In the current situation dominated by the coronavirus pandemic, the simple observer – at first glance - may think that the economic downturn (or in some cases, freefall) caused by COVID has taken its toll on the world of startups and on venture capital markets as well.
Despite the troublesome circumstances, the truth is that venture capital markets have hardly ever been in better shape than nowadays. We live the golden age of venture capital investments. Investment value is growing in an unstoppable manner in the European Union, in the United States, and frankly in all economically developed areas of the world.
The phenomenon itself raises interesting questions and even more interesting answers and shall be subject to detailed analyses. Nevertheless, if that certain idea has been born, now it is the time for startups to prepare and assess what makes them attractive in the eyes of potential investors beyond the developed solution and the corresponding business concept. It may sound like a cliché, but our first and foremost advice for the management is to act in a disciplined manner, to know their company and to ensure its fully compliant, legitimate operation. The foregoing is of paramount importance, and in some cases may prove to be difficult to realize, considering that most startup managers are not holding decade-long managerial experience. Although legislation changes quickly and often, it is safe to say that venture capitalists are willing to take a serious risk for the success of an idea, but they prefer order and want to make sure in advance that it indeed exists.
Now let’s take a look at the cornerstones which are handled by investors as priority during a due diligence procedure, and which (or the lack of which) can be decisive factors in making an investment decision, in addition to the attractivity of the idea and the business concept.
Corporate governance, membership and investment relationships in advance of the transaction
Although we may think that corporate governance as an expression refers to huge corporations, the reality is that in fact every company should have some sort of it. Regardless to the corporate form of the given company, it is essential to familiarize the potential investor with a mature and properly documented corporate governance structure. This structure shall be built in a way that allows the swift insertion of the potential investor’s governance rights if an affirmative decision is made on the investment. What is meant by that? The basic governance structure of the company is laid down, it is accepted by the current membership (or shareholders), shareholder meetings, shareholder resolutions and managerial decisions are properly documented, and the minutes reflect the decisions made by the company in a detailed manner. All in all, there is order in the company. However, the willingness to invest may be increased in itself by communicating towards the potential investor that the startup holding the idea, know-how and business concept is an entity which is in fact separate from the founders.
This seems to be logical, but in several cases we experience that it is not always an easy thing to differentiate between the relationships of the company, and the private relationships of the founders (especially if there are only one or two shareholders in the company in advance of the investment). To this end, it is important that the founders refrain from showing an attitude towards the potential investors which sends the message that the company will be handled by them as only their own after the investment. The reflection of this attitude may scare away investors, therefore, it is necessary to convince them even in advance that they will be regarded as true partners, not just as silent monetary contributors.
Before coming to the decision on making the investment, the investor will certainly conduct a due diligence investigation at the company. Within the framework of the foregoing, the investor will request from the founders the most important organizational documents, and will pay particular attention on familiarizing themselves with the ‘history’ of the company, and on getting to know that who and in what volume made capital or any other sort of contributions to the company in the past. During such a procedure, it is of key importance to point out whether there is any ongoing or expected dispute between current/former shareholders, or the ownership and investment relationships between members (and former members). If the company has already received investment from third parties in advance of the contemplated transaction, it is a typical investment condition stipulated by venture capitalists to repeal such investment agreements and to re-regulate them in a unified structure with the new venture capital infusion, in the new shareholder agreement.
Term Sheet, Shareholder Agreement
Should the venture capitalist decide to enter into the investment, as first step it is strongly advised for the parties to stipulate their agreement in a Term Sheet. The unique nature of a Term Sheet lies in that, although in most cases this type of agreement does not have legal binding force, the parties often consider Term Sheets as preliminary agreements. A Term Sheet, in general, contains the agreement of the parties in broad terms: it determines main features like the amount of investment, the method of performance, the decision-making and management rights to be acquired by the investor, and obviously, the planned course of return. With respect to the foregoing, we strongly advise startups to manage the Term Sheet as a priority even if it is concluded as non-binding. The usual way to specify the terms of the agreement laid down in the Term Sheet is to conclude a shareholder agreement (SHA). Typically, the SHA determines specific provisions on voting rights, veto rights of the investor, priority rights pertaining to return on investment, drag-along and tag-along rights, anti-dilution provisions, and several other material conditions without which the venture capitalist would not invest in the company. Sometimes the parties in cooperation decide to specify their agreement in the deed of foundation, which requires caution as company documents are available to the public in Hungary. If their agreement contains sensitive information which should be qualified as business secret, it may be better to regulate the cooperation in an SHA, the confidentiality of which is secured by the parties.
Intellectual Property (IP)
It is a common issue that several companies are not aware of how to protect their intellectual properties. The foregoing may lead to serious difficulties as present times the value of several startups lies in the idea developed by the founders, together with the corresponding business concept, which are held by the know-how. This is specifically true to young companies being in the early stage of their development, and which are mostly targeted by venture capitalists. As in these cases the main or sole holder of company value is the IP, in order to attract investors, it is crucial to ensure that the intellectual property is properly protected, its status is properly settled from a legal perspective. It happens often that the IP is in fact not held by the company itself when the startup is targeted by the investor, which complicates or hinders the investment process later. In order to the avoidance of such difficulties, it is strongly advised to have the IP transferred into the company in advance of the investment. Thereby the founders can verify towards the potential investor that the target already owns the IP, which comprises all the know how necessary for succeeding with the business concept. If persons outside the company have also contributed to the development of the IP, founders should expect that the investor will require them to procure their waiver of rights/claims in relation to the IP.
In addition, founders can also expect that the investor will investigate whether the IP violates any third party rights, and even in the lack negative conclusions it will prescribe as investment precondition to stipulate the proper warranty and/or indemnity undertakings.
From investment perspective it definitely increases attractivity if legal relations are arranged. This means that procurement and supply agreements, client agreements and employment agreements as well are properly documented and all of them are available in detailed written form. In advance of investing in the company, the potential investor will likely request these documents as well and include them under the scope of the legal due diligence. It is expedient to act with precaution and involve professional legal assistance during the course of negotiating and concluding these contracts. Some disadvantageous contractual provisions can not only harm our interests in the particular legal relationship, but in bigger perspective they can discourage venture capitalists from allocating their interests in our company and from cooperating with us.
Even if the idea is very attractive, the investor will not sacrifice money if they do not clearly see that it conforms with the prevailing regulatory environment. With respect to the foregoing, it is crucial to familiarize the potential investor with the idea by way of ensuring them that the whole concept fully complies with law and we are, or we will be in possession of all official licenses that are required for putting into market our invention. So even the best idea, the most innovative business concept and the best corporate strategy can fail if order is lacking from the company, as it causes uncertainty in the eyes of investors.
It is therefore worth the effort to duly regulate shareholder relations, to document every agreement and to allocate resources on protecting the IP and other business secrets.
And finally, if the investor is knocking at our door, it will surely be rewarding to use the best professionals who are well prepared when it comes to representing the interests of startup-owners during the elaboration of investment terms, in the course of Term Sheet and shareholder agreement drafting and negotiations.
(Dr. Gábor Márky is a Senior Associate at Jádi Németh Attorneys at Law)