Start-ups: Practical tips on fundraising

When raising funds for your company, there are certain steps that you can take both before and during the fundraising exercise in order to smoothen the process.  This article provides some general and practical guidance to start-up companies looking to raise funds as well as a brief overview of the key legal documents that you will likely encounter.

Be prepared

Before embarking on a fundraising round, it is important to get your ducks in a row.  As part of your preparations, you should have ready some basic core materials that any potential investor will typically expect to see during the due diligence stage such as:

  • a pitch document/ presentation including information about the company and its business, products and/or services;
  • historic performance data;
  • the actual new product / invention;
  • financial statements and recent management accounts of the company;
  • biographies and credentials of key persons (including shareholders and directors) and employees involved in the company and an organisation chart; and
  • information and documents relating to the company’s cap table, existing assets and liabilities, incorporation and corporate structure (including group chart).

Having a set of well-prepared core documents at the outset can help you in making a good first impression on investors and by expediting the due diligence process (more on this below).

Term sheet

A term sheet (also known as a letter of intent (LOI), memorandum of understanding (MOU) or heads of terms) is by no means mandatory (some just go straight to drafting the final contracts), but it does feature regularly in transactions as a means of recording the principal terms on which the investor(s) will, subject to the satisfaction of any mutually agreed conditions, invest in the target company.

Generally term sheets are not binding on the parties except for certain provisions such as confidentiality and the governing law clause.  Nevertheless, it is an important document because it sets the basis and tone for the negotiation and drafting of the definitive transaction documents and, once signed, the investor(s) may be reluctant to deviate from the agreed terms.  Therefore, you should consider having a lawyer review your term sheet before signing it.  In addition, you should also pay attention to any exclusivity clauses which could restrict your ability to approach or otherwise deal with other potential investors.

Due diligence

Due diligence is the process by which a third party investor obtains information and documents about a target company (including financial and legal information and documents).  Seasoned investors will usually kick-start the process by sending their preferred form of due diligence questionnaire to the company’s management and/or representatives who must then provide the requested information and documents in the agreed manner and, if applicable, by the agreed deadline. Generally speaking, the due diligence process becomes lengthier and more complex with the maturity of a start-up company. In contrast, due diligence should be a relatively straight-forward exercise with younger start-up companies.

As mentioned above, advance preparation of core documents can greatly assist in expediting the due diligence process.  Insofar as the legal due diligence is concerned, a start-up company which is incorporated in Hong Kong should be prepared to provide the following corporate information and documents when requested by an investor:

  • certificate of incorporation;
  • certificate of change of name;
  • business registration certificate;
  • articles of association;
  • copy of the shareholders’ agreement relating to the company (if any);
  • copies of the company’s registers of members, directors and transfers;
  • copies of all documents filed at the Companies Registry in respect of the company since the date of incorporation (or in respect of a period specified by the investor);
  • complete set of executed documents relating to previous financing rounds and share cap table (if any);
  • copies of all convertible notes / bonds, options, warrants and other securities convertible into shares that have been issued by the company;
  • copies of all loan / facility agreements, security, guarantee and finance documents;
  • copies of employment contracts of key employees and option schemes and benefits (if any);
  • copies of all material contracts of the company (e.g. client contracts and supply contracts);
  • documents relating to any premises owned and/or leased by the company;
  • documents relating to intellectual property owned and/or used by the company including licences and evidence of registration; and
  • information regarding any pending or threatened litigation, arbitration or other proceedings involving or affecting the company or any of its assets.

The above list is not exhaustive and will be tailored to suit the circumstances including the potential investment amount, the sector in which your start-up company operates, and the maturity of your start-up company.

After you have responded to the investor’s due diligence questionnaire, you may receive further rounds of follow-up questions and requests.  You should answer them honestly and avoid withholding information for fear of scaring off the potential investor.  Most issues are capable of being resolved or managed from a risk allocation perspective.  For more complex requests concerning legal issues and documentation, a lawyer can assist you.

Involving a lawyer in the legal due diligence process is helpful when it eventually comes to negotiating the representations and warranties to be given by the company and/or the founders to the investor.

The transaction documents

If you have cleared the due diligence stage, the next step is to negotiate, agree and execute the transaction documents.  Each round of investment is usually labelled as a ‘Series’ (such as a Series A Investment) with the earliest rounds being labelled as ‘Seed Round(s)’. Institutional investors will usually invest in the equity of your start-up company (though there are different types of investment), which means that such institutional investors will become shareholders of your start-up company. In an equity investment involving a subscription for shares, the transaction documents will generally include a subscription agreement, a shareholders’ agreement (or, as the case may be, an amended shareholders’ agreement) and amended articles of association.

A subscription agreement, as the name suggests, is the contract that governs the terms for subscribing for new shares that will be issued by the start-up company. Such an agreement would contain key terms for the subscription such as subscription price and the number of shares that will be subscribed. A subscription agreement will also set out representations and warranties about the start-up company and, where relevant, its subsidiaries. Contractual warranties are statements made by a person (whether that person be a founder, the start-up company, or the relevant subsidiary) in favour of an investor (or the investors) about the conditions of the relevant company to which the warranties relate. The main purpose and effect of such warranties is to impose legal liability upon the warrantor making such statements and to provide the investor with a remedy if the statements made about the relevant company prove to be incorrect, and the value of start-up company thereby reduced (i.e. where the investor suffers a loss). As an investor will have direct recourse against the person who gives the warranties, it is not uncommon to request a subsidiary of the start-up company, that owns the relevant assets and operates the actual business, to be a party to the subscription agreement and to give warranties.

The shareholder rights of an institutional investor are usually different from (and usually better than) that of a founder. For instance, an institutional investor may request that certain critical matters (commonly known as reserve matters) can only be carried out with the consent of such investor. An investor may also ask for liquidation preference where their rights to a distribution of assets of the company will rank ahead of an ordinary shareholder (e.g. the founder). Different shareholder rights can be distinguished by different ‘classes’ of shares. Usually institutional investors’ shares that have better rights are called ‘Preferred Shares’. The rights of the shareholders are usually set out in the articles of the start-up company and the shareholders’ agreement. The model articles that are prescribed to a Hong Kong company at its incorporation do not provide for a separate class of shares, and would need to be amended in order to accommodate an investor’s request for different class rights. It is also important to amend the articles so that they are consistent with the terms of the shareholders’ agreement. A failure to do so may cast doubt on the enforceability of a specific right or obligation to the extent that there exists any inconsistency.

A lawyer can guide you through the entire fundraising process and advise you on the legal risks and implications of the terms of your transaction.  For more information on fundraising and how MinterEllison LLP can assist you, please contact George Tong or Caroline De Souza.

6 September 2021
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