Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect.  This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel.  Cara Stone, LLP. and the author expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion. Reading, downloading, or covering this article does not create an attorney-client relationship.

As entrepreneurs start and grow their business, an exit may seem like a long way off. Events that trigger an exit can build slowly or progress rapidly. Timing is key! Cara Stone, LLP’s (“Cara Stone”) “Preparing for Exit” series will discuss some practices companies can put in place early and throughout their growth to ensure that when the time comes, their exit goes as smoothly as possible.

The first part of the series will discuss good corporate hygiene. We’re drilling down into the paper side of the business to talk about how to set up the company’s day-to-day operations to put it in a healthy position to speak with investors or acquirers.

 

Tip 1: Don’t Reinvent the Wheel   

The first tip for companies is to go with the norm. Companies should stick with generally accepted practices for businesses in their industry. For instance, in most cases, there is a right and wrong way to set up a biotech or mobile app company that plans to raise money. Although this is a fact intensive issue, most biotech or mobile app companies seeking venture capital will want to be structured as a corporation.

If the company is planning to take on investors, issue stock options to employees, etc., the founder will want to structure the company as a corporation early on. If the company starts off as an LLC, and must reorganize later, it will likely cost more in time and fees than it would to have gotten the structure right to begin with.

One way to figure out what is standard in your industry is to talk to advisors, lawyers, accountants, etc. who have worked with companies in the industry before. Find people who know the standard deal terms in the market and structure the company around that from the get-go.  Some founders will take a “fake-it-till-they-make-it” approach when they start their company. Find advisors who have been at the table for big deals and know the ropes.

Tip 2: Get Your Capitalization Straight

Every company has a record of owners starting with the founder. In the beginning, many companies issuing ownership do it informally using handshake deals, casual emails, spreadsheets, or conversations. This is problematic. Making sure you account for these transactions correctly ensures all shareholders know their ownership and that every shareholder is accounted for correctly when you bring on more investors or sell the company.

One common misconception around how share issuance works is that when an investor, employee, or other owner gets shares in the company, they get them from the founder. In most cases, founders should be setting aside some shares for themselves, and setting aside other shares to sell to investors. In other words, founders (generally) do not sell their shares to investors. The company sells shares to investors. This is something that founders commonly misunderstand.

Talking to someone who knows how cap tables are set up or using a cap table tool to track shares and ownership will help companies keep ownership in order as they grow.

It is also helpful for companies to map out who owns what early on. Then companies can plan their strategy for raising money (and even exit strategies) in early stages of their business. This forethought gives business owners a clearer picture of how the financial decisions they make along the way will impact the company’s value and the founder’s and investor’s ROI on the business.

Cara Stone has a Cap Table Tool that helps companies manage their cap table and allows founders to see how different financial strategies and exits will impact their companies valuation and ultimately the amount that the founder can expect to get in the event of an exit.

Tip 3: Get Your IP Assignments

Most startups will think about intellectual property (“IP”) at some point in their business’s lifetime. Your IP assignments could make or break a deal at exit. Properly protecting your IP (including trademarks) early on is often easier and less costly than trying to protect it down the line.

Protecting your IP can be inexpensive to do at the beginning, but when it’s time for the company to fundraise, it gives investors confidence to know that the company’s IP is protected.

It’s easy to think of your company’s IP as complex technology or methods, but it’s important not to forget about the simple things around the company’s brand such as the website or logo. Large and small companies alike have run into costly issues because they realized too far down the line that someone else owns their domain name, logo, or that there is a trademark claim against an element of their branding.

Keeping your IP assignments in order is something that is easy and inexpensive to do early on but will be useful in the long run.

Tip 4: When It’s Time to Raise, Don’t Chokehold Yourself with Documents

When the company raises a round, it’s easy to get caught up in the excitement and want to get formal documents drafted early. However, as a round comes together, deal terms tend to change.

Instead of drafting documents that may need to be rewritten, go out and discuss the terms with investors. Entrepreneurs are much more likely to identify suitable investors by working with advisors who know the angel and venture capital market. When companies work with people who have been involved in a limited number of deals or have not been through the fundraising or investing process, it is harder to raise money.

Once you have gotten advice from someone with deal experience, have that person help draft a term sheet. This strategy keeps the ball rolling while allowing room for flexibility. It also helps unify the terms of a deal among investors and helps avoid “one-off” deals which can lead to bad terms or bad investor dynamics.

Ideally, when a company raises a round, they can find a lead investor and unify the terms of the deal around that investor. Then additional investors can come in under terms that are agreeable to both them and the company.

Tip 5: Organize your Company Documents with Due Diligence in Mind  

When sophisticated investors come into a transaction, one of the things they will require is due diligence on a company. This involves digging into the numbers, evaluating markets, etc. The process will also involve legal due diligence. During legal due diligence, attorneys will look at every paper that represents the business. This means that documentation that outlines all aspects of your business needs to be in place.

Investors and acquirers look at a company in an organized manner (a due diligence request list). When a company is set up with the due diligence structure in mind, it saves a lot of time and energy at exit.

Setting up a business with this structure from the beginning also gives founders a good way to think about the strategy of their business, not just the paperwork behind it. Again, speaking with someone who has been involved with transactions, can help guide the company in the right direction early on.

Cara Stone, LLP works with companies at all stages of their life-cycle on setting up a corporate structure to ensure their exit goes smoothly and successfully. For more information on what you can do now to prepare for your exit, check back on the blog for Part 2 of our series Good Management Practices.

 

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5 Key Steps in the Fundraising Process
Equity Incentives for LLCs
Qualified Opportunity Zone Overview

 

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