General Law

Startups: Taking In Your First Investment

Written by Team Farallon | May 28, 2019

The Process

After a company is incorporated, the founders would typically look to obtain funding to bring their ideas to life. However, creating that minimal viable product to attract potential investors isn’t cheap. Substantial resources would be required to create an initial prototype, such as labour, computers, material, or even specialised equipment. Even if a startup succeeds in developing its prototype or minimal viable product without an initial investment, it would also require substantial investment to grow the company by bringing in talents, streamlining production, and expanding operations.

Therefore, it is critical for founders to obtain financing to continually grow their startup into a successful business. More importantly, that first investment the startup accepts is the foundation of a successful business. Startups would want to avoid being overly generous with initial terms or turn off potential investors by being too stingy or engaging in unnecessary haggling.

Finding that first investment for the company isn’t all about money.

In that regard, what kind of financing or investment should a founder be focused on finding? What is the documentation, terms, and points to consider when accepting the startup’s first investment?

Seed Funding

Seed funding is the very first investment that the founder collect to kickstart their business. Startups usually get their initial funding from FFF (friends, family, and fools), angel investors, incubators, accelerators, or crowdfunding. Professional investors will unlikely enter a business that is unproven and entirely conceptual. Seed funds are thereafter utilized to bring in first hires, develop the product or idea, and to help the startup take its first steps into becoming a sustainable company. Startups may engage in several rounds of seed financing before the company obtains financing led by an institutional investor.

Typical seed round investment instruments include convertible notes, simple agreements for future equity (“SAFE”), and ordinary shares.

Documentation

The following are several important documents that have to be prepared when a company takes in its first investment.

Term Sheet

The term sheet is not legally binding (other than the confidentiality obligation and the governing law provisions). It simply sets out the key legal and commercial terms agreed in relation to the proposed investment.

Generally, the term sheet will include important terms such as:

Other important terms may also be present in the term sheet, depending on the profile of the investors and the chose investment instruments. We will also discuss what a prudent founder or investment would consider in relation to the aforementioned terms later in this article.

Investment Agreements

Generally, investment agreements contain two components – the subscription agreement and the shareholders’ agreement.

Subscription Agreement

The subscription agreement is basically the agreement detailing all the terms agreed between the founder and the investor. The company would indicate its agreement to sell a certain number of shares at a specific price, and in return, the investor (or the “subscriber”) promises to buy the shares at the predetermined price.

Shareholders’ Agreement

The shareholders’ agreement should not be confused with the subscription agreement. While the subscription agreement contains transactional details about the investment, the subscription agreement contains each shareholder’s rights and obligation. The shareholders’ agreement will contain details such as how shares of the company could be disposed of, the management of the company, and the privileges and obligations of each shareholder. Every investor that becomes a member of the company will have to enter into the same shareholders’ agreement.

Amended Constitution

It is not uncommon for investment agreements to contain provisions that require the company’s constitution to be amended upon the completion of the investment to reflect the terms of the investment agreement, so that when the documents are read together, they reflect the intentions of the parties.

Additionally, the shareholders’ agreement can only be relied on by parties to the agreement. If the company is not a party to the agreement, then, prima facie, the company does not have to comply with the terms of the shareholders’ agreement, unless the constitution is amended to reflect the same.

Finally, if the company intends to issue preference shares as part of the investment agreement, section 75 of the Companies Act requires the company constitution to set out “the rights of the holders of those shares with respect to repayment of capital, participation in surplus assets and profits, cumulative or non-cumulative dividends, voting and priority of payment of capital and dividend in relation to other shares or other classes of preference shares”. In that regard, the constitution must be amended if preference shares are issued to the investor.

Employment Contracts

So as to assuage investor’s concern about possible misuse of the investment proceeds or that the company could possibly lose key employees after investment had been made, the investors would usually request for key employees and/or the founders to enter into employment contracts. These contracts would typically contain restrictive covenants to prevent founders or key employees from competing with the company if they leave the company and/or soliciting ex-colleagues or customers of the company.

What to consider

Investment Terms

The long-term success of the business could very well depend on the quality of terms of that first investment. Therefore, set out below are just some of the key investment terms that a founder (or an investor) might wish to consider before entering into any investment transaction.

Valuation of the shares

This is particularly important when any shareholder wishes to exit the company as a startup typically does not have much assets to its name other than the intellectual property rights that it holds. The valuation of such rights would usually be subjective and disputed.

Pre-emptive rights/anti-dilution clauses

Pre-emptive rights are usually present in any standard investment agreement to prevent shares of the company from landing up in the hands of 3rd parties whom the founder or investors might not have contemplated working with or to prevent the dilution of existing shareholders. It is essentially a right that requires any shares that are being sold to be offered to existing shareholders pro rata before it is sold to the general public or a 3rd party.

Board Composition

Deciding on the board composition of any startup is critical as the board dictates the direction and strategy of the company. Investors would usually demand some seats at the board of the company so as to ensure some form of control over their investment in the company, but founders should be wary that the proposed board composition should not render them powerless in operation of the company. Generally, it would be far better for founders to assess the overall direction and strategy of the business as they are more equipped and experienced than investors.

Reserved Matters

A standard investment agreement would usually contain key decisions that has to be approved by a special majority. Usually the threshold for approval would be greater than the founder’s shareholding so as to prevent the investor from being excluded from any significant decision regarding the company. These decisions would typically include:

However, investors and founders should avoid the inclusion of too many reserved matters as this could hamper the company’s ability to make swift decisions and also possibly result in unnecessary deadlocks.

Capital structure

A common problem that founders might face as the startup takes in more investment is dilution of its shareholding. If a founder relinquishes too much of the company at its very first investment, it risks losing control of the company at the later rounds of investment when it issues more shares to potential investors.

For example, if a founder agrees to a 51:49 split in shareholding in its first round of investment, a second round of investment will result in the founder holding less than 50% of the company’s total issued shares. This essentially means that founders would not be able to pass any resolutions requiring a simple majority without at least one of the other shareholder’s approval and this in turn could hamper the development of the company.

Intellectual Property Agreement

As mentioned earlier, the main asset of a startup (and hence a good portion of its value) would be its intellectual property (“IP”). Hence, it is vital that IP assignment agreements and confidentiality agreements should be drafted to ensure that the company is assigned the relevant IP and also to protect IP from being disclosed when a key employee leaves the company.

Employee Share Option Schemes

Employee Share Option Scheme (or “ESOS”) is a scheme that allows key employees the right to purchase shares in the startup at a pre-determined price (usually heavily discounted) over a certain period of time. Startups are usually keen to implement an ESOS because it incentivises their key employees to grow the company (and thereby grow the value of the shares that they are potentially entitled to).

By offering share options that would vest over time, the startup also encourages the key employees to stay with the company (or at least until the end of the vesting period). The end of the vesting period usually coincides with a milestone of the startup (e.g. when the product enters open market or when it secures its Series B or C round of fundraising).

Conclusion

The first investment is arguably the foundation of any startup. Founders should not develop tunnel vision when they receive an offer of an initial investment. It is not just all about the size of the investment. Instead, founders should be a prudent and make a calculated consideration about how much they are willing to give when receiving that very first investment.