With more start-ups coming to market quicker in Australia and many emerging growth tech companies flourishing, one of the big challenges for our technology entrepreneurs is to increase the conversion of local companies that close a VC Series A funding round.
To assist local companies getting ready for that next step, this article sets out our key recommendations from a legal perspective as to how founders can best get prepared.
Series A fundraising from a VC is not the only option for growth funding in Australia, however, and so we have also explained below some other alternatives for emerging companies to consider.
STEP ONE: UNDERSTAND THE PROCESS IN DETAIL
Venture capital is a mature industry with a well-worn path for fundraising rounds and an established set of deal terms routinely followed. Each VC fund has particular investment mandates they must adhere to, which you should understand in detail. They also have criteria to satisfy for every fundraising including minimum due diligence standards, a need to have a credible option to exit their investment (usually in 3 to 6 years) and a requirement for certain control and veto rights over decisions of each business they invest in. You should get a lesson in VC fundamentals from your mentors and experienced advisors at the outset and research as much as you can.
STEP TWO: HAVE THE ESSENTIALS IN PLACE
Before actually pitching, you must prepare your pitch and business plan in detail. That does not mean you need reams of paper, but it requires role playing with your mentors and advisors to ensure your plan addresses the issues and opportunities VCs are most likely to test you on. In particular, you need to pre-empt and concentrate on your greatest opportunities and threats, including your competitors, how you will scale your business and any disruption occurring in your marketplace.
You should also take some months to consider who you are going to pitch to and when and through who will you get the necessary introductions. Ideally, you will have established relationships that you have slowly developed with the VCs in question and if you don’t presently, you should be looking at linkedin profiles and other publicly available information to understand who can introduce you. You should also streamline your efforts and time to those VCs most likely to be a good fit.
STEP THREE: ANTICIPATE THE NEXT STEPS AFTER THE INITIAL PITCH
If your initial pitch is well received, you should expect a terms sheet to be negotiated to outline the key terms proposed for your fundraising. The terms sheet is not usually legally binding other than with regard to exclusivity, confidentiality and a break fee (if any), however, its sets out your agreement in principle and you should be committed to those terms once signed – any later deviation risks you losing goodwill and trust with the investor. You should therefore consider the terms sheet carefully and always take the opportunity to meet and discuss it with your advisors.
If a terms sheet is executed, the VC will undertake due diligence and this can last for anywhere from 1 week to 2 months. To enable a VC to quickly commence due diligence, you should be ready to launch a data room. Any data room should include your key corporate documents (such as your constitution, company register, details of previous equity issues and financings), financial information and assumptions to support your business plan, full details on the intellectual property rights of your company, material commercial contracts, employment contracts, any property lease and details of any litigation (past or present).
You should be careful with disclosing any information that is commercially sensitive to your business and consider redacting or initially withholding the most sensitive information.
STEP FOUR: YOU MUST HAVE AN IP PLAN
Prior to commencing any fundraising campaign, you should have your most valuable proprietary intellectual property protected so your company can use it anywhere in the world. While there is a tendency for some companies to favour speed to market over registration and protection, we recommend you register early. At the very least you should establish and be able to clearly convey to a VC what is patentable in your opinion, when an application will be filed (and the reason for any delay), what is not able to be protected and why and how you will mitigate risk regarding that intellectual property which cannot be protected.
If intellectual property is developed outside of your company you should have an assignment of all rights (and a waiver of moral rights) from the developer. Also, any use of open source software should be detailed, with mitigation steps if you think the open source software makes your business vulnerable. Ultimately you will need to warrant to a VC that you have access to all intellectual property necessary for your business, which means intellectual property protection is as important for you as it is for an investor.
STEP FIVE: Be prepared for the documentation YOU WILL NEED TO NEGOTIATE
Series A financing will usually be documented by way of a Subscription and Shareholders Agreement where a VC is to invest in equity or by way of a Shareholders Agreement and Convertible Note if the VC is to invest by way of convertible debt. Key terms of VC documentation for an equity subscription will include the founders and seed funders receiving ordinary shares and the VC usually subscribing for convertible preference shares, with a dividend, exit and liquidation preference attaching to the convertible preference shares to ensure the VC gets their money returned in priority to founders.
The documentation will also deal with board participation rights and it is standard for a VC to require veto rights over key decisions of shareholders and directors. The documentation may also provide terms governing future financings (which could include a ratchet that penalises the founders if further financing is necessary), drag along rights, pre-emptive rights and forced exit or liquidation obligations.
As well, the documentation will need to reflect an agreed valuation of your business, which is one of the most contentious issues you will need to negotiate. This requires a lot of preparation and your financial information and projections, plus the assumptions to support them, should be developed in detail and well tested.
STEP SIX: TASKS FOR A RAINY DAY
We also recommend you take any spare time available to get your employment documentation in good shape. This means ensuring any stock options, protective covenants, confidentiality terms and general employment terms that you have all seek to achieve best practice protection for your company and motivate your employees to remain with you and to work hard to grow your business.
Undertaking a review of your supply chain from start to finish, to ensure your compliance measures and terms of trade throughout the process offer the best outcome for your company, is also a good idea. Reviewing procedures for outsourcing, and particularly how your outsourcing approach seeks to limit legal and commercial risks to your business is also a useful preparation step.
You should also consider whether a move to the United States prior to or at the time of Series A financing is a viable and smart move. Many US VCs will only invest in companies located in the US. As well, the US is often the largest customer market for a tech start-up or emerging growth company and Silicon Valley is well established as one of the best environments for such companies to thrive.
While a move should not be seen as mandatory by any means, we suggest you have good reasons for why a base in Australia is most compelling and procedures to mitigate the risk associated with a cross border investment for a VC. In particular that means convincing the VC you are on top of your Australian compliance requirements which will be unfamiliar to them. You may also need to ensure compliance with US regulations like anti-corruption laws which will be binding on a US VC.
AND WHAT ARE THE ALTERNATIVES TO A VC?
The opportunities for venture capital funding in Australia are limited as compared to the United States and as a result alternative funding options including seeking funding from high net worth individuals, a strategic alignment with a corporate, a local equity raising or taking a slower path of incubation are common for many Australian companies. We are also seeing increased interest from Asian private equity.
With regard to high net worth individuals, the process and documentation is usually very similar to that of a VC funding round, however, family office companies or an individual’s lawyer will often manage the process and getting to know the investor and the key drivers behind their investment decisions can be more difficult. Meetings are crucial to this in our experience and ideally this should include a meeting as soon as possible with the high net worth individual (or family members) themself. As with VCs, your advisors should be experienced in acting with high net worth investors to ensure you are best placed to understand what is standard practice.
Negotiations with a corporate can be more complex, often caught up in bureaucratic procedures which require a complex due diligence and lengthy shareholders agreement. However, your company can often benefit from this and run more smoothly because of the time spent at the outset.
One of the dangers of an alignment with a corporate can be a conflict where the motives of the corporate are significantly different to those of the founders (i.e. where a corporate is simply looking to understand a sector or technology better or to buy in on the cheap) or where the corporate may conflict with future customers or investors. You should agree how you will deal with these potential conflicts at the outset.
With regards to Asian private equity, introductions and strong relationships are very important and you must be prepared for the due diligence and negotiation process to not always follow established Australian and US approaches. A focus on the ability to extend a business model to China or India is also usually a key focus.
If you are interested in a local capital raising, you must comply with the requirements under the Corporations Act and except for sophisticated investors or the costly and time consuming process of preparing a prospectus, this will usually limit the number of investors who can subscribe for shares and the value of funds you can accept. The process can be very time consuming and ultimately there must be investors wanting to invest, which demands a high level of justification for your business model and considerable work with a team of advisors.
Regarding a slower incubation, for many companies this can create an opportunity to pursue a mix of organic growth and bolt on acquisitions over time, with bank financing potentially available once a business has proven cash flows. It can also ensure a business model or product is better prepared for when a bigger break does eventually come.
This is a guest post by Joel Cox who is a senior associate at global business law firm, DLA Piper, and specialises in all aspects of fundraising law and M&A transactions for technology companies and investors.