Australian startups face stiff competition for investment. When you, as a startup founder, decide to raise capital from external investors, how do you ensure that you stand out from the crowd? The key is preparation. Potential investors will have many and varied questions, and you need to be ready to answer these comprehensively and convincingly. We set out below some of the key issues investors will be looking at so you can make sure you have your answers at the ready.
1. What are the Terms of the Investment?
You will need to provide a pre-money valuation for the startup (i.e. the current valuation of the company before it receives the financial investment). There is no set formula for calculating this, so you will need to be able to justify the method you use, especially when you have not been operating for very long and/or have not started to sell your products/services yet.
You will need to do your market research. Try to find similar businesses to yours which have successfully raised money and look at the pre-money valuation (and formula) they used. Ask people within your network what they think is standard.
You will also need to decide on the minimum and maximum amount of money you want to raise. Again, you need to be able to justify why you have chosen these figures and how you intend to use the money so as to account for every cent you plan to raise!
You should also provide a pre-money and a post-money cap table:
- A pre-money cap table shows the number of shares currently on issue to each shareholder and the percentage shareholding they have.
- A post-money cap table shows the number of shares which you expect will be on issue to each shareholder/the investors at the proposed pre-money valuation as well as the percentage shareholding each shareholder/the investors will have following the raise.
You should provide an additional cap table if you have an employee share option plan in place or intend to implement one post raise. This cap table should show what percentage shareholding each shareholder/investor will have if the maximum number of options are exercised under the employee share option plan.
You might want to provide serious investors with a term sheet setting out the key terms of the investment. Signing a term sheet is not binding, but provides some comfort in that you have committed investors who have agreed to a set of terms.
2. What is the Structure of the Startup?
Critically, external investors will want to know how you’ve structured your startup. Typically, startups use a company structure. If you are not using a company structure, investors will want to know why and how your proposed structure works.
Some questions to consider include:
- What are the advantages and disadvantages of the structure?
- Does it expose them to liability?
- What are the tax and accounting consequences?
- Does the structure adequately protect the business assets?
Investors will also want to know whether you have correctly set up your business. Assuming it is a company, they will want to know:
- Whether registration has been completed with ASIC;
- What number and type of shares have been issued in the company;
- Who the directors are.
An ASIC search will reveal all of these points.
The investors will also want to know who has control of the company. Questions to prepare for include:
- Who has the right to vote?
- Do all issued shares have voting rights?
- Do they have equal voting rights?
- Does each director have one vote?
- Does each shareholder have one vote per share held or one vote (regardless of the number of shares held)?
- Who controls the day-to-day operation of the company?
- Are there matters which require the approval of the shareholders? What are they?
Providing investors with a copy of the shareholder’s agreement and the company’s constitution will help them to answer these questions. It is a transparent way for the investors to see how your business intends to operate.
3. What are the External Investors Investing In?
The investors will want to know what they are investing in and will ask questions such as:
- Does it provide a product or a service?
- What is the product or service? Is it new?
- If not, who are the main competitors?
- How does the business fare against its competitors?
- Is there a big market for the product or service it is providing?
They will want to see your financials and so you should prepare:
- Revenue growth to date;
- Profit to date; and
- Burn rate to date
As well as:
- Expected revenue growth over the next few years;
- Profit over the next few years; and
- Burn rate over the next few years
Again, you should be able to explain the figures (particularly the future projections) and justify any poor performance in the past. It is essential to know your numbers inside out.
4. Who are the External Investors Investing in?
Perhaps one of the most important things that an investor looks at is the founders – you are, after all, responsible for establishing and growing the business. They are counting on you to make it a success. They want to know that you have the ability to do this and to bring them a substantial return on their capital. They are essentially investing in you.
The investors will want to know all about you:
- What is your background concerning qualifications and work experience?
- Have you ever set up a startup before?
- Did it succeed?
- If not, what did you learn from the experience and how will you ensure that this time is different?
As well as all the usual attributes that one looks for in successful people (e.g. intelligence, drive, motivation, efficiency), they will want to know that you believe in what you are doing and will do what it takes to make it a success.
The investors will also want to know whether the founders and any other key employees are tied into the business for the foreseeable future.
For founders, this may be by way of vesting shares. For employees and contractors, this may be by way of options which vest under an employee option plan.
Accordingly, they may want to see copies of the shareholders agreement/share vesting agreements and the employee share option plan which set out the vesting provisions. They will likely also want to see relevant employment agreements and/or contractor’s contracts containing appropriate non-compete clauses.
5. What Intellectual Property Do You Have?
Most startups are intellectual property (IP) heavy. Investors will want to know that the company they are investing in are the owners of the necessary IP as well as assurance that the IP is adequately protected.
Investors will also want to see that the founders have assigned the IP to the company via an IP Assignment Deed. They will want to see that the employment agreements and contractor’s contracts contain IP assignment clauses in which employees and contractors assign any IP they create to the company.
6. What Legal Contracts are in Place?
External investors will want to see that the company is taking things seriously and protecting the company from unnecessary risk. Is the business complying with all applicable laws and regulations, for example, by obtaining any requisite licences?
Raising money from external investors is hard. There is an enormous amount of competition, and very few startups succeed. To assist with your preparation, speak with other startups who have met with potential investors as well as startups that have failed to attract investment. Find out what types of questions investors asked and the answers they gave.
Know the market and be realistic when setting a pre-money valuation. Consider how much money you will need to raise and how you will use your funds. Be prepared to provide potential investors with the backup documents they require, and most importantly – convince the investors that YOU are worth the investment.
If you have any questions about raising capital from external investors, get in touch with our startup lawyers on 1300 544 755.