Singapore is one of the most diverse start-up ecosystems globally and in the region. Private equity and venture capital investments in Southeast Asia reached US$23.5 billion in 2017, as reported in the Singapore Venture Capital & Private Equity Association Report on Southeast Asia PE & VC: Investment Activity (May 2018). With a conducive ecosystem for start-ups to grow and flourish, this article seeks to highlight certain legal pointers as a broad guide and framework for start-ups and founders to be aware of when approaching fundraising exercises.
Manner of investments
Generally, the various rounds of fundraising in a start-up may include the following:
- Initial angel round, which may include investments from family, friends, or high net worth individuals.
- Seed financing involving a limited number of investors, typically to support initial working capital needs.
- Various subsequent rounds of financing (Series A, Series B, etc.), which are typically led by venture capital or institutional investors with a view to scaling the business of the start-up.
- Pre-IPO financing prior to the start-up's imminent initial public offering (IPO).
Some common forms of investment instruments are as follows:
- Ordinary shares.
- Preference shares: Shares with separate terms and conditions, some of which are preferential to those of the ordinary shares, allowing parties to vary the voting rights, dividends, and liquidation preference of the shares, amongst others, as well as determine whether such shares may be redeemable or convertible at the investors' option, or upon the occurrence of certain prescribed events, such as an IPO or the sale of the start-up.
- Simple debt: Simple debt with interest.
- Convertible debt: Debt that may be convertible into equity in the start-up (ordinary or preference shares) upon the occurrence of certain specified events.
- Venture debt: Equity-linked debt instruments, such as a loan with an attached warrant or option, granting the investor a right to further subscribe for shares in the start-up.
The type of investment instruments adopted would depend on various factors, including:
- Commercial considerations and the bargaining power of the start-up vis-à-vis the investors.
- Specific requirements of investors, e.g. the scope of the investors' investment mandate, their ability to divest of the investment, the level of investor protection required, etc.
- The financial position of the start-up and the accounting / financial impact of the investment or type of investment instrument on the start-up's financial statements.
- Tax considerations.
Key transaction documents
A typical round of fundraising would involve a suite of legal documents, the key ones being:
- Term sheet.
- Subscription / investment agreement.
- Shareholders' agreement.
- Service contracts for the start-up's founders.
Where new classes of shares are being created, the constitution of the start-up will also need to be amended. The amendments would typically also include certain terms of the shareholders' agreement to be entrenched in the constitution.
Investors would usually carry out a business, legal and financial due diligence before proceeding with an investment. This would enable investors to understand the financial, legal and business position of the start-up and the investment risk profile, and also flush out any legal irregularities that it may wish for the start-up to resolve pending or post investment. Depending on the complexity of the start-up's business and operations, this may take the form of a cursory desktop due diligence or an extensive review of the start-up's records.
As an assurance, investors would typically require the start-up's founders to stand behind the start-up by providing personal guarantees and/or contractual warranties as to the condition and operations of the start-up. The warranties may be generic, and may also address specific issues noted from the due diligence.
As investors usually hold a minority stake in the start-up, they would typically expect certain minority protection rights. Some examples are:
- Undertakings to be given by the founders of the start-up to achieve certain performance milestones;
- Board representation.
- Reserved matters at the board or shareholders' level that may require certain approval thresholds to be met or approved by the investors.
- Rights to certain information such as the start-up's financial statements or business plans, or observer rights to sit in on board meetings.
- Pre-emption rights over the issue and allotment of new shares or the transfers of shares, drag-along, and tag-along rights.
- Put option for the investors to sell their stake back to the founders.
In structuring the investment, both the founders and investors would usually consider what happens upon the occurrence of an exit event, usually an IPO or a trade sale. The investment documents would commonly include provisions to address and regulate such exit events.
As a final point, some other factors that start-ups and founders should bear in mind when considering fundraising options are:
- Terms of the fundraising: These are commercially driven and depends on the bargaining power of the start-up vis-à-vis the investors, as elaborated above.
- Valuation: This would determine the amount investors are willing to pay for a share in the start-up, which would affect the amount raised per equity issued.
- Dilution: Founders should consider how much of their shareholding in the start-up is being diluted at each round of funding where equity is issued.
- Investor profile: This includes the investors' reputations, track records, and what they may be able to offer to the start-up apart from financing, including board guidance and business connections.
- Investment timeline: Certain investors may be investment funds with a limited fund life; in such case, their investment may require the start-up to meet certain milestones (such as an IPO or trade sale) within a limited time period, or a put option for the fund to exit prior to the expiration of the fund life.
- Other fundraising options: In addition to the fundraising options mentioned in this article, start-ups should also consider other avenues for funds, such as government grants and bank borrowings; each option would entail its own set of advantages and disadvantages that need to be considered and weighed, and would also depend on the start-up's need for the funds and its cash flow situation.
Dentons Rodyk acknowledges and thanks senior associate Kevin Chua for his contribution to this article.
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