Founder Series: Top Tips to Follow to Get Ready to Raise

Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 320 growth financings and tech M&A deals totalling US$9.76bn in 2022 and has dominated the European venture capital tech market for 7 years in a row (PitchBook, FY 2022). In our previous instalments, we have guided founders through the process of incorporating a private limited company, building their team, how to use share options to attract and incentivise their employees, protect their ideas and helped to identify key compliance considerations.

For many founders, raising funding can be a particularly stressful time. Sourcing and managing potential investors while continuing to run the business all become part of the day to day. In the sixth instalment of Orrick’s Founder Series, our Technology Companies Group offer top tips to help UK startups structure their funding round, navigate term sheets, and get diligence ready.

1. The fundraise. Below are some useful considerations when structuring your fundraise:

   • Option pool dilution: if you are increasing your unallocated option pool as part of the funding round, you should consider whether this increase will be counted in your pre-money valuation or your post-money valuation. If the increase is counted in the pre-money, the dilution will impact the founders and existing shareholders; on the other hand, if it is in the post-money, the new investors will also be diluted. For more tips about options, you can read our instalment, Top Tips to Follow to Incentivise Your Team.
   • Timing: from the time you sign a term sheet, negotiating and completing an early-stage equity funding round can (for simple deals) take an average of 6-8 weeks (sometimes longer for more complicated deals or if there are any unanticipated issues in the funding round process). To bridge this interim period, you might consider asking your existing and/or incoming investors to invest some capital in advance through an instrument such as an advance subscription agreement or convertible loan note, which will convert when your equity round completes.
   • SEIS/EIS: it is best to know whether you will have any SEIS/EIS investors as early as possible as there will be a number of structural changes that will need to be incorporated in your investment documents to accommodate the SEIS/EIS rules. For example, in order to ensure that you don’t exceed the £200,000 (or £250,000 from April 2023) gross assets threshold, your SEIS investment monies will need to be received first, with the SEIS shares issued immediately in exchange for the fresh injection of cash. SEIS/EIS requirements will also dictate the rights and potentially class of shares that need to be issued.
   • Rolling closes: after you have negotiated the investment documentation with your investors, you might find that your round is not fully subscribed for and/or some of your investors will need more time to complete. In such cases, you might consider structuring your round to accommodate rolling closes, i.e. a close/multiple closes that will occur within a period of 30 to 90 days from the initial close to bring in any additional or late investors. All Board, shareholder and investor consents should be obtained at the initial close to avoid the additional administrative burden.

2. Investment funds. In today’s global market, investors might value the company and their investment in a different currency, for example USD. UK companies should be aware that raising in a different currency might present an FX risk from fluctuating exchange rates and may present additional complexities if the existing liquidation stack of the company has previously been priced in GBP.

3. Understanding your cap table. Your cap table provides investors with a comprehensive overview of the company’s share capital and the dilutive impact of the round, including any option pool top-up, convertibles and rolling closes. It is important for both founders and investors to understand the % ownership of the company, which might affect Board appointment rights, consent thresholds and de facto veto rights, and information rights (see below). Understanding who is a controller of your company is also important if your company is regulated.

   It is also important that you and your investors know who sits on your cap table – this is a surprising point, but startups can often get this wrong, especially where an investment is made through a syndicate and/or fund where the underlying investors hold the shares in their personal capacity. Mismanagement of your cap table can also trickle through to incorrectly made-up company registers and could cause delays to completing the financing round.

4. Due diligence and your data room. Most VC investors will insist on some form of legal due diligence. A template due diligence questionnaire can provide you with the building blocks to start populating your data room early – the sooner the better. You can expect to provide information relating to:

   • the company and the shareholders;
   • financial information such as the annual and management accounts and any loans and debt facilities;
   • documentation relating to registered and unregistered company intellectual property and the company's IT stack;
   • customer and supplier agreements; and
   • all template employee and contractor documentation, including anonymised data relating to the company's workforce and any employee benefits (such as share options).

5. Warranties and disclosure. Almost all investors will insist that the company (and sometimes the founders personally, though new market data would suggest no founder given warranties) give warranties as part of the investment round. These warranties are contractual promises from the company to the investors as to the health of the business and allow the investors to make an informed assessment of their investment. If the company cannot give a warranty, it will need to disclose this to the investors in a disclosure letter. The warranties are usually a key point of negotiation, and some of the key elements to consider are:

   • Scope: if you have converting investors as part of the round, you might consider whether the warranties should be extended to these converting investors or whether the warranties are given to the new money investors only. You might also consider whether the warranty suite is appropriate for the stage and size of your business.
   • Limitations: the maximum liability of the company for a breach of warranty claim should not be more than the aggregate amount invested in the round (which will exclude any convertible funds to the extent the converting investors are not being given the warranties). In addition, you might also consider limiting the time period which the company is vulnerable to a warranty claim. For seed rounds, we tend to see these settle anywhere between 9 and 18 months.

6. Founder vesting. One of the more heavily negotiated terms is founder vesting. The intention is to reduce the impact of a founder leaving the company, by putting some or all of their equity in the company “at risk” (i.e. subject to re-purchase or conversion into economically worthless deferred shares) during the vesting period.

   • Vesting and leaver provisions: a typical vesting schedule is 4 years monthly, with a 1-year cliff, which means that a lump 25% of the founder shares vest after 1 year, with the remaining 75% vesting monthly over the following 3 years. Where a founder leaves as a "Good Leaver" (which is usually with mutual agreement and in non-contentious circumstances), that founder can keep the shares they have vested. If a founder leaves as a "Bad Leaver" (which is usually in contentious circumstances), they would normally lose all of their founder shares.
   • Upfront vesting and vesting commencement date: it is not unusual for vesting to be “re-set” on a subsequent funding round. To acknowledge a founder’s contribution to the business up to the investment date and in recognition of any prior vesting schedules the founders have been subject to, founders can request for a portion of their founder shares to be excluded from the vesting provisions (such shares having been deemed "earnt").

7. Information rights. Investors will often request the right to receive certain financial information about the company (e.g. annual accounts, management accounts and the annual budget and business plan) to allow them to monitor the progress of the company and their investment, as well as meet their own internal fund reporting requirements. In negotiating these rights, you should consider whether it is appropriate to limit which investors receive the company's financial information and whether the volume of information requested is proportionate to the stage and size of the business. It is however worth noting that a light information rights regime is not a reason for poor corporate governance, and companies should seek to build good corporate governance systems early on.

8. Assembling your Board. Our Deal Flow 2.0: European Venture Capital Deal Term Review 2021 data shows that in 2021 there was a 12%+ increase in founder and Board appointment rights as founders maintained or increased their positions within their companies, meaning greater founder control over future funding rounds and growth strategy. We have not seen a reverse in this trend this year, though there is a continued focus on a nimble Board.

   Investors will often request a right to appoint a director to the Board. It is important that you consider tying this right to an equity floor (e.g. that investor holding a minimum of 5% of the equity shares) to ensure that as you grow your company, your Board does not become overcrowded with investor directors who hold immaterial shareholdings.

9. Consent regimes. As the founders are usually the majority shareholders and directors of a company (especially at the early stage), VC investors will negotiate for negative controls over the company to ensure that certain actions cannot be taken without their consent.

   These are usually in the form of (i) Investor Majority consent matters (which go to the heart of the economic value of the shares held by the investors e.g. matters affecting the company's share capital and rights, or the adoption of new articles of association), and (ii) Investor Director consent matters (which include administrative and operational matters relating to the business of the company e.g. expanding to a new jurisdiction, approving the company’s budget, or incurring material expenditures).

   When negotiating who constitutes the Investor Majority, it is important to set the Investor Majority consent threshold at the correct percentage to avoid an investor deadlock. It is also important to ensure that no single investor is given a veto over decisions that would hinder the company from being able to operate efficiently moving forwards. Likewise, founders should ensure that the requirements for Investor Director approvals will not hinder the company in operating its day-to-day business.

   An additional protection for the founders is to require founder approval in addition to any Investor Majority consents to ensure that the founders have an equal say. We encourage founders to think about this from an early stage so that this can carry through in future investment rounds where they might have a lesser say by virtue of their shareholding alone.

10. Other legal provisions. There are other legal provisions often included in term sheets, which you will need to consider, including drag, liquidation preference and anti-dilution.

    • Drag along: these provisions allow a majority of the shareholders wishing to sell their shares, to “drag” (or force) the minority shareholders to also sell their shares. Our Deal Flow 2.0 data shows that in 2021 there was a shift towards a specific percentage of shareholders (such as 75%) required for drag rather than a simple majority (over 50%) including an investor majority, with 100% of the deals at each funding stage featuring a drag threshold of 50% or higher. You also often see a founder veto prevalent in earlier stages which drops off in the later stages.
    • Liquidation preference: a typical liquidation preference is a 1x non-participating preference, which gives the investors their money back first (before the non-preference shareholders) in a liquidity event. This has been the market standard for a number of years, however in an uncertain market, investors might push for a higher multiple or a participating preference. We have seen more of this this year.
    • Anti-dilution: this protects the investors from their investment being diluted if the company raises further investment at a lower valuation. Our Deal Flow 2.0 data shows fewer early-stage deals having anti-dilution preferences. However, this trend has changed considerably this year – more to follow on this in Deal Flow 3.0 next year!

Our London TCG practice reflects London’s role as one of the world’s leading financial markets and a centre for international commerce. Nothing inspires us more than helping tech companies develop novel strategies and push boundaries. Through our extensive client portfolio, deal volume, and relationships in the tech ecosystem, we provide commercial and legal insight to each company’s strategy. We work with tech companies on all aspects of their business plans: financing strategies, protecting intellectual assets, retaining talent, securing and monetising data, and advocating for innovation-friendly public policy.

To keep to 10 top tips, this instalment is just a whistle-stop tour through funding round readiness. There are a number of other considerations we can help to guide you through as you negotiate the terms of your next round.

If you would like more details on any of the issues above, please contact Jamie Moore.