Our latest blog is a guest post by Ali Ramadan, senior Associate in the Venture Capital Practice at Bird & Bird, where he works with investee companies and investors on equity and growth capital investments.
Below, he outlines some common corporate due diligence issues which arise with early stage companies:
1. Issuing shares or granting options over shares in lieu of service
Many companies in the early stages of product/concept development issue or grant an option (a right to be issued with) shares as a means of compensating or incentivizing employees or service providers.
While this is useful to help build your business when you have no money, it can cause problems when misunderstandings arise about what exactly has been agreed.
Therefore, it is very important there is a written agreement in place, which clearly states the number of shares issued, or over which an option is to be granted. Try to avoid promising a set percentage of the company, but if you do mention percentages, always be clear that the shares to be issued will represent a set percentage of the company at the time of issue or the grant of the option i.e. the percentage will change as a result of subsequent share issues.
2. Angel financing
Angel financing is risk money from the perspective of an investor and therefore the terms of the investment should be kept as simple as possible. The ideal position from an investee company perspective is to issue ordinary shares with no special rights or protections, which is required, in any event, if the investor is looking for their investment to qualify for SEIS or EIS relief (see below for more information).
Many founders feel they need a shareholders' agreement and end up agreeing to restrictive terms which come back to bite them. So, try to avoid having any shareholders' agreement unless the investor specifically asks for one.
If an investor does require a shareholders' agreement then be careful what you agree to, as it will set the precedent for future investment rounds. In particular try to resist giving the investor any consent (or veto) rights that will restrict you moving the business forward (for example a veto over issuing new shares).
3. SEIS/EIS tax relief
Many early stage investors are now looking for their investments to qualify for tax relief under the Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS).
There are a number of qualifying conditions that companies must satisfy (and maintain) for this relief, as well as procedural formalities to be adhered to with the timing and process for issuing shares.
It is important that you seek advice when issuing shares to investors who wish to qualify for SEIS/EIS treatment, because if there is any deficiency in the process it's unlikely you will be able to remedy it after the event, and could result in your investors not getting the relief.
HMRC do in fact provide an advance clearance service whereby they confirm if a company meets the qualifying conditions for SEIS or EIS. This can be a useful marketing tool when looking to raise money from early stage investors.
4. Intellectual Property Ownership
A common diligence issue with early stage companies is intellectual property not being owned by the company.
If you have employees or third party consultants or service providers developing any intellectual property for the company you must ensure you have written agreements in place which specifically provide for the intellectual property they create to be assigned to the company.
Furthermore, many founders fail to draw a distinction between themselves and the company – you should ensure that all intellectual property (i.e. domain names or trademarks) are registered in the name of the company and not the founder.
5. Company Administration
Ensuring your legal documentation is complete and organized will help with due diligence when it comes to raising money – it is not uncommon for key contracts to be signed incorrectly or be incomplete.
On the corporate side in particular, you should ensure the company has a set of statutory books (namely a register of members, allotment of shares, transfer of shares and a minute book), and that these are kept up to date.
It is also good practice to ensure you have an up to date share capitalisation table, which shows the share capital of the company on an as "issued basis" (i.e. all shares currently issued by the company) and a "fully diluted basis" (i.e. all shares currently issued by the company and any shares the company has agreed to issue at a future date pursuant to any other option or other right).
If you have any questions on the above issues or would like any advice on raising finance please feel free to get in touch with Ali directly:
+44 (0)20 7415 6000