External fundraising is often crucial in allowing start-ups to scale. Ensuring your business is in the best position it can be before starting this process is important for maximising value from an external fundraise, whether that’s the amount of money raised, the best terms or securing the most strategic investor.
Below, we have identified the ways in which you can prepare your business to get the most out of an external fundraise.
- Prepare for an investor due diligence exercise by getting your house in order
Whether you are looking for investment from high-net-worth angels or venture capitalists, nearly all investors will want to conduct some due diligence on your business so they know what they are investing in. Exactly what they are looking for will depend on the nature of your business, but we have outlined some of the key things they will be looking for, and how you can demonstrate them:
- What is the current ownership structure of your business? I.e., who currently owns shares and how many, or what proportion of shares, do they own.
- We often see start-ups where the founders know who should own shares in their company, but haven’t got round to issuing those shares to the relevant people. Making sure all the shares which should have been issued have been, and that your company books (including your register of members and directors) as well as your Companies House filings are up to date is important in evidencing who already has a stake in your business to a potential investor. It also demonstrates that you are organised and ready for the administrative burden of an even large business.
- If there are multiple founders, is there a co-founders agreement or shareholders’ agreement in place to govern that relationship, or something equivalent in your articles of association?
- If there are multiple founders or shareholders, you may wish to put a co-founders or shareholders’ agreement in place to set out the relationship between the parties. This would often include information around who has a board seat, and any business decisions which require the specific consent of certain founders or shareholders. Alternatively, this information could go in your articles of association. If your company has different share classes, this will need to be reflected in the company’s articles.
- Do you have written copies of any commercial contracts which are crucial to your business?
- If your business is operational and reliant on relationships with third parties for revenue, investors will want to see copies of the contracts you have in place, usually in the form of your general terms and conditions or any key supplier or customer contracts. If you have been running things on a more ‘ad hoc’ basis, preparing to fundraise might be the time to put things in writing and get agreements signed to show potential investors that such arrangements are in place.
- Does your company own IP which is crucial to its business, or is this owned by anyone else?
- If your business relies on any particular IP, it will be important to be able to show an investor that it has the right to use it – either because it owns it, or has a licence to use it. If the IP has been generated by developers, employees or other consultants working for the company, there should be a clause in their service agreement which assigns all IP to the business. If you licence IP from another company, there should be an agreement in place setting out the terms of that licence. If you have a logo or name that would benefit from a trademark, you may want to start that process before you start fundraising.
- Do you have accounts to back up your financial position, and a business plan and budget for the future?
- As well as reviewing the legal structure and key contracts of your business, investors will want to review your company accounts and a business plan and budget setting out your plans for growth. Having these read to go alongside any pitch documents will give investors confidence that any plans for growth are backed up by existing financial information and c clear strategy.
Many investors will want access to a virtual ‘data room’ of documents to review in connection with your business, and it is often helpful to set this up in advance, with sub-folders relating to the different aspects of your business. The questions above will be a good starting point for populating this.
- Valuing your business
Ultimately, the value of your business will come down to what someone is willing to pay for a portion of it. However, it is a good idea to go into negotiations with an idea of what this might be. From a technical perspective, there are different methodologies for valuing a business which accountants and corporate financiers can use to determine what the entire issued share capital of your company is worth, and thereby what a smaller stake in it will cost on a price per share basis.
However, start-ups often want to raise money before they have started generating profit or even revenue, and in that case it is simpler to think about how much money you want to raise, and how much of your business you are prepared to give away for that amount. Then it is a question of negotiating this with investors. Generally, most founders think about what they will need for a given time period (which is called a ‘runway’), and a good starting point for this would be the next 12 to 18 months. You should also try and give away as little of your business as possible to achieve your funding requirements – although this generally ends up being between 5% and 15% for an early stage funding round.
In terms of negotiating this, investors will use various terms to describe their valuation, and it is important that you understand them before agreeing to an investment.
~Novel Serialisation: Heavens Fire~
If an investor says they have made a pre-money valuation of your business, this means the value of the business before the proposed fundraise. A post-money valuation refers to the value after the investment has been made. This means that a pre-money valuation of a company at £2m is the same as a post-money valuation of a company at £2.5m if the proposed investment is £500k. If an investor wants to invest £500k at a pre-money valuation of £2m, the company will end up being worth £2.5m and the investor will hold 20%. If an investor wants to invest £500k at a post-money valuation of £2m, the company will end up being worth £2m and the investor will hold 25%.
It is also important to understand whether the valuation is based on un-diluted or fully-diluted share capital. Undiluted share capital refers to the total issued share capital of a company, which includes all the shares which have been issued in a company, and which appear in the register of members and on Companies House. Diluted share capital also includes various ‘rights’ to shares, which may not have actually been issued yet, such as options, warrants and convertible loans and SAFEs (simple agreements for future equity) or ASAs (advance subscription agreements). If an investor wants to buy a 10% share in a company on an undiluted basis, and the company has an option pool of 10%, the investor will only end up with 9.1% on a fully-diluted basis. If you do have an option pool in place or any other convertible instruments, it’s therefore very important to know whether an investor is investing on a diluted or undiluted basis.
- Identify your investment terms
Finally, you will want to spend some time thinking about the terms of the fundraising beyond the valuation. Often, either you or your potential investors will draft a term sheet setting these out, and it will be useful to think in advance about what you will be prepared to accept. These will vary from business to business, but various points to consider should include:
- What kind of share class will investors be getting? Some investors will be happy to accept ordinary shares, but others might want preference shares with a right to their money back before ordinary shareholders, for example
- Will investors have a right to appoint someone to the board of directors, or a board observer? If so, will they count in the quorum for board meetings?
- Will the consent of any investor directors or shareholders be required for the company to make certain decisions, or will they have any veto right?
- What information will investors be entitled to receive and how often? For example, they might want to see monthly management accounts or an annual business plan and budget
- Will investors want pre-emption rights over further share issues the company makes, or when existing shareholders want to transfer shares?
By Sally Johnston, Russell Cooke
How we can help
For further information, please contact Sally Johnston in our corporate and commercial team. Sally has experience advising start-up and scale-up companies on a range of matters with particular expertise on fundraising and growth, from seed to institutional investment.
