What is the point in funding your business if you stand to lose it all in an avoidable dispute in the future? Having the right legal documents in place from the outset will protect your startup from launch, through growth and all the way to acquisition.

It’s now easy to download free legal documents. However, you should fully protect your startup by speaking with a startup lawyer to draft tailored legal documents.

Term Sheet

There are circumstances where a startup will provide a term sheet to investors (generally an early stage friends and family or seed round). But when an investor decides to invest in your startup, they will generally provide you with a term sheet. The basic terms you should look out for are below.

Investment & Valuation – How much is the investor investing (maximum and minimum)? Can you raise more from other investors? What will be the pre-money valuation for the round?

Vesting – Will the founders’ shares vest? Standard procedure on a Series A round is four-year vesting with a one-year cliff. What this means is if a founder leaves the startup before the first year, none of his or her shares will have vested. 25% of the founder’s shares will then vest at the one year anniversary, and the remaining 75% will vest over the next three years, generally on a monthly schedule. You may want to negotiate a good leaver provision. So, if you stop working for the company within 12 months and you’re a good leaver (i.e. left the company due to events outside of your control, such as death or health reasons), then 25% of your shares will automatically vest. Try to ensure that accelerated vesting occurs on an exit event, so that you don’t lose all your shares if there is an exit event.

Board/ Control – Will the investor/s have a board seat? What control will the investor/s have over decision making?

ESOP – Will you be setting up an employee share option plan? How will the ESOP affect the pre-money valuation (i.e. is the valuation the VC is offering inclusive or exclusive of the ESOP?).

Tip on ESOPS and ValuationsFounders often get confused when discussing valuation and ESOPs. When a VC says they’ll invest at $10 million pre-money, they usually mean $10 million inclusive of any ESOP the startup will be setting aside for future employees. If you’re setting aside 20% of your stock for future issuance under an ESOP, this means the real pre-money valuation your VC is offering you is $8 million, not $10 million. As long as you know what you’re getting into this is fine. If you’re looking for a $10 million valuation not inclusive of the ESOP, you’ll need to negotiate a higher pre-money valuation. In this case, $12.5 million.

Liquidation Preferences – If you’re issuing preference shares, what level of liquidation preference will you be offering (1X non-participating is standard – anymore is greedy!)

Anti-DilutionWhat anti-dilution rights will you offer investors (if any)? If possible, you want to avoid offering anti-dilution rights to investors so that all shareholders are diluted (pro rata) when the company issues additional shares. Early stage VC investors will generally require broad-based weighted average anti-dilution rights. This means that if the startup issues shares at a lower share price than the share price the VC pays in the future, the VC will receive additional shares reflecting an adjusted share price (of all their preference shares). The adjusted share price will be calculated by the average of the price they paid and the lower price paid by the later investors. If you’re bringing on investors who insist on anti-dilution rights, it is essential to engage a lawyer who understands how they work and the different types of anti-dilution rights available.

DividendsIf you’re issuing preference shares, it is unlikely you will be offering preferential dividend rights. However, if you have to, you want to offer non-cumulative rather than cumulative preferential dividend rights. Non-cumulative means that if the company does not pay a dividend in a particular year, then the investor loses its right to receive a dividend. On the other hand, cumulative means that even if the company doesn’t pay a dividend that year, the investor carries over its right to receive a dividend. The company must then pay the investor all dividends before paying any ordinary shareholders.

Legal Documents – A term sheet will typically set out the basic legal documents to be used in the deal (in Australia more and more Seed/ Series A rounds are being completed using the AVCAL documents).

What are AVCAL Documents? AVCAL is an association of sophisticated investors (principally private equity and venture capital investors) that created a suite of documents named “Open Source Seed Financing Documents” and made them available for public use.

Shareholders Agreement

Your shareholders agreement is your startup’s most important document as it sets out the relationship between shareholders and directors. It will cover matters such as:

  • issuing new shares
  • sale of existing shares
  • directors duties
  • conduct of board and shareholder meetings, and
  • dispute resolution.

You can have your shareholders agreement drafted before looking for external investment or when raising a round, based on your term sheet.

Subscription Agreement

A subscription agreement formalises the terms of the investment with a specific investor. It’s typically based on the final term sheet and specifies:

  • how many shares the startup is issuing
  • the subscription price for those shares
  • when the startup will issue the shares, and
  • company (and sometimes founder) warranties.

Company warranties are statements which an investor can rely on saying everything has been done above board.

IP Assignment Agreement

Your IP is critical to your startup’s value. Startup founders may have owned their IP personally in the early stages. It is important to ensure you have assigned your IP to the same company your investor is investing in. To do so, you will need an IP assignment agreement to transfer the ownership of the IP to the company. You may also need an IP assignment agreement if you use external developers without a development agreement, or incorporate a holding company to hold the assets of your operating company.

Employment Contracts

Some startups will raise a round without the founders having signed employment contracts, but this is rare. Investors want to make sure the startup has employed its founders.

Cap Table

Your capitalisation table, or cap table, is a spreadsheet that sets out who owns shares in your startup. The formulas needed to work out shareholdings are not that complicated, but it’s remarkably common to mess up cap tables!

Cap table management comes down to accurately recording all transactions that affect the valuation of a company such as option issuances, sales transfers, conversions of debt to equity and any exercises of options. We have built a cap table spreadsheet for founders to record options.

This cap table template allows you to easily take control and manage your startup’s equity. You can also analyse and compare new financing rounds to make the best decisions around raising capital.

With this free template, you can:

  • Easily view and manage your startup’s shareholding and options
  • Eliminate time-consuming calculations so you can focus on making smarter equity decisions
  • Track all types of equity events
  • Calculate pre-money and post-money valuations

You can download the cap table template for your startup at at http://bit.ly/lvcaptable

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This article was an extract from LegalVision’s Startup Manual. Download the free 60-page manual featuring 10 case studies from Australia’s leading VCs and startups.

Chapter 2: Startup Manual →

 

Lachlan McKnight
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