If you’re a startup planning to grow, you may be thinking about taking on investors and raising capital to help finance your growth plans. So what legal things do you need to know as a startup preparing for a capital raise?
When preparing to raise capital and attract potential investors, it’s helpful to think about your legal considerations in two broad categories:
- Getting your company structure prepared for investment
- Preparing your legal documents for investment
In this article, we’ll explore each of these aspects in detail.
Your Company Structure is significant for several reasons – it can help protect you from liability, ensure your business’ intellectual property is protected and help make your business more attractive for investment.
There are three different types of company structures that are commonly used for investment: the single company structure, the dual company structure and the ‘hybrid’ trust/company structure.
Single Company Structure
A single company structure is the simplest to set up. It involves having a single proprietary limited company, which receives funds from investors in exchange for shares in that company. In this structure, the company receiving the investment is the same company which will own all intellectual property of the business, as well as engage customers and employ staff.
This company structure is simple to set up, but is less appealing to investors than a dual company structure (explained below) as it does not provide as much liability and intellectual property protection.
Under a single company structure, if the company is held liable for an issue with an employee or customer, then all of the company’s assets (including its intellectual property and cash) could be at risk.
Dual Company Structure
A Dual Company Structure is a little more attractive than a single company structure as it offers more protection for investors of their investment.
Under a dual company structure, you’ll have a holding company (or HoldCo) which owns 100% of the shares in a subsidiary company, usually referred to as the ‘operating company’ (or OpCo). The founders and investors will then hold shares in the holding company.
Once the dual company structure is set up, the company can then split ownership of business assets between the two companies. The holding company can hold the business’ most important assets, like cash and intellectual property, whereas the operating company can be the body responsible for entering into riskier contracts with clients, staff and suppliers.
If things go wrong in the operations of the business (e.g. a client sues the business), a dual structure means that the key assets of the company are generally not at risk – because a holding company will usually not be liable for its subsidiary’s debts. This means that clients can sue the operating company, but generally won’t be able to come after the business’ important assets, such as the business’ intellectual property.
The downside is that it is a little more complex and costly to set up and maintain a dual company structure than a single company structure, as it requires the administration of two companies rather than one.
Hybrid Trust & Dual Company Structure
A third option is to set up a hybrid trust and dual company structure. If you’re not too familiar with this, it’s worth doing some reading into how a trust works.
The hybrid structure is very similar to the dual company structure, except instead of the founders holding their shares in the holding company personally, they hold their shares in the holding company through a trust. The advantage of this is twofold.
Firstly, founders benefit from asset protection. If an investor attempts to lodge a claim against other shareholders they may only be able to claim against the founder’s trust, rather than the founder individually – and so the founder’s personal assets will not be at risk to other shareholders.
Secondly, founders may gain certain tax advantages by holding their shares via a trust, particularly in the event that the company distributes profits or the founder eventually sells some or all of their shares.
Trust-based structures are complex, and it’s always best to get tax or legal advice before setting these up to ensure they are appropriate for your personal circumstances. They can also be expensive and may require the business to maintain many different companies.
What Structure Is Right For My Business?
The correct structure for your business depends on your circumstances, but it is most common for companies that raise investment via equity to use a dual company structure.
Angel Ventures wants to invest $2 million in a software company, Pear Technologies, which has developed a SaaS tool based on innovative machine learning technology developed by Pear Technologies. Pear will be using the funds to develop and improve its technology.
Pear Technologies seems very promising to Angel Ventures, as they believe that the machine learning technology is difficult to replicate and will set Pear apart from its competitors.
However, Pear Technologies has a single company structure, with one company Pear Tech Pty Ltd. Angel Ventures is concerned that the machine learning technology they are investing $2 million in will be at risk if things go wrong in the business.
As such, Angel Ventures requires that Pear Technologies restructure into a dual company structure prior to receiving investment.
Pear Technologies restructures its business, by renaming Pear Tech Pty Ltd to Pear Tech Operations Pty Ltd and creating a new parent company, Pear Tech Holdings Pty Ltd, owned by the founders. All of the shares of Pear Tech Operations Pty Ltd, as well as the intellectual property and other key assets, are transferred to Pear Tech Holding Pty Ltd prior to investment.
Angel Ventures is then able to invest in Pear Tech Holdings Pty Ltd.
What Documents Do I Need?
Once you have your company structure organised and investor-ready, the next step is preparing and understanding the important legal documentation you’ll need for the investment.
The first document that is usually prepared as part of a capital raise is a Term Sheet.
The Term Sheet will contain all the general terms regarding the investment and the company. It will also summarise all the legal documents which will subsequently need to be prepared to finalise the investment, including the investment agreement (usually called a Subscription Agreement), the Shareholders Agreement and, in some cases, the establishment of a Employee Share Scheme or Employee Share Option Plan.
Term Sheets are generally ‘non-binding’ and are used as a short form document which investors and the company will negotiate. Once the Term Sheet is signed, the parties can begin preparing the actual legal documents mentioned in the Term Sheet to finalise the investment.
The Subscription Agreement is a legally binding contract that will contain information on both parties, the value of the investment and regulations around business activities.
It will usually include:
- The amount of money being invested by the investor
- The number of shares the investor will be entitled to in exchange for the investment
- ‘Warranties’ – promises the company and the investor make to each other about their financial and legal wellbeing, which the other party is relying on in agreeing to the investment deal
The Shareholders Agreement is also usually signed by the investor at the same time as Subscription Agreement. If the company already has a Shareholders Agreement, the investor will ‘accede’ or ‘join’ the existing Shareholders Agreement (although it may be amended to suit the terms of the Term Sheet). If not, the company may prepare a new Shareholder’s Agreement for use with the investor.
A Shareholders Agreement is all about the management and control of the company. It covers things like:
- Voting rights: what actions require investor approval?
- Transferring or selling shares: when can investors or founders transfer or sell their shares to third parties?
- Anti-dilution: what happens if the company wants to issue more shares and ‘dilute’ shareholders?
- Drag along/tag along clauses: what happens if the majority of shareholders want to sell to an acquirer and the minority doesn’t?
Employee Shares Schemes
It’s becoming increasingly common for companies to create Employee Share Schemes as an incentive for employee retention. It’s a clever way to ensure the employees’ goals and the company’s goals are aligned by encouraging them to tie themselves to the company through ownership.
Sometimes, the shares aren’t ‘real shares’, but are offered as an ‘option’ to receive shares. These are known as Employee Share Option Plans (ESOPs). It’s worth knowing the difference between an ESS and an ESOP if you want to raise capital for your startup.
Often, investors will request that companies set up an employee share scheme prior to their investment being finalised. This is because they want to ensure that the company has incentives in place to retain key staff who are critical to their investment.
There’s a lot to consider when thinking of raising capital for your startup. Getting an expert’s advice is the best way to ensure your business has a strong starting point.
If you would like a consultation on your options going forward, you can reach us at 1800 730 617 or firstname.lastname@example.org for a free, no-obligations chat.
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