For most Australian start-ups, attracting investors and raising a round of investment is something they can only dream about. A recent survey conducted by Startup Muster estimates the number at around 14 per cent. Out of the start-ups that manage to secure seed round investment, an even smaller portion will secure venture capital (VC) funding at Series A. Despite these fairly moderate levels of investment in the Australian startup environment, it is worth understanding what legal considerations Angel and VC investors have when deciding whether or not to invest. This article will explain the legal essentials needed to attract investors and secure investment.
Incorporate your business
You will struggle to raise funds unless you are operating the business on a limited liability company structure. In fact, it’s worth setting up a holding company/operating company structure, as investors will look to invest directly into the holding company, which will have 100 per cent ownership of the operating company. This acts as a safety net for your company’s assets. If the operating company is sued, the assets are safeguarded from potential claims.
A pattern we are seeing more of amongst the well-versed founders is a desire to set up their companies in the US while operating the business from Australia. You have to ask yourself: Is my goal to secure investment and attract investors from the US? If it is, this may be a sensible approach.
Founder Vesting: A win-win for Investors and Founders
The truth is that start-ups are not that valuable, at least in the initial stages, if the founders pack up and leave. It is not a good idea to issue the founders with equity, unless it is vested over two or three years, which investors understand. Your vesting structure should schedule over four years with a one-year cliff (this means that if you leave before one year in the business, you get nothing). By drip-feeding the equity to the founders over a four-year schedule, founders are more likely to stay with the company and “invest” their time and effort into growing the business.
VC investors will often ask the founders to “revest” following investment. This basically means that the founders, regardless of how long they have already worked in the business, will have to work for four more years if they want to see the rest of their shares.
Founder vesting is tactical and logical from an investor’s point of view. In their minds, the business devalues if you or another founder abandons ship early on. Imagine what would happen if your co-founder called it quits months in and left with 25 per cent full vested. The business would no doubt suffer, and probably fail. Your two options in this situation are to pick up the slack and carry on like a workhorse increasing the value of your ex co-founder’s shares, or throw in the flag like your ex-partner did. By vesting, the departing partner takes only a small amount of the shares to which he or she would have been entitled.
Another common form of investment that start-ups offer to attract investors is a preference share in the company. The principle that underpins a preference share structure is that investors enjoy a liquidation preference if the business is sold. This structure gives investors a guarantee that they will not lose their initial investments, or at least that upon selling the company; the investors are first in line to be repaid, followed by founders and employees.
Needless to say, if you can manage to avoid issuing preference shares, i.e. only issue ordinary shares, this is a favourable position to be in for you and your fellow co-founders.
It is not common for startups to worry about drafting employment contracts during the initial stages of the business. What’s the point, right? You’re probably not even on a salary yet!
However, these finer legalities will need to be sorted out when it comes to opportunities for investment. First of all, investors need assurance that your business is legitimate and that you’re going to use their money wisely. Obviously you’d be wiser allocating yourself a moderate salary, but a salary nonetheless. Above all, the investors will require you enter into non-compete agreement with the company. If all else fails and the business relationship breaks down with your investors, they want to know they’re not going to be competing with you in another business the following day.
Investors are not all the same. Some will prefer a different structure to what I’ve proposed. If you have a great business model, a dynamic and committed team, and your business is generating traction, you’ll be better equipped to negotiate the terms of any investment agreement. This doesn’t happen a lot, which is why it’s worth having a professional structure that you can use as a springboard for negotiating with potential investors about a reasonable investment offer that is mutually beneficial.