The Tech Entrepreneur’s Journey – The Capital Requirements

This article, as part of a wider series of articles, will consider the key legal aspects associated with a tech entrepreneur effectively and efficiently funding the capital requirements of his/her new business venture during its corporate life cycle.

There are alternative mechanisms available to entrepreneurs (e.g. venture debt, grants etc.) but we will be considering the most common methods we see used to raise working capital for the proposed new business during its corporate life cycle.

Initial Considerations

The seed stage of a new business is the development of an idea/concept into a trading business. In order to do this every entrepreneur will require an injection of working capital.

Once an entrepreneur has settled upon his/her business idea/concept and prior to founding the actual legal business entity he/she will need to:

decide upon a business ownership structure (including what skill sets will be required to grow the business and identify people with these skills and consider whether to incentivise such people with equity in the business) (being the Founder(s));
find appropriately skilled professional advisors (legal, tax and accounting advice will, as a minimum, be required in the early days of a start-up business); and
create a business plan to assist with raising working capital for the business.

We believe that the primary goal for any fundraising of a technology business should be to give the Founder(s) (and his/her team) the resources and time required to create a product/service that fixes an issue they have identified in the market/solve the problems of their targeted customer base, always with the view of making a profit.

Family and Friends Investment

The most common means of obtaining initial seed capital for a start-up business is from the Founder(s)’ personal assets, friends or family members.

The capital raised from family/friends is normally obtained in exchange for an equity stake in the business.

Once raised this capital is normally used to:

pay the initial expenses of the business (including but not limited to tax advice as to the business structure, incorporation of the relevant legal entity, drafting of any shareholders’ agreement etc.);
finance product development and market research;
fund salaries of staff (including the Founder(s)); and
develop the company’s business plan.

This capital, whilst essential to initial growth of the business, traditionally has a short life span as start-up technology businesses usually require continued cash injection to fund necessary research and product development to ensure that the identified business opportunity is still viable or drive the business towards profit.

Third Party Investment

Once the financial needs of the business outgrow the financial appetite of family and friends, start-up businesses often experience difficulties trying to convince third parties to invest due to the risk profile associated with such an early stage business.

Seeking third party investment is a significant (and potentially daunting) stage in any company’s life cycle. As such, when it comes to choosing the right investor, it is important that the company understands all of the options available to it.

In all cases, the company should consider each of the following points in an effort to to encourage a constructive relationship with the desired investor:

funding level – how much does the company need for its desired growth;
typically investors will want an exit plan from day one – be prepared to discuss and commit to an agreed exit plan;
the company’s market value will be established upon taking on this investment – bear this in mind when speaking to investors as the valuation of the business will need to be justifiable;
how much time and costs will be needed for the process of securing the desired investment – don’t underestimate ;
what value can the desired investor add beyond the financial contribution e.g. sector expertise or additional introductions to key industry contacts/companies;
type of investment – debt or equity funding; and
if equity, what percentage of the company’s shareholding you are willing to give up.

The traditional avenues available to a company seeking to obtain seed capital investment from third parties are:

professional “Angel Investors” – high net worth individuals who provide capital for a business start-up, usually in exchange for equity. There are multiple Angel Investor networks in existence that allow start-up companies the opportunity to connect with these high net worth individuals;
from a Seed Capital Fund - a fund established solely for the purpose of providing capital for a business start-up in return for a mixture of debt and equity; or
a mixture of these two.

Any investor’s appetite to invest in a technology start-up will be determined by the founder(s)’ skills, business capabilities, track record (if any) and sector experience, together with the product’s or service’s ultimate benefit to its users. Such factors will ultimately determine how much seed capital (if any) an investor may contribute to a start-up technology business and for what equity stake.

From our experience the most common area of contention is what can be referred to as the “Dragon’s Den Dilemma”. This being a large disparity in what equity stake in the company an investor wishes to obtain for its investment and what equity stake the founder(s)’ is/are willing to give up for this level of investment.

The ultimate structure of any proposed investment is usually heavily influenced by tax. A company may be able to incentivise investors with potential tax reliefs that are available to companies e.g. Investors’ Relief that enables qualifying investors to pay tax on up to £10 million of gains realised on ordinary shares issued to the investor after a 3 year holding period at half the usual tax rate (i.e. 10% instead of 20%), EIS (Enterprise Investment Scheme) and SEIS (Seed Enterprise Investment Scheme) both of which, subject to differing financial limits and conditions, enable qualifying UK based investors after a 3 year holding period to pay 0% tax on gains realised on its investment of ordinary shares in the capital of the company.

When a start-up requires urgent funding but has not yet settled on its fundraising valuation it is becoming more prevalent for investments to be made pursuant to the terms of an “Advance Subscription Agreement”. The reason for this is that any capital advanced by an SEIS/EIS investor must be used as subscription for shares in the company (as opposed to, for example, being a loan to the company). This is a relatively new concept that allows a start-up to receive an immediate capital injection whilst retaining the investor’s opportunity to obtain EIS or SEIS tax relief. As this is a relatively new concept, it remains subject to HMRC scrutiny but at the date of publication of this article it seems to be appealing to both start-ups and investors.

Investment Structure

We would expect such investment (subject to the size of investment being deemed low in value to the investor) to be made pursuant to “Series Seed Investment Documents”. Such documentation tends to be less extensive than “Series A Investment Documents (these documents being used for the first venture capital investment made into the company) and will normally impose fewer restrictions on the company and how the business is managed than would be expected in Series A Investment Documents.

The Founder(s) should expect to provide a seed investor with a number of investment protections including but not limited to:

simple, non-participating liquidation event preferences (i.e. the investor gets its investment reimbursed to it prior to any other capital being split between the shareholders of the company);
basic warranties;
non compete provisions;
participation rights in the event of a sale of the business or company;
pre-emption rights on an issuance of shares by the company (a right for the investor to be able to subscribe for shares in preference to any other third parties);
rights to receive key information related to the company e.g. accounts and management accounts, annual business plan etc.,

but should, at this stage, expect to retain ultimate control of the company (including the board) and, subject to basic investor veto rights, the day to day operations of the business.

Conclusion

Whilst this article provides a high level overview of the Seed Capital stage of a business’ corporate life cycle, it is only the initial stage. Set out below is an overview of a typical business corporate life cycle. We will comment on each of these stages in our the future articles of The Tech Entrepreneur’s Journey – The Capital Requirements.