Companies often go through various stages of capital raising to facilitate growth. Investors in early-stage capital raises are typically friends, family, and small angel investors. By contrast, more prominent institutional investors and venture capital funds often invest in and lead later-stage funding rounds. These investors make significant contributions to the business, meaning deal negotiations are often more complex. This article explores how to prepare for and what to expect in later-stage funding rounds.
1. Preparing for the Due Diligence Process
Prospective investors in later-stage funding rounds often carry out due diligence investigations before they are willing to commit to investing in a company. This gives the investor greater:
- clarity of the risk profile of the investment; and
- certainty that they are making an informed financial decision.
The transaction documents often state that the investor's investment is subject to satisfactory due diligence. For this reason, companies must prepare for the due diligence process to ensure that the deal's completion is not delayed.
Before or while the company commences preliminary discussions and term sheet negotiations with the lead investor, it should start compiling all of the documents and information that will be included in the data room. The data room is the virtual location storing all the due diligence materials the investor will examine.
What to Include in Due Diligence Materials
Some things the company should include in the data room are:
- a copy of its share register;
- any governing documents being the constitution and shareholders agreement, if the company has them;
- the cap-table;
- an organisation chart setting out the corporate structure of the company or group;
- any agreements or arrangements which oblige the company to issue shares, options or convertible securities, such as Employee Share Option Plans, Convertible Notes and SAFE agreements;
- resolutions and minutes of board and shareholder meetings from the previous three years;
- a summary of all intellectual property held by the company or group, including registered and unregistered trade marks, patents, designs, software licences, domain names and copyrighted materials;
- employment agreements between all employees and the company;
- any IP assignment deeds between the company, the founders and key employees;
- material contracts with customers, suppliers and government agencies;
- details of any ongoing or anticipated disputes to which the company is a party;
- details of any licences and insurances held by the company;
- details of any financial arrangements, loans and other liabilities of the company; and
- a list of the company's leased and purchased assets and security interests.
2. Deal Structure
Deal structure is an essential consideration in any capital raise. As a result, later-stage funding rounds can adopt various forms, including:
- equity rounds;
- bridging rounds;
- using convertible instruments, such as SAFEs or convertible notes; and
- venture debt.
A Note on Venture Debt
Unfortunately, venture debt is typically unavailable for early-stage companies because they cannot demonstrate the consistent cash flow required to service venture debt arrangements. However, venture debt can be viable for mature companies as the higher interest rate and lender fees may still be cheaper than issuing equity. In addition, it limits upfront dilution for founders and other shareholders.
Some essential considerations in venture debt arrangements are:
- the lender will likely want to take security over the company's assets to guarantee repayment, meaning the company's assets are at risk if it cannot meet its repayments;
- venture debt lenders are usually issued warrants (or the right to purchase shares at a set valuation) to give them the option to participate in any equity upside if the company is doing well;
- venture debt interest rates are generally higher than traditional lending institutions to offset the risk of venture debt lending; and
- venture debt is less readily available than an equity investment in New Zealand as it is an emerging market.
3. Common Deal Terms
The deal terms of later-stage funding rounds are generally more complex than early-stage funding rounds. However, some standard deal terms of later-stage funding rounds include the following.
Companies typically issue preference shares to investors in later-stage capital raising because they have certain rights and protections that ordinary shares do not. As the company grows, it may have several different classes of preference shares. So, one of the key terms to negotiate in a new round is whether new preference shares will rank equally with or superior to existing preference shares.
Many investors support equal ranking preference shares as a principle, even in later stages. Hence, all investors are treated equally if a liquidation event occurs. However, later-stage investors may suggest that because they contribute more money than investors in previous rounds, they must protect against greater risk by getting 'first dibs' on the company's assets should it wind up.
Ordinarily, liquidation preferences are not a primary concern for founders because the founders are unlikely to receive any proceeds if the company is liquidated. However, the company's existing shareholders will need to consent to create a new class of shares if the company does not have preference shares on issue. Alternatively, shareholders must consent to create a class of preference shares that ranks senior to the other preference shares on issue in the company.
Most preference shares in later-stage capital raising will have anti-dilution rights on down rounds. In other words, the company sells shares at a price per share that is less than the price per share sold in the earlier financing round.
In New Zealand, anti-dilution rights are usually calculated using a 'broad-based weighted average' adjustment. This means that the conversion price of existing preference shares is adjusted downwards. This is usually between the price paid for the shares and the down-round price.
As the company grows and undertakes further funding rounds, it should consider how these anti-dilution rights interact with its other interests. For example, suppose the company is implementing anti-dilution rights for shares issued in a new round. In that case, it should consider whether it has any existing warrants or convertible securities with a discounted conversion mechanism that may trigger the anti-dilution rights. If so, your anti-dilution terms will need to be structured around this.
Forced Exit Provisions
Forced exit provisions are becoming more common in later-stage rounds because investors can be eager to ensure that the company is motivated to achieve an exit within a specific timeframe.
Notably, forced exit provisions can vary and may require the company to:
- undertake an exit within a specific time frame; or
- compel the company to undertake an exit based on advisers' opinions.
The time frames in which forced exit provisions are triggered can also vary. However, around five to seven years from the initial investment is customary.
Later-stage capital raising rounds are usually more complex than early-stage financings. Mature companies can prepare for their capital raise by:
- organising their due diligence materials; and
- considering an appropriate deal structure to ensure that completion is not delayed.
The terms of the deal itself can require significant negotiation as investors may be contributing significant amounts of money relative to early-stage investors. Therefore, the transaction documents are often more substantive.