To prepare for an equity financing round, the first step is to set, in advance, the desired financial parameters, such as the target company valuation and the percentage of equity that may be offered. It is equally important to understand the types of investors being targeted, their expectations for return on investment, the level of involvement they seek, and the strategic value they can bring to the company. Indeed, not all sources of capital are the same: investors differ significantly in terms of the value they provide beyond just funding. Some may offer strategic benefits, such as networks or expertise, which can be just as vital as the investment itself. On the other hand, certain investors might come with downsides, such as slower decision-making processes or stringent conditions that can make the company less flexible.
When comparing offers from different investors, it’s important to evaluate and compare the offers and terms from different investors, and consider not only the valuation and dilution, but also the governance, control, exit, and other rights and obligations that they entail. Moreover, the choice of investors should also align with the company’s stage of growth. Early-stage companies may attract angel investors, incubators, or venture capitalists who are comfortable with higher risks, while more mature companies might seek institutional investors (including private equity funds) or strategic corporate partners, who are looking for stable growth and a clear path to profitability.
The key is to research and approach potential investors who have relevant expertise, network, and track record in a specific industry and stage, and who share the company’s vision and goals. Therefore, it is essential to be prepared to answer their questions, address their concerns, and demonstrate the company’s traction and potential.
Before approaching an equity financing, the company’s capital structure should be well-defined and clearly documented in a capitalization table (commonly referred to as a “cap-table”). This table should outline the current ownership structure both on a non-fully and fully diluted basis, including details on shareholding, options, convertibles, and incentive plans. If potential investors have already been identified, the post-round cap-table should also include a projection of the stakes that will be held by investors upon the completion of the transaction.
During the equity financing process, the investors will request to conduct a due diligence review to evaluate the company therefore a key preliminary preparatory step is conducting a self-due diligence review. This process is not only useful for identifying potential problems or liabilities within the company, but also provides the opportunity to address and resolve these issues before investors conduct their own due diligence. By proactively remedying problems, the company can reduce the risk of negative outcomes during the investor review; a negative due diligence outcome could potentially disrupt the equity financing process, making thorough preparation necessary.
To be well-prepared for the purposes of the due diligence, several areas should be given particular attention:
Financial Documentation. Ensure that all financial documents are up-to-date and accurate. This includes having current financial statements, such as balance sheets, income statements, and cash flow statements, to show the company's financial health. In addition, realistic financial projections should be prepared, outlining expected growth, revenue, and expenses.
Intellectual Property and Data Protection. Make sure the company’s intellectual property (IP) assets, like patents, trademarks, and copyrights, are properly registered and legally owned by the company itself. This can be a significant factor in investor evaluations. Additionally, prioritize data protection by implementing processes and procedures that cover aspects of security and regulatory compliance. This includes safeguarding sensitive company and customer information, ensuring adherence to data protection regulations.
Key Agreements and Governance. Review all significant agreements, including those with customers, suppliers, and employees, to ensure they are complying and accessible. One of the most common risks faced during due diligence activity is the reclassification of consultancy agreements as employment contracts, which can have significant legal and economic implications. Therefore, it is advisable to pay particular attention to ensuring that consultants are indeed treated as independent contractors (e.g., without fixed working hours, direct supervision, or specific directives that would imply an employment relationship). Additionally, ensure that the company’s governance structures are in place, such as well-documented board and shareholders’ meetings. These steps will show investors that the company has a solid foundation and is prepared for growth.
Conducting a self-due diligence beforehand can also help ensure thorough preparation for the investors’ review, enabling the identification of potential issues in advance. Their review can be more or less extensive, based on the company’s stage and investors’ needs and it may include financial, legal, tax, and accounting considerations, while also extending to other areas such as regulatory compliance, intellectual property rights, and operational risks. Preparing a well-organized data room with all pertinent company documents readily accessible can help make this process smoother and avoid potential delays. Transparency is key, so it’s important to be ready to address questions about the company.
Of course, there are many other aspects to consider in preparing for equity financing, but addressing the areas above provides a solid starting point. By taking a proactive approach, founders can navigate the equity financing process more smoothly and increase their chances of securing investment, while also setting the stage for long-term growth and stability.
Engage a reputable and experienced legal advisor who can help you negotiate and draft the term sheet, shareholders’ agreement, investment agreement, and other relevant documents, and protect your interests and rights as a founder and shareholder.