In the last instalment
we talked about the ways in which the founders of KNow Wear Limited could protect the intellectual property in their business. Since then, the business has been progressing well and our founders have been working on developing a prototype.
To take the business to the next level our founders have decided that it is time to find external investment and want to raise £500,000 at a pre-money valuation of £1.5 million. You, Sarah and Chris have had discussions about the type of investors you should be targeting. Family and friends will often invest in the early stages of a startup but due to financial circumstances caused by COVID that is not a possibility for either you, Sarah or Chris. You have also considered crowdfunding, which can be useful to raise money at the same time as generating publicity. However, because the prototype is still at an early stage, you don’t think it is the right time to be targeting the public generally. In addition, the amount you are raising may be a bit small for venture capital funds and therefore you have decided to focus your efforts on raising investment from angel investors. You hope that as well as bringing money to the business, these angel investors will also have their own expertise and experience which you will be able to draw from, as well as potentially provide useful business contacts.
The founders have agreed that you are going to lead on fundraising while Sarah and Chris continue to focus on developing the prototype.
So what are the next steps to prepare for a fundraising?
1. Pitch deck. You will need to prepare a pitch deck which you can provide to potential investors. The pitch deck will need to set out the key details about the business including (1) what the problem KNow Wear Limited is addressing, (2) how it will solve that problem, (3) the market opportunity, (4) competitors in the market and how you are different, (5) details of your business model, (6) financials, (7) details of the team and your expertise and (8) how much money you want to raise, for how much equity and what you are going to spend the investment on. If the business has had any good press, or you have had any good scientific peer reviews, or the like, it is good to mention this here too.
You are aware that the Financial Services and Markets Act 2000 (FSMA), prohibits a person in the course of business from engaging in an investment activity unless the promotion has been made or approved by an authorised person (i.e. someone regulated by the Financial Conduct Authority) or is exempt. You are also aware that there are a number of exemptions which are available to startups including (1) making a communication to a certified high net worth individual or (2) making a communication to a self-certified sophisticated investor. Falling foul of these laws can have serious consequences and can result, at worse, in a criminal conviction resulting in fine or 2 years imprisonment. Therefore you are aware that you will need to be careful who you send the pitch deck to and how you send it, including making sure that you have only sent your pitch deck to certified high net worth individuals or self-certified sophisticated investors and making sure that you have the appropriate disclaimer wording on your pitch deck. For more on self-certifying – see the blog 'An introduction to angel investing'.
2. Cap Table. You will need to prepare a cap table which details who the current shareholders of the company are, the number and class of shares they own and their percentage shareholding.
You should also show the fully diluted position in the cap table e.g. what the position will be following the proposed investment and once equity has been issued to anyone else you have offered equity to but who is not yet a shareholder. Ask yourself, have we promised anyone shares that we haven’t issued as yet? Perhaps someone has let you use office space and you agreed to issue them with shares, or an adviser has helped, on the understanding that they will get shares. You and your cofounders are planning to put in place a share option scheme following completion of the investment pursuant to which you can issue options which can be used to attract and incentive employees. You haven’t discussed the details of this share option scheme with Sarah and Chris yet but you have agreed that it will be equal to 10% of the fully diluted share capital of the company, so you will show this in the cap table.
While preparing the cap table you have noticed a problem. When you incorporated the company you did so with each founder holding one share of £1.00 each in the capital of the company. If you raise £500,000 at a pre-money valuation of £1.5 million, following the investment the founders will need to hold 75% of the shares and the investors will need to hold 25% of the shares. Therefore, in order to maintain these percentages, you can currently only issue 1 share to the investors. This is going to make it difficult to issue shares to potentially a number of angel investors. Therefore you decide that prior to the investment you will need to subdivide the current shares so each founder holds 10,000 shares of £0.0001 each. This means that the aggregate share capital of the company remains the same (£3 in total) but you will be able to issue 10,000 shares to the investors and still maintain a 75% shareholding for the founders.
3. Due diligence. You are aware that once you have found angel investors who are interested in investing in KNow Wear Limited they will want to carry out due diligence before making the investment; including due diligence on the company’s finances, the tech (including seeing evidence that the company owns all the IP in the prototype and tech), the founders and your business plan. So you are ready for the due diligence stage you decide to put together a data room (i.e. a set of folders with all the key information in it) in advance. The data room will contain the key documents that are relevant to the company which you anticipate the investors will want to see. This will include company information such as the articles of association of the company, the business plan and any budget, management accounts and key legal documents such as the deeds of assignment of IP which Sarah and her friend entered into with the company and the company’s trademark registration documents.
4. Shareholders’ Agreement.
You, Sarah and Chris have considered the importance of putting a shareholders' agreement
in place. However, as you are currently equal shareholders in the company and you are planning on fundraising imminently, at which point an investment agreement and new articles of association for the company will be put in place which will replace the shareholders’ agreement, you have decided not to put a shareholders’ agreement in place at this time.
5. Advanced Assurance. You are aware that the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS) are two tax incentive schemes for individuals who invest in early-stage companies. As you have decided to target angel investors for the investment into KNow Wear Limited, you are aware that these tax reliefs will be important for your investors. You therefore decided to speak to the company’s accountant to check that the investment into KNow Wear Limited will be eligible for these reliefs and to apply to HMRC for advanced assurance that the investment would meet the conditions for these schemes. You can then use this advanced assurance to show your potential investors that their investment may qualify for the schemes.
That’s all for now but look out for the next instalment in our lifecycle of a startup series where we will be focusing on the terms and conditions needed for the business (and will return to fundraising later).