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March 12, 2014
There is no hard-and-fast process, but we work with both investors and startups, through accelerators such as Microsoft Ventures and startup hubs like Minibar. In our experience, legal issues can often trip you up.
Given the rise of accelerators and other support networks for tech startups, there are now more startups competing for funding and many are better prepared for that competition.
Preparation is key and considering the legal issues before an investment round may:
- be the difference between securing and not securing investment
- affect the proportion of the business that must be given up on an investment round
- impact upon the timescale and expense of the investment process
- reduce the costs of rectification (third parties are likely to seek a higher price for their co-operation if they know investment is imminent).
The type of funding source – eg angel investor, VC, large tech corporate – and the amount of investment being sought will have a significant bearing on the investment process and in particular, the legal due diligence exercise carried out by the investor.
For example, some less sophisticated angel investors may be prepared to invest relatively small amounts with limited legal due diligence (if any) and limited legal documentation. But a VC, which is likely to be investing significantly more, will require a more rigorous legal due diligence exercise and will require long-form investment documents.
One of the key provisions in the long-form documents in this context will be warranties. These are contractual statements usually given by the founders and the startup itself confirming the legal, commercial, financial and technological position of the startup. Put very simply, if those contractual statements are incorrect when given, the investors may have the ability to sue the founders and the startup for their loss.
Many investors (mainly angels and some VCs) will also require investments to be eligible for seed enterprise investment scheme (SEIS) or enterprise investment scheme (EIS) relief. SEIS and EIS reliefs, while extremely attractive to investors (who are UK taxpayers), do not come without complications and there are a number of conditions that must be satisfied by a company for it to be eligible to offer SEIS or EIS compliant investment.
Founders should take advice if possible, or if not, should at least consult the HMRC website, to assess whether their business would be eligible to offer SEIS or EIS investment.
Here are my four top tips for startups preparing for investment.
Be clear on corporate structure.
Investors will want a clear picture of the fully diluted share capital of a startup before investing, so founders should ensure that the legal documents and formalities relating to the issue/transfer of shares, or the granting of options, have been properly dealt with. Investors will also want to understand who controls the company in addition to understanding any rights held by existing investors from previous investment rounds.
Get your IP in order.
Intellectual property (IP) will usually be the key asset for tech startups and therefore, is likely to be the main focus of any legal due diligence exercise. IP issues we have come across in legal due diligence include:
- Domain names being registered in the name of an individual rather than the startup itself
- Registerable IP such as trademarks and patents not having been registered or not being registered in the name of the startup company
- IP generated by contractors and consultants – not having been assigned into the startup. While there is the presumption that copyright generated by employees in the course of their employment will be owned by the employer, in the absence of a written agreement to the contrary, IP generated by consultants and contractors will belong to such consultants and contractors. Therefore, it is crucial to ensure that the correct contractual arrangements are in place
- Licences of IP in not covering a sufficiently wide enough geographical territory to enable the startup to exploit the relevant IP in all the countries in which it trades, being too short in duration, involving very high royalty fees or including onerous provisions such as wide and uncapped indemnities
- Licences of IP out – not including sufficient protection for the startup’s IP
- Open source software – having been used with no real records of the type of licences entered into or impact on the proprietary code
- IP-based disputes – relating to infringements of the startup’s IP or an infringement of a third party’s IP.
Know your employment arrangements.
The question of who is and who isn’t an employee can be a challenge. The legal status of an individual determines their rights, whether the IP they create is owned by the startup (as mentioned above) and whether their pay should be taxed at source. Remember, different people mean different things when referring to temps, casuals, contractors and freelancers.
Review key commercial contracts.
Investors will be very keen to see that the key commercial contracts relating to a startup are valid, enforceable and do not contain unusually onerous or unfavourable terms. In particular, investors will be keen to see that the startup can continue to enjoy the benefit of revenue-generating contracts or contracts that are key for the operation of the business, after the investment has taken place.
The legal due diligence exercise will also touch upon other areas such as property, disputes and financing arrangements.
Quite rightly, startups tend to focus on developing their product and proving it has a market rather than ensuring that all of their legal arrangements are fully dealt with. But, in a competitive investment landscape where more and more tech startups have access to advice through tech startup hubs or accelerator programmes, a startup can be at a competitive disadvantage if these legal arrangements have not been addressed. Ultimately, it could mean that founders need to give up more equity than they wanted to or even miss out on investment altogether.
This article first appeared in TechCityinsider on 24 February 2014.