Many businesses, especially in the technology sector, are started with the idea of selling them one day. Even if that isn’t on the cards, it’s a rare company that won’t one day want outside investment to grow the business, whether you’re seeking venture capital from an international fund or a new partner to take up a shareholding. In either case, your task as a business owner will be immeasurably easier if you lay some basic legal groundwork early on.
The essential principle to keep in mind is this: complication and clutter can alarm investors. The less complex your capital structure and financial statements, the more reassured they can be that they know exactly what they’re getting themselves into.
So here’s a checklist of things to put in place before you ever need to open your doors, and your books, to a potential investor:
1. Keep things tidy. Startups and young companies typically have multiple loans and elaborate contracts designed to help fund growth in the early days, for example, loans which are convertible into shares or even by granting an option to a landlord in return for lower rent. If that’s you, take action now to consolidate your balance sheet, especially your loan funding, as much as possible.
2. Maintain a clean shareholding structure. Where there are lots of “rats and mice” minority shareholders there is potential for uncertainty and confusion for investors. Beware of giving real shares to your employees (as opposed to phantom shares or other instruments that track the value of the company). However, fundamentally valuable members of the management team MUST have an equity incentive of some sort.
3. Allocate shares to your founders and anchor investors early on. The later you leave it, the more value they have, and the greater the tax hit will be (gifted shares can be taxed as income, so tax may be payable now, on a share that can’t be sold for years).
4. Give up any thoughts you may have of recouping all that sweat loan account in cold hard cash – here we are talking about salaries sacrificed or other money foregone. It’s very unlikely you’ll find an investor who’ll be prepared to treat sweat loans by a founder as a true cash loan. If you actually dipped into your own pocket for cash to fund operations there’s a better chance, but in reality almost all the founders’ sweat loan funding may be written off when a new investor comes in. Rather pay yourself decently from the start – then loan that cash back to the business, and keep a written record of your loan arrangement!
5. Take a good hard look at your board. Do the directors add real value to the business or are they largely family members, angel investors and other founders with experience as limited as your own? Look for board members who can provide useful advice and guidance, and whose CVs will make you look credible to potential investors – remember, they are buying into the executive team.
6. Especially relevant for software and other IT companies: Check who actually owns your fundamental means of production! If you’ve built a product, be extremely careful that you own the “building blocks” and/or have a valid licence to use those components. In the case of open source software, are you within the licence terms? Also make sure that your employees have all properly assigned to you the intellectual property rights to anything they develop in the course of their employment.
7. Pay attention to all the standard due diligence issues: Make sure all existing contracts (employment, supply, lease, etc.) are in place and up to date and not overly skewed against you, that your incorporation documents are up to date, and so on.
While much of this looks like basic common sense to lawyers, in reality many entrepreneurs just don’t get around to these details – they’re too busy doing the work.
Adrian Dommisse is founder and senior partner for Dommisse Attorneys