Scaleup Vlaanderen
Are you organizing a funding round? Avoid these common mistakes
There are several mistakes that can be made by many start-ups and scale-ups when organising their funding rounds. In this blog post, we've listed five common (legal) mistakes that start-ups and scale-ups should be wary of, so you can make sure not to fall into the same traps.
We often see in practice that companies raising funds are inadequately prepared for the due diligence process. As a rule, investors will conduct due diligence on the company to determine whether or not to invest. This will also determine what representations and warranties or special indemnities the founders/current shareholders will be required to provide to investors. Such due diligence includes not only legal, financial and tax aspects, but also increasingly takes into account IT and technical aspects.
As a startup or scaleup, you need to put yourself in the shoes of (future) investors: what elements do you think will be most important to them? Let's say you determine that intellectual property will be an important value driver of your company. Then you need to verify that all IP is well protected and that IP risks are adequately covered. For example, are the necessary clauses included in contracts with employees? What about contracts with freelancers? What about your overall IP strategy or broader management in terms of know-how?
A man forewarned counts for two. Put yourself in the shoes of your (future) investors, and get a timely picture of the potential investor's list of due diligence information requests. From day one, make sure you have a good document management system within your company, so that you can easily retrieve the documents that investors will request for the due diligence data room.
During a funding round, investors look at your company with a magnifying glass because they want to know what and who they are investing in. On the other hand, it is crucial for a startup or scaleup to know who you are getting involved with. We sometimes see startups/scaleups not giving this enough thought.
The first question to ask yourself is: who do I want to work with? What kind of investors do I want to attract? Am I looking for an investor who is in it for the long haul and who wants to be actively involved in the business, and would possibly take 100% ownership of my company in the future? Am I even looking for "smart money" (i.e., an investor who can help build my business and make his network available)? Or am I rather looking for a VC investor who wants an exit in X years and who will not interfere with the day-to-day operations?
Once you have determined who you want to work with and the interest is mutual, it is important to perform proper due diligence on your potential investor(s) to ensure that your company and the investor(s) are a good match. This will not be a legal, financial or tax due diligence, but more of a "cultural" due diligence. For example, you could interview other companies in which the investor has invested. They could give you more insight into what to expect from the partnership.
We cannot emphasise this enough: it is of the utmost importance to properly document the funding round and obtain legal counsel (timely). You will in any case need the following three key documents for your funding round:
Term sheet - The importance of a properly drafted term sheet is often underestimated. Don't wait to seek expert legal and financial advice until after the term sheet is signed: making sure everyone is on the same page from the start can prevent confusion, avoid future discussions and save unnecessary costs. Investors often use terms whose impact may be unclear to the startup/scaleup. We think mainly of the mechanisms to avoid dilution of investors in subsequent down rounds (such as when a subsequent investment is made at a lower valuation of the company than the valuation at which the investor made their investment). Start/scaleups should be aware of the effect of these mechanisms (e.g., the "full-ratchet" mechanism) on future dilution for current shareholders or even on the willingness of future investors to invest in the company.
Investment Agreement - An investment agreement (also often called a "subscription agreement") documents the terms of the investment transaction by setting forth the terms of the investment and the rights of the investor(s) seeking to invest in your company. It typically includes elements such as valuation, investment tranches, investment guarantees, investor rights and any restrictive provisions. An investment agreement can also reassure investors because they can see that their rights are protected.
Shareholders' Agreement - A shareholders' agreement sets out the rights of shareholders in the company (that is, the rights of existing shareholders and of investors once they become shareholders). Its purpose differs from the investment agreement: while an investment agreement is there to set out the terms of the investment transaction, the purpose of the shareholders' agreement is to govern the relationship between the shareholders and between the company and the shareholders once the investment has taken place.
Many startups and scaleups implement employee stock option or warrant plans (ESOPs) to control payroll costs at the outset and motivate their staff. ESOPs allow your company's employees to participate in the company's success through their stock ownership. When you set up an ESOP for your company, you need to clearly document how it will work in practice, such as: how the options will be allocated, what are the criteria for vesting (vesting) that will give the employee the right to exercise their options, what is the agreed purchase price for the shares, what happens when the employee leaves the company...
It is also important to be aware of any tax implications. Implementing an ESOP the wrong way could cause various legal and/or tax problems. The aftermath of such legal/tax problems could also cause employees to lose interest in working for your company and possibly even leave the company. If an investor detects such problems with the ESOP, this will obviously discourage them from investing or could lead to the investor requesting a special indemnity in the investment agreement.
Startups and scaleups often have an innovative and unique idea that they (rightly) want to protect. It is important that the company take sufficient measures to protect its confidential information. Examples include using an electronic sharing platform where you can track who is accessing your confidential information (and where you can revoke access if suspicious activity occurs), or entering into a non-disclosure agreement (NDA) with an investor.
A few concerns about NDAs: investors often dislike NDAs and sometimes even refuse to sign them. Moreover, it can be difficult to enforce an NDA in court in the event of a breach, since it can be difficult to (1) determine the source of the leakage of the confidential information, and (2) determine the exact amount of damages. Nevertheless, NDAs can be useful in practice in cases where, for example, some of your potential investors are in contact with one of your competitors.
Thus, we recommend carefully assessing whether it is useful to enter into an NDA and, if so, carefully drafting the NDA (not too "heavy," but not too "light" either) and adequately guiding investors in requesting them to sign such an NDA. Furthermore, we recommend providing highly confidential information at a later stage of the due diligence process (e.g., as an "affirmative" due diligence once it has become clear that the investor is likely to invest).
Finally, we advise you to use common sense. In principle, it is not necessary for an investor to know the names of clients or exact figures (e.g. sales, profits) per client, so please omit such information before uploading it in the data room. It may also be useful to provide such information only on an aggregate basis. If you have any questions on these topics or would like to know more, please do not hesitate to contact our specialists.
Frank Hoogendijk (frank.hoogendijk@osborneclarke.com)
David Haex (david.haex@osborneclarke.com)
Karen Calvo Vleugels (karen.calvo@osborneclarke.com)
