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The Investor/Founder Relationship: A Legal Perspective

Posted by Joe Garza on 2017-05-10

If your company is looking for funding, there are numerous considerations that need to be taken into account. Luckily, this guest blog post from our friends at Linkilaw outlines the most important points founders need to think about before committing to an investment deal.

Securing investment is crucial for any businesses development and continued survival. Whether you’re Microsoft or a recently-launched startup, businesses seek funding for all kinds of reasons. The business may want to build out a minimum viable product, hire a team of skilled employees or even expand into untapped regions.

That being said, with any business venture there is always risk. Within one moment everything could change. This has never been truer when a founder brings a new shareholder or investor onboard. It is the founder’s responsibility to make sure you’ve got all your legal documents in place to ensure legal compliance, attract investors and regulate your relationship with an investor once they’re part of your business.

The list of what could go wrong is particularly endless: a lawsuit against the business, an investor wishing to exit, or a startup failing because of internal conflicts.

Considerations Before Looking for Investment

Here are a some different types of investment to consider:

  • Equity Investment - This means giving away a share (%) of your business in return for investment. If the business makes a profit, puts this into a bank or reinvests it into the business, the likelihood is the investor's share price will increase. If the business wants to give a return to the investors, it pays a dividend and everyone who owns a slice of your business’s pie gets a portion of the profit proportional to how many shares they own.

  • Debt Financing - In exchange for a loan, the business must pay back the previously agreed amount plus interest. The investor gets back the original amount regardless of how well the business does; they don't participate in the upside. In return, they're given priority payment i.e. if the business fails, and they have to sell off valuables, the lender gets paid back before any shareholder take a penny.

  • Royalty Financing - An investor may agree to investing it return for a percentage of revenues on the sale of a product, or supply of a service. This type of investment relieves the founder of the pressure felt when giving equity too early. Royalty financing is more attractive to so many entrepreneurs since royalty repayments are based on profit and allows for better cash flow management.

Do I Need A Business Plan?

You'll need a business plan if you want to secure investment or a loan from a bank. You need to know how much money you're going to ask for and a preliminary plan of how the invested amount will be spent. There are several things you should bear in mind:

  • Your business plan should be based on your businesses potential to yield a high investment return.

  • Describe your product / service as a solution to a problem in your respective market.

  • Be aware of your competitors and the sector your business is in.

  • Include the background / experience for yourself and key members of your team. Do you, or they have the skills develop the business so you can give your investors a good return, pay off debt or sell more goods to give investors higher return?

  • Does your business have the ability to scale?

What Type of Investor?

As simple as it sounds, choosing the right form of investment can be as important as choosing the right investor:

  • Angels - This type of investor uses their personal funds to finance startups. Some angel investors are more than pleased to get a return on their investment, whilst others just want a share of equity. Obtaining angel investment tends to be an informal process with the initial investment based on interest or instinct in comparison to analytics. Angel Investors are a fantastic option for startups who have received no interest from the types of investment described follow. 

  • Venture Capitalists - A Venture Capitalist tends to be part of an investment fund. Typically, Venture Capitalists are not interested in funding early stage startups, unless data suggests it is likely to yield good results. Unlike Angel Investors, they are more likely to invest a larger sum of money, but also more likely to request equity and to be involved in the decision-making process.

  • Banks - Approaching a bank is another alternative. Banks work in a very similar way to an investment firm. A bank will want to know what your business plan is and have some sort of proof that you’ve given some thought to the challenges that may arise and have considered ways to preemptively avoid problems.

  • Peer-to-Peer - This investment option utilises the internet to link lenders and founders together. The lender and business owner negotiate terms for the lender to provide financing. Although similar to angel investment, because peer-to-peer lending uses a platform, different lenders bid on investment opportunities.

  • Reward-Based - This type of crowdfunding gives investors a reward and not equity. Let's say you’re planning a Netflix biopic. You turn to a crowdfunding platform to raise £10,000. Instead of offering to pay back your investors in money, you may give them a reward i.e. premiere tickets or a their name in the credits. Think of reward-based crowdfunding as being similar to sponsorship in comparison to investment.

  • Equity-Based - This type of crowdfunding acts like conventional investment - money in exchange for equity. Early stage entrepreneurs offer shares in their business in exchange for an upfront investment. Equity-based crowdfunding is attracting substantial levels of investment, and some trailblazing UK crowdfunding platforms are growing the sector rapidly and funding some fantastic small businesses.

Line Up Your Team

The question you’re bound to get asked by any investor is: does your business have the capacity to do this? Considering you're asking for a large amount of cash, it's not so outrageous to think that your investor wants to make sure that the management team can execute an ambitious business plan and get a return on their investment. You need to ensure that everyone involved in your business is able to talk about the problems your business may experience and recommend solutions.

Considerations Before Agreeing to Investment

The Right Deal

Before even approaching prospective investors you need to work out how you want your business to progress. As a founder you should ask yourself:

  • How much investment will I need to achieve my goals?

  • What will our exit strategy be?

In Q4 of 2015, the average seed-stage investment size was £648k which was a 28% increase on the previous year. If you’re going to need more than this it is advisable to search for established investor funds or consider crowdfunding as an alternative.

  • Letter of Intent - This is a non-binding document detailing a company's intended action and the steps required to carry out or negotiate the investment. Obtaining and implementing investment is not only a complicated procedure but the finalised investment can be just as complex. Letters of intent aim to add clarity making your life easier in the long run.

  • Term Sheet - A term sheet acts like a blueprint for investment and is the product of negotiations between the investor and business until a binding agreement is made. Typically a term sheet sets out the terms of the deal and reflects the due diligence including issues such as the valuation, proposed levels of investment, equity and also any requirements for warranties from the business owners. If you think of the relationship between an investor and company as a marriage, the term sheet is the ideal document to agree on a mutually beneficial arrangement rather than putting on paper a more adversarial prenuptial agreement.

Tax Relief

  • SEIS and EIS - The Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) are tax incentive schemes which enable investors to benefit from a tax rebate against their personal income tax. The rebate is equal to 30 % of the original amount of their investment. It also provides the investor with the ability to sell their shares capital gains tax-free. Whilst it is not worth becoming compliant with SEIS or EIS in order to attract investors, it is certainly worth structuring a company so that it can become compliant if required by an investor in the future.

Click the images below for the full size.

SEIS

https://fi.co/system/upload/SIES_infographic.jpg

EIS


Your Best Foot Forward: Agreeing on an Investment Opportunity

The Legal Documents

As soon as the investment has been agreed you need to draft either an investment agreement or a shareholders agreement. Each is an essential legal document in your startup’s arsenal, both will help you regulate your relationship with your investor once the investment has been made. It will address the specific rights of the investor(s), such as:

  • Rights to appoint directors

  • Elect board members

  • To receive information on the business

  • To veto certain actions of the company

  • Share transfer restrictions

  • Drag Along Rights

  • Vesting provisions (if applicable)

  • Contains warranties as to the company’s business

Understand IP Concerns

Intellectual property is always difficult to protect, but often the most valuable asset your business will own. You are going to have to hire a lawyer to conduct patent, copyright or trademark searches. If your IP has not already been registered, you need to start filing to get the ownership of your creations. Otherwise, you could find yourself under attack from those who hold similar legal protections and feel that your products are infringing on their legal rights.

It's not uncommon for successful crowdfunded and recently invested in projects to be pirated by overseas interests, some of which may sell similar products or services. As the legal holder of trademarks, patents, and copyrights you must protect your interests and go after those who try to infringe your IP rights. For example, if Person A puts up a photo on their crowdfunding page and Person B claims to own the copyright, Person A can be sued for copyright infringement.

Marketing and PR

One of the avenues recently invested businesses go down is to create buzz, drive traffic to their website or perhaps get more followers on social media. Although you may wish to bootstrap and do all the marketing yourself, specialist expertise can make all the difference. Obviously, an established marketing or PR agency may be out of your price range, but there are tonnes of freelancers out there who will work on a flexible basis. Think People Per Hour.

Mentorship

You can never beat the value of mentorship. Recent research has shown that new businesses who meet regularly with a mentor are more than three times as likely to be top performers than those without mentor support. Those entrepreneurs who have benefited from mentorship say that it helps them make faster and more effective decisions, a crucial factor to succeed in the fast paced startup world.

Hiring an Accountant

With the influx of cash you've been dreaming about you need to start taking your startup's finances seriously. Hiring an accountant will not only ensure you’re staying on top of your tax responsibilities, but will also be able to help with financial forecasting for the years ahead. You’ll know what you’ve got to spend and will be notified to any potential money flow issues around the corner – meaning no nasty surprises. No one wants an employee of HMRC knocking on their door.

With 65% of startups failing due to internal conflicts, finding the perfect investor, securing their investment and figuring out how to use once it is secured is a daunting task. With every single individual; you bring into your business the higher the chances you will have a dispute, the higher the chance your business will fail.

All you can do as a business owner is mitigate risk as much as you can, take the time to consider what type of investment you would like, what kind of person you would like making the investment and develop your team's capacity to deal with the injection of cash. Once you’ve considered that, its time to negotiate and make your business as attractive as possible, get a term sheet and make your business eligible for EIS or SEIS. In a sea full of new startup minions you need to make yours the shiniest, most attractive and safest for an investment whale to put their weight behind. After you've got the full force of an investor behind you, make sure you get the best value for the money. Although this article will have taken you through the advised steps before, during and after an investment has made if you have any questions and need to know about any of the aforementioned sections in more detail, please contact Linkilaw directly.

Linkilaw is committed to stopping inefficiencies, streamline legal services & help legal work become accessible. Through our technology, in-house solutions & legal marketplace, we provide businesses with the greatest legal support ever. Visit our website! We offer a free Startup Legal Session.

 

(Business people shaking hands, on office background by Shutterstock)

The Investor/Founder Relationship: A Legal Perspective

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