is important that this document is accurate. Further, most investors will want confirmation that the members register has been updated to include the investors and their shares once the funding round has been completed.

If a start up also has options on issue, it must also prepare an optionholders register. Like the members register, section 168 of the Corporations Act requires each company with options on issue to have a “register of optionholders” that sets out specific information in relation to its optionholders.

Other considerations

If you have not already done so, you should consider putting in place a dual company structure, whereby one company (HoldCo) holds the business’ intellectual property (IP) and another company (OpCo) is the business’ operating entity, meaning that it is the entity that employs employees, engages contractors and enters into contracts with customers. This is a common strategy that is designed to protect what is, for most early stage technology companies, their most important asset – their IP.

In the dual company structure, OpCo is a wholly-owned subsidiary of HoldCo and investors in a funding round invest, and receive shares, in HoldCo. There can be tax implications for the start up in putting this structure in place, so it is important to obtain tax advice, but for most start ups the tax implications will only become more complicated as the start up grows, so it is best to consider this as early as possible. It is also necessary to put in place an IP assignment and licence back agreement between HoldCo and OpCo.

Start ups should also consider putting in place the following legal documents prior to commencing a funding round if they have not already done so:

  1. employment agreements between the start up (the OpCo company if the startup has a dual company structure) and each employee (including the founder(s));
  2. contractor or consultancy agreements between the start up (again, the OpCo in a dual company structure) and each of its contractors or consultants. In particular, such agreements should make it clear that any IP created by the contractor or consultant for the start up is owned by the start up; and
  3. IP assignment deeds between the start up (the HoldCo company in a dual company structure) and each founder, pursuant to which the founder agrees that all IP associated with the start up is owned by the start up.

Side letters

If a start up has previously issued equity to an accelerator programme or to investors under a small funding round, it may have issued one or more “side letters” to those parties. Under a side letter the company grants special rights to the third party (e.g. a right to participate in the next funding round, to appoint an observer to the board of the company, etc.) or agrees to ensure that certain terms are included in the shareholders’ agreement that will be put in place at the next funding round.

Side letters can have an impact on the terms of a funding round. Accordingly, prior to commencing a funding round, start ups should collate all side letters and ensure they are aware of their requirements.

Prepare a data room

It is likely that one or more investors will want to conduct due diligence – whether legal, financial, technical or otherwise (or a combination thereof). To streamline this process, start ups should consider collating a data room prior to commencing a funding round. A data room is a central depository of the documents and information that an investor may wish to review. While a start up and its advisors cannot predict every document that an investor may wish to review, there are some documents that most companies have or should have that an investor conducting legal due diligence will want to review – e.g. the constitution (if any), cap table, members register, optionholders register, employment agreements, contractor or consultancy agreements, IP assignment deeds, etc. Virtual data rooms vary in their levels of sophistication, and the price for such data rooms increases exponentially, but the key thing for early-stage funding rounds is that the documents and information are in a single, secure, easily accessible location.

What do you not need to do?

If you do not already have a shareholders’ agreement in place, there is often little value in putting one in place shortly prior to commencing a funding round as investors will usually require amendments to the shareholders’ agreement (or for the shareholders’ agreement to be replaced in its entirety). The company’s constitution is usually amended or replaced at the same time as the shareholders’ agreement, so there is also generally little value in doing this prior to commencing the funding round. However, if you are a founder team and you do not have a founders’ agreement in place then there is value in the founders discussing the key terms of the shareholders’ agreement in advance of commencing a funding round, to ensure you are aligned before commencing discussions with potential investors.

Conclusion

A funding round can be both an exciting and challenging time for start ups and their founders, but with a bit of forward-planning, legal aspects that often cause stress or delay can be dealt with prior to commencing the funding round, which allows start ups and founders to focus on finding investors, negotiating the terms and closing the transaction (and getting the money in the bank!).

If you are a start up looking for legal assistance to prepare for a funding round please contact the Corporate Advisory team.

Liability limited by a scheme approved under Professional Standards Legislation.
© ADDISONS. No part of this document may in any form or by any means be reproduced, stored in a retrieval system or transmitted without prior written consent. This document is for general information only and cannot be relied upon as legal advice.