Executive Summaries Jan 22, 2019
How to Go About Pre-seed and Seed Funding?
An investor invests capital in a company or lends it money in exchange for securities, such as shares, a promissory note (convertible or non-convertible) or bonds, allowing the investor to obtain a return on his investment, for instance in the form of dividends.
To an investor wishing to finance a startup at the pre-seed or seed stage, aside from the challenge of choosing from among numerous candidates that all promise to embody innovation and growth, there are a number of legal issues surrounding the investment that should be considered in order to protect the rights and interests of the investor. In this article, we will focus specifically on the legal issues involved when investing in a startup which can be grouped into two successive steps, namely due diligence and negotiation of the investment instrument.
Due Diligence: a Crucial Step in the Investment Process
Conducting due diligence on the company’s affairs can be quite a tedious process, but it is an important step for the investor’s protection. Although an early-stage startup seldom has an operational or financial history that will permit an assessment of the company’s activities in terms of accounting and legal matters, due diligence can guide the investor in deciding whether or not to invest and in determining the points to be negotiated with the company.
Firstly, a legal counsel’s work consists of analysing the company’s “genealogy” to ensure that the chain of title is valid if the investment is to be made by way of a subscription of shares. The links in this chain are essentially constituted of each successive issuance or transfer of the securities that the investor wishes to acquire. Accordingly, the title examination has a dual purpose: 1) to establish that the holders are the true owners of the securities issued and 2) to ensure the investor ensure the investor has an undisputable title of ownership.
Secondly, the purpose of due diligence is to obtain detailed knowledge of the company’s key projects, to consult the documents supporting its valuation (e.g., financial statements, business plan, presentations) and to gain access to the company’s financial forecasts. At this stage, the analysis will generally include a background check on the founding shareholders and a review of the company’s principal assets and obligations, including contracts with customers, debts, security interests, potential litigation, leases, employment contracts, intellectual property, and licence agreements. It is unlikely that the investor will be investing in the same conditions if it comes to light that the company is being sued or is hampered by a non-competition clause covering a particular activity sector or territory, or that the intellectual property is unprotected or could easily be copied by a competitor.
Of course, this process varies from one investment to another, according to the extent and nature of the activities of the subject company. At the outcome of the process, the investor will be able, on one hand, to clearly identify the company’s strengths and weaknesses and thus know what may be problematic, and on the other hand, to evaluate his return on his investment opportunities.
Negotiation of the Investment Instrument
Since 2013, the number of ventures obtaining pre-seed and seed funding quickly through standardised investment instruments has been growing steadily. The Simple Agreement for Future Equity (SAFE) and the Keep It Simple Security (KISS), which were first developed in the U.S., are examples of such instruments which are now common in Canada. These instruments, which are virtually identical from one investment to another, are very similar to the convertible promissory note in that they permit the obtaining of immediate funding from investors in exchange for a future stake in the company’s capital stock when a financing round takes place.
Despite the apparent simplicity of these instruments, a precautionary approach is warranted. Indeed, these instruments typically provide investors with little or no significant rights in the interest of expediting the process and minimizing the costs and the timeline as much as possible. However, unlike a business partner, an investor is generally not involved in the operation of the company or in daily decision-making. The financial instrument through which the investor acquires an interest in the company must therefore be carefully negotiated to ensure the investor’s rights and interests are protected. It will be necessary to include, for instance, voting rights or the right to ask questions at shareholders’ meetings to learn about the company’s successes or failures, and even to systematically obtain pertinent information about the company, such as financial information.
Where applicable, the investor should also review the existing or proposed shareholder agreement, which will vary widely from one company to another, and seldom favour a minority investor.
Startup financing is an area where passion and reason are in a continual tug of war. It is therefore always essential that an investor enlist the aid of experienced professionals who can guide him when he invests in a company at the pre-seed or seed stage. The result will be a more efficient process and the elimination of post-investment concerns. Indeed, it will be very difficult for an investor who voluntarily eschewed the due diligence process to argue that his consent was vitiated. Similarly, it is strongly recommended that investors seek legal counsel to ensure that the drafting of the investment instrument is in line with the parties’ expectations and that it includes any additional protections that may be needed. This is where BCF’s venture capital team can be of assistance, guiding its clients from the very beginning so they can properly understand the issues and address them.