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Legal: Structure for success

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So the blood, sweat and tears of the last five years has finally paid off and you have developed the next big thing. You have put together a business plan and begun speaking to venture capitalists. But while they appear interested in the technology and business, they have reservations. How could this be?

Marcus Best and Simon Davidson examine some of the more common pitfalls of early stage business and equity structure planning.

The information memorandum is drafted, the pencils have been sharpened, the deal appears to be a fait accompli but the VC is stalling. This is the greatest fear of the entrepreneur. And sometimes it happens.

Maybe you’ve run the business out of your discretionary family trust? Perhaps your father’s ex-wife holds 10% of the business? It could be that your contract programmer didn’t assign the copyright in that critical piece of source code. Or your partner never quite got around to signing that new employment contract with the non-compete clause.

While none of the above are likely to make a VC reject a proposal outright, these structural issues are likely to stall even the most enthusiastic investor. A little early business planning can save significant time and effort, at a period in the company’s growth cycle when the plan of attack should be firmly focussed on raising capital.

BUSINESS STRUCTURES

The golden rule with business structures is to keep it simple. A stand-alone Australian-incorporated company is appropriate in most cases. Tax driven structures, such as trusts, partnerships, offshore entities and complicated group structures, can make a VC nervous.

What a VC wants

  • Transparency – They need to understand the business structure. They do not want the investment entity to become a Bermuda triangle where their money disappears.
  • Simplicity – Complexity only adds to costs, particularly for professional services. Complexity makes every corporate action more difficult than it needs to be.
  • A clear exit – They know the IPO/trade sale market requires a logical business structure and will not want their exit harmed by a poor or confusing one.

VCs also know that the longer a business operates without addressing these issues, the more it will cost to fix them, and they don�t want to see their return reduced by additional professional fees, taxes and other costs.

Therefore, if an entrepreneur wants to create a tax-driven structure, they need to balance the structure’s advantages with the costs of potentially dismantling it when seeking funding.

The moral of the story is, spend a little money and time seeking professional advice and, where practical, get it right at the start, to save a lot of money and time when it really counts.

SHAREHOLDING STRUCTURE

Fewer problems arise from a poorly prepared equity structure. This is because VCs usually seek to invest using preferred equity or debt, which subordinates all other shareholders.

However, the capital raising process can still be derailed or delayed if the equity structure involves layers of complexity for the VC, lawyer and corporate advisor to wade through.

A large number of shareholders or shareholders with different classes of shares may cause delays in obtaining agreement to the deal, or amendments in the future. The need to obtain the approval of a large number of shareholders or classes of shareholders mean that shareholders’ decisions are likely to be more complicated.

A good rule here is to seek fewer partners with similar goals or who share the business vision, and give them the same shareholding rights as you have. VCs will demand alignment of interest between the founding parties – it will help if you already have it.

It is important to reward people appropriately, but you may jeopardise your chances of longer term success if you dilute your shareholding too early and too widely.

INTERNAL STRUCTURING

As well as the appropriate corporate structure, VCs will want to see a stable internal business structure. An important step is securing the assets of the business – today that means intellectual property (IP) and employees.

No VC will invest in a company that cannot prove proper ownership of its IP or demonstrate the commitment of its key employees.

A VC wants to see:

  • Ownership rights to all of your IP, evidenced by valid assignments to the company from all developers – in particular, copyright in source code, manuals or written processes.
  • Procedures to track all IP and to protect it, as necessary, through registration or patents.
  • Appropriate long-term employment contracts with all key employees.
  • Employee contracts which assign all inventions and IP rights to the company.
  • Enforceable non-compete clauses in all employee contracts.

Finally, VCs will be looking for a strong and experienced management team, to satisfy them that the company can be driven to achieve the goals set out in its business plan.

Strong management is often the difference between presenting a VC with a good and a great opportunity.

Early business planning and appropriate legal and financial advice will make it easier to sell your next big thing to a VC. Steer clear of the unnecessary complications and your path to success will be far smoother for it.

Marcus Best is a Partner and Simon Davidson a Senior Associate in the Private Equity Group of Minter Ellison.

Visit www.minterellison.com or contact 03 8608 2508.

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