VC Focus | Top 10 tips for companies on how best to prepare for VC investment
Published on 9th Jan 2023
Businesses may encounter a number of issues when preparing for a venture capital fundraising – but careful planning can make the process smoother
Preparing for and going through a venture capital fundraising for the first time can be tough. Venture capital funds (VCs) will give your business a thorough assessment before they invest and you may end up finding that you are less prepared for the process than you thought you were.
As advisors to a range of companies seeking VC investment, we see the same issues crop up time and time again as founders seek investment before they have got their houses in order. So how do you avoid these issues and make your deal run as smoothly as possible?
1. Due diligence
As part of the fundraising process, your investors will almost certainly do some due diligence on your business. They need to satisfy themselves that your business matches your initial description and valuation aspirations. They will also want to check there are no skeletons in the closet, which would mean the business is not worth as much as the pre-money valuation you have initially agreed with them.
As part of that process, you will need to disclose a fair amount of information about your business, including all of your key financial, legal and commercial documents so you should be organised and prepared ahead of time.
Before you even begin talking to investors, start to collect copies of your principal documents and organise them in a clear, logical folder system. This should include, among other things, all of your incorporation and constitutional documents; your annual and management accounts and cash flow forecasts; tax computations (if any); key commercial contracts; intellectual property licences or assignments (including any development agreements); employment contracts; real estate leases or licences; and insurance policy summaries.
If you can pull this together early, you will be ahead of the game when the investors send you their due diligence request lists. You will be in a great position to make your information available quickly when the process kicks off (ideally at that point through a secure virtual data room or, alternatively, via a cloud hosting site).
You will also have the chance to identify and address or explain any gaps or issues before you get too far down the track with the investors (at which point those sorts of issues tend to be more disruptive).
If you need guidance on what documents to pull together, ask a lawyer or investor for a sample legal due diligence questionnaire. It may not be exactly what your investors ask for, but it will almost certainly cover substantially the same areas and requests, and by being on the front foot you can try to avoid investors even needing to send their full "blanket" request lists.
2. Intellectual property
In the early days, a company may not own all of the intellectual property (IP) created for the company by its founders, initial employees or contractors. This leaves the company susceptible to claims further down the line that the IP which it is using and monetising does not belong to it or that a third party has rights in that IP.
Through due diligence, an investor will want to see evidence that the company has full and clean title to the IP underpinning the business. Investors also require the company and the founders (or the management team) to warrant that the company has full ownership of (or valid licences for) all of the IP which the company uses. This means that if there are any problems or claims around IP, the risk and cost will effectively fall back onto the founders and/or the company.
As such, it is critical that you either have – or obtain – an express written assignment of all IP created for the company. This can be through an IP assignment provision in an employment contract or a separate IP assignment agreement. Do not rely on an implied understanding that the IP was created for the company – the assignment must be in writing.
As with your due diligence materials, you will be in a much better position if you can take care of this before your fundraising, particularly if any of the early employees or contractors has since moved on (where, depending on the circumstances, there is sometimes a chance that they may not be co-operative).
Separately, if you have any registered trademarks, patents or domain names (or applications for any of them), make sure that they are registered in the company’s name and not one of the founder's or employee's as an individual. If these rights do happen to be registered in an individual’s name, disclose this to your investors upfront and show the investors that you have a clear plan for getting any IP which is material to the company assigned to it before or as part of closing the fundraising.
If you use open source software, make sure you have a record of what licences are used and satisfy yourself that your use of those licences does not trigger any disclosure or “copy left” provisions which could force you to disclose the rest of your source code.
If you can show you are on top of your IP, it will be much easier to gain an investor’s trust and confidence (and support). This can be really important, as the IP position is rarely smooth in technology-driven businesses, especially those looking to disrupt existing business models.
3. Statutory books
A company is legally required to maintain certain records about its share capital, shareholders, directors and secretaries and any charges granted by the company. These are often referred to as the company’s statutory books (or “stat books” for short). Traditionally, the statutory books were just that: a book with the different registers contained in them. Nowadays, many companies maintain their statutory books electronically. The statutory books are not publicly filed and so are distinct from your Companies House filings (see below).
The statutory books are meant to be held at the company’s registered address and maintained by its company secretary. In practice, this often means the firm of accountants or lawyers who helped set up the company will be holding the books.
If a company does not have a company secretary or was set up online or through an incorporation agent, however, it is not uncommon that the statutory books may have been lost or never been produced. Equally typical is that the statutory books have not been updated to record share allotments, share transfers, new shareholders or changes in the directors.
The statutory books – and in particular the register of members (or shareholders) contained within them – are the ultimate, legally binding, record of who the shareholders of the company are, and what shares they hold. As such, the investors and their lawyers will want to see your company’s statutory books to verify that the share capital is held in the way you have told them it is (that is, in your share capitalisation table).
Make sure you know where your statutory books are (or, if they are lost, reconstitute them) and make sure that they are up to date. If you are unsure about what records you need to maintain or how to update them, speak to a lawyer (rectifying mistakes in the registers may require a court order, so it is important to get this right).
4. Companies House filings
A company is also legally required to make various filings and returns with Companies House. This includes its annual return and annual accounts, as well as, among other things, filings in respect of changes to its share capital (including share allotments), directors and articles of association.
Make sure your Companies House filings are up to date and that the filings which have been made are correct in advance of the fundraising process. As part of the due diligence process, the investors will be comparing what they discover on the public registry with what is in your statutory books. If they do not match up, you will need to explain why and rectify it before the investment round can be closed.
5. Managing your existing stakeholders
As part of an investment round, a company may need to go to its existing shareholders for approval to be able to allot new shares to the investors, adopt new articles of association, and disapply pre-emption rights over the allotment of shares to the investors. In certain cases, a company may also need to seek specific consent from existing investors or a specific majority of the shareholders.
As part of preparing for a fundraising process, you should figure out which consents are required and how you are going to deliver them in order to complete the transaction.
Where the company has a small group of shareholders with a controlling stake, this can be relatively simple to achieve, both in terms of garnering support for the investment and in practical terms of obtaining signed resolutions and consents.
Where the company has a larger shareholder base and perhaps individual pre-emption rights which cannot be waived by a majority, more planning and earlier communication will be required in order to obtain the relevant approvals, waivers or consents.
Be aware of shareholders’ whereabouts during the fundraising period so that you can plan around any holidays where people may not be so readily available to sign documents.
Before approaching your shareholders, remember that the company will almost certainly have confidentiality obligations to the investors under the heads of terms, so make sure that your investors are ready and happy for you to disclose the proposed transaction. Get legal advice about this early on in the process.
6. Employee and founder equity
As you engage with investors, you should have an idea about how much equity is or will be available for employees, whether under an enterprise management incentive (EMI) option scheme or through some other form of employee share scheme.
An investor will often want the option scheme included in the capitalisation table for the purposes of calculating the amount of equity which they receive (meaning that only the existing shareholders suffer the dilutive effect of the options). Be aware of the dilutive impact of those options and be prepared to increase the size of your option pool if the investors feel it does not provide sufficient headroom to properly incentivise the key members of your team and the critical future hires.
While investors are frequently happy for an option scheme to be implemented within a few months of closing the investment round, they will often want you to agree to key terms before they invest. The more equipped you are to discuss and agree the size, shape, allocations and vesting conditions of your scheme with your investors, the better you will be placed.
Separately, as founders, you may or may not have agreed terms attaching to your equity between yourselves, in particular vesting conditions. Depending on the time already committed to the business, an institutional investor may require the founders to “vest” or “re-vest” all or a part of their equity, and may require you to give up your vested equity if you leave the company (albeit at a fair value if you are a “good leaver”). Similarly, an investor may not allow you to keep your board seat if your equity is diluted below a certain level. Be prepared to have these conversations.
7. Term sheets
The first document you will be asked to sign as part of the process is a term sheet (sometimes called “heads of terms” or a “letter of intent”). While the term sheet will be non-binding (other than in respect of a few provisions, including confidentiality and exclusivity), the commercial terms set out in it will form the basis of the long form, binding legal documents that are entered into on completion.
Once something has been agreed in a term sheet, it is difficult to renegotiate and, even if not legally binding, it is binding at least in honour.
As such, before you sign a term sheet, make sure you understand what it is that you are signing up to.
Most VC investors’ term sheets will cover more than just the headline valuation and amount to be invested, and will include legal terms which will have an impact on you and the other shareholders’ position within the company.
We recommend that you always seek advice before you sign the term sheet so that you understand exactly what you are being asked to agree (and also what has been left out and therefore remains to be agreed at the long form document stage).
Engage a lawyer (or someone experienced in VC fundraisings) to explain the terms to you (like the difference between a “full ratchet” and a “broad-based weighted average” anti-dilution protection or the implications of a “participating” vs “non-participating” liquidation preference), and what the exclusivity terms mean for the company. (For more about term sheets, see our Insight on jargon and our Insight on leaver provisions).
8. Roles and responsibilities
A fundraising can be a time-consuming and drawn-out process, often taking several months from start to finish. From preparing the business plan, to speaking to investors, to negotiating the heads of terms, to answering due diligence queries and agreeing the long form documents, a fundraising will divert a lot of management time and attention from operating and growing the business.
As part of preparing for a fundraising, you should decide with your co-founders or management team who is going to focus on the fundraising, and who is going to run the business during that time.
Give someone primary responsibility for dealing with advisors and investors and for agreeing the deal. There will be times when everyone’s input is needed (for example, around disclosure or key points on which consensus is needed), but make sure that someone is focusing time on the business so that, once the fundraising is closed and you have got cash in the bank, the business is still on track to hit its targets and deliver on the plan which you have sold to the investors.
Closing an investment round can take longer than anticipated, particularly where there are heavily negotiated points or issues to iron out before closing. If the process starts to drag out, there will be uncertainty for the company and a risk that the company misses its forecast performance for the next month. This can lead to a situation where an investor may want to delay the process until they have seen the next month’s numbers and potentially revisit the valuation if the company has underperformed.
As part of signing a term sheet, you should also agree a clear, achievable timetable with your investors and the advisors on the transaction. Set deadlines with the investors for the delivery of long-form documents (which will often be prepared by their lawyers) and the completion of their due diligence.
If you have prepared your due diligence materials in advance, flagged any issues up front and have a plan for dealing with your stakeholders, you will be in a good position to respond quickly and keep the process moving towards completion on the agreed timetable.
Finally, start talking to advisors – in particular, accountants and lawyers – early. They will help you navigate the process, tell you what to expect and be on hand to help you sort out the issues that will invariably arise during the course of the process.
Osborne Clarke has a market leading venture and growth capital practice across Europe, supporting investors across sectors including financial services, media and communications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this note please connect with one of our experts.