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February 14, 2020
You’ve developed your product, gathered a winning team, set up your business model, and now you’re confident you have what it takes to attract outside funding. All that’s standing between your company and millions is a well-crafted pitch, right?
Wrong. There are a lot of legal steps startups can’t afford to overlook before beginning to raise funding, and neglecting these is a red flag for investors. Jaakko Lindgren, Partner at Dottir Attorneys, offered to share the most important ones so that an untidy house doesn’t stop you from raising funding.
For most technology-intensive startups, raising funding serves as a stepping-stone for the company’s future growth. However, fundraising is an abiding challenge for startups and founders need to be well prepared to secure funding — or as a lawyer would put it — they need to keep their house clean.
In this post, I’ll walk you through what the tidiness requires. I’ve outlined a couple of topics that are of the essence from a legal point of view when preparing to raise funding: how startups should prepare for investment rounds from a legal point of view, what the key pitfalls in due diligence processes are and how to avoid them, and how to build a transparent relationship between your company and your potential investors.
Investors perform due diligence (DD) of the company before the investment round. The simple purpose of the review is to discover if the company has any skeletons in their closet which might pose potential risks for the company’s future. As the investors are — at least most of the time — investing someone else’s money, it is in their interest to go through the DD material with a fine-tooth comb. The result of the review is an understanding of the risks or even potential deal-breakers that may have been caused by poor administrative, legal, and financial practices.
Administrative issues and contract management are, unfortunately, often neglected in early-stage startups before an investor joins the company. For most companies, the DD process is the first time any outsider reviews their administrative, legal and financial practices — and if these practices have been neglected, many startups find themselves racing to tie loose ends ahead of the investment round. Giving administrative and legal matters some attention in the early days saves you from time-consuming and sometimes costly housekeeping measures before or during the DD.
By clearing up issues related to the Trade Register, contract management and IPR before gearing up for the investment round, you can make your company more attractive to potential investors. This will also help you strengthen your negotiation position — you won’t have to accept exorbitant terms to close the deal, and you can guarantee an appropriate valuation of the company.
1) Keep the Trade Register up-to-date
Notifying the Trade Register on changes in the company might seem like a burdensome process, and thus, early-stage startups tend to neglect filing the necessary notifications on time. Founders may be enticed to delay updates and send all their notifications at once in order to avoid extra costs and the inconvenience. This can lead to a situation where the Trade Register is lagging and incorrectly represents the state of the company — for example, there can be a disconnect between the cap table and the official number of shares.
Before an investment, your company should have registered all shares, granted options, special rights, and possible reallocations of shares to new team members. Make sure that the shareholder or board resolutions have been recorded in accordance with the Companies Act — drafting up the resolution documentation and making the registrations afterward takes up twice as much time and resources compared to a situation where all the company information is up-to-date in the Trade Register.
So if you’re reading this and feel guilty, make sure this is on your fix list for this week. If you’re in the process of beginning to raise funding, add it to today’s to-do list. And from now on, make it a routine to file notifications to the Trade Register as soon as changes are made. A good cycle is to check that the Trade Register is up to date at regular intervals, such as board meetings.
2) Get your contracts in order — and most importantly, on paper
Sometimes young companies engage in many different flexible and ad-hoc contracts regarding the company’s business, financing, or ownership. Before entering into complex and — yikes! — unwritten agreements, you should consider the possible effects of these contracts on your ability to raise money in the long run. For example, if the company’s employment agreements do not contain necessary clauses relating to non-solicitation, non-competition or confidentiality, you risk losing key employees or assets to competitors without the possibility of indemnification for damages. A good rule of thumb is to only have written agreements that have been checked by a lawyer — I can’t overstress how important this is, particularly when it comes to ownership contracts.
The shareholders’ agreement (SHA) is one of the most critical pieces of paper in the company and should, without exception, always be in place. It regulates the relationships between the owners of the company, serves as a framework for issue management and enables the company to operate in times of crisis. To steer clear of exotic arrangements relating to equity, you can use a standardized free of charge SHA, which works for all parties and represents the current market practices in Finland.
3) Protect your IPR — Investors will take note if you don’t
You should always make sure to safeguard intellectual property appropriately, as it might be your only valuable asset. The first thing is to make sure you have a trademarkable name for the company. Next, you should immediately file for the necessary patents for your products.
On a practical level, intellectual property rights (IPR) should solely belong to the company. Thus, the SHA and possible employment agreements should contain necessary clauses regarding IP created by the employees and founders. If necessary, all IPR should be transferred to the company from the founders with separate agreements. You should also protect your IPR in all of your agreements by having clear stipulations on the division of IPR and executing adequate non-disclosure agreements with potential partners.
Founders should always understand the IPR components of the company’s products — For example, if the company is offering a software, it is necessary to know all the different components of the software so that IPR of these different parts can be legally assessed. Especially when using open-source software components, founders should pay attention to the licensing terms to avoid making the company’s proprietary software open-source when it is not the intention.
I’ve just written a lengthy blog post on legal housekeeping and provided a checklist of things you should have taken care of yesterday — so you might think I’m going back on my word when I say that a company’s paperwork can often be fixed during an investment round with the help of legal experts. However, this usually leads to a hefty and costly DD process, which is always at the expense of developing your company. What’s more, a company’s disorganized administrative management inevitably affects the attractiveness of the company, and the founders’ creditworthiness may decrease in the eyes of potential investors. At worst, poorly managed administrative issues can repel investors from otherwise appealing investments.
The best way to build robust relationships with investors is to be transparent about the company’s administrative shortcomings that could affect the valuation or future operations, and have all the paperwork in order before an investment round. As investment agreements include representations and warranties bounding the founders, sweeping issues under the rug does not help your founding team or your company move forward. That’s why I never tire of emphasizing that mutual trust between founders and investors serves as a solid ground for keeping the house clean.
Jaakko Lindgren is a Partner at Dottir Attorneys — a tech law firm with offices in Helsinki, San Francisco, and Berlin. His focus lies in IT sourcing & transformation, Tech-driven M&A, VC, startups & GDPR. @jaakkolindgren