Australia’s start-up scene is one of the most promising and rapidly progressing in the world. With the thirteenth largest economy and the ninth highest income per capita, Australia is fast beginning to project a Silicon Valley-esque sense of opportunity for start-ups. Venture capital is one way for aspiring founders to get their companies up and running. But before rushing into obtaining venture capital, you need to think carefully about what such a contract is going to mean for your company. You should also get thorough legal advice at the earliest opportunity to ensure that the financial arrangements you set in place are advantageous to you and your start-up in the long-term.
What are Venture Capitalists?
Venture Capitalists are financial investors who take an active role in the development of the companies they invest in. Different venture capitalists invest in different companies in different ways. As many aspiring founders lack experience in the business world, dealing with venture capitalists can bring challenges. While it’s great to have access to capital, it’s also important that the investor providing it is committed to your idea and is going to steer your company in the right direction.
The ideal investment for a Venture Capitalist is a company that possesses high growth potential, but also requires management and expertise. It is an investee company which:
- targets large or fast-growing markets;
- possesses both a cooperative and innovative management team;
- is made up of a simple business structure where ownership can be clearly defined; and;
- provides a high chance for a clear and profitable exit.
Venture Capitalists will only invest in a company they believe has a significant chance of providing them with the ideal return, which is usually set at 10-20 times the initial investment.
How Venture Capital Investors protect their interests
Once you’ve made your pitch and undergone due diligence, you will be faced with an investment offer accompanied by a Share Purchase Agreement. A new venture capital investor will typically require the following from an investee company:
- a seat on its board of directors;
- a preferential discretion over company management and operation, including:
- the power to appoint and dismiss the CEO;
- the power to sell company assets;
- final discretion over incurring additional debt; and
- securing further financing (whether by debt or equity).
Further, in addition to the above protection rights, Venture Capitalists will look to be granted ‘Preferential Shares’. This grants them the first right to have their investment return paid out in preference to other ‘Ordinary Shareholders’. In addition to this, a Venture Capitalist’s preference in shares may also include other veto rights such as fixed, preferential dividends and preferential rights of participation in future capital raisings. To summarise the controls exercised by Venture Capitalists: they do everything they can to guarantee the desired return on their investment.
Is Venture Capital for you?
Venture Capitalists establish their controls over an investee company through its Constitution and Shareholders Agreement. The first step to setting up these arrangements is to have an investee agree to and sign a meticulously drafted Share Purchase Agreement. Within this agreement, you will set out the preference attached to the company’s shares as well as any representations and warranties addressing matters such as company structure, ownership of assets and the capital structure of the company. These agreements can be lengthy and complex so the assistance of an experienced lawyer to draft the agreement, or review it once it has been drafted, is essential.
Of all venture capitalists investments, approximately 65% fail or return less capital than expected and only around 4% actually deliver the projected returns. Looking at these figures, it is understandable that Venture Capitalists have to exert a lot of control over investee companies. Furthermore, Venture Capitalists typically acquire their funding from a ‘pool’ of external investments and as such, are in turn under pressure to provide returns to these third-party investors.
You may find that venture capitalism is not the path best suited to your start-up. In determining your financial position in relation to any investment, you should always focus on the figure following the dollar sign and try not be too drawn to what lies before the percentage sign. There is an element of negotiation in any investment and it always pays to get thorough advice from both accountants and lawyers.
The importance of a good legal team
Aspiring founders often overlook the potential for further negotiation once an offer of terms is presented. A good legal team, which is well versed in your financial circumstances and your start-up idea, can help you to secure the best offer possible. It is also easy to underestimate the importance of capital to a start-up venture. Appropriate advice is crucial here, not only for negotiating contractual terms, but to provide an additional viewpoint on the overall desirability of investment. Contractual agreements can be complicated and every potential founder looking to secure Venture Capital investment should do so with the expertise of an experienced lawyer by their side.
Venture Capitalism can be a very good thing. It allows companies, which would otherwise never see the light of day, to thrive in highly competitive markets while simultaneously boosting entrepreneurial innovation. However, as a business owner, you should endeavour to always have a clearly defined picture in your mind of how you want your business to operate. While there will be situations where compromise is unavoidable, your goal should be to negotiate an investment in terms which suit the direction you want your company to go in.
If you require legal advice in relation to your business needs, please contact Go To Court Lawyers.
By Jonathan Liberis, Legal Assistant