All too often the lawyers and/or ‘the legals’ (we’re basically interchangeable) are seen as tricky or adding complication (and, of course, cost) when entrepreneurs want to close a deal and get back to running their businesses.
With this in mind, and in the hope of explaining why the process is so vital to your deal, I think it’s important to share some insight into the legal points and procedures involved in the investment process.
Is it in the termsheet?
The termsheet is where the legal side of investing kicks in – ironic since most parts are actually not legally binding. The termsheet, or Head of Terms, sets out in medium detail what the deal looks like; valuation, structure, director and observer seats, veto and consent rights etc.
Although it represents the offer from the investor, it is fine to negotiate before signing. If something is important to you, then it’s worth negotiating to try to get it in. That said, however detailed the termsheet, inevitably things will come up which are not listed, or which mean that some re-negotiation is required. The lesson is this: don’t get so bogged down in the termsheet that you have no energy for the real documents.
To my mind, it’s important to have a Plain English termsheet. Both sides need to fully understand what we are collectively aiming for. Very deliberately, most of the termsheet is not legally binding. For example, the only parts of MMC’s termsheets that are binding are:
Break costs: Broadly that you will cover our costs if you pull out, we discover that you are lying to us, or you break the two other legally binding bits.
Exclusivity: We are investing a lot of time and money even just in the diligence process so, unless we have agreed you can continue discussions with others, we expect to be your one and only for a set period of time.
Confidentiality: Once the deal is done we’d love to sing it from the rooftops, but in the meantime, better to keep in under wraps. On a similar note – we don’t share your metrics around the market, we’d appreciate it if you didn’t splash our valuations around.
Be prepared for questions
So you’ve done more pitches than you can count, answered numerous questions about metrics, teams, market, competitors, 5 year plans, KPIs and the rest. Be prepared for more.
We want to find out about you and your company. As well as diligence on your financials and technical capability, there will be legal due diligence. At MMC we usually do this two ways: a questionnaire about your company and one about you.
A director’s questionnaire will focus on your background, experience, your other commitments (corporate and personal) and gives you a chance to tell us anything else that we ought to know (don’t be embarrassed, we’ve seen most of it before!).
To make the delivery of the questionnaire as painless as possible, we most commonly use Dropbox to order the documents. This is sometimes referred to as a data room. Depending on your background, this process might be more or less of an effort.
If it’s any consolation, it will stand you in good stead for growth and private equity investors, who will expect a full data room.
Warranties? Is that something to do with warrants?
To keep costs proportionate to amounts invested, we ask the founders, senior management and the company to put their names (and some money) to various factual statements about the company; these are the warranties.
There is a lot of information available on the structure of financial warrants, but typically it is the quantum of the round and two times annual salary.
If there is something you need to tell us before you can sign, it should go in the Disclosure Letter. We are less interested in the money we might be able to claim if there is a breach of warranty and more in that you have sat down and seriously considered each of the statements.
That shows us that you are honest, thoughtful and thorough – qualities that good investors value very highly.
Can we have our money now?
Some VCs are able to fund as soon as signatures are in. Others may have compulsory conditions before funding, which creates a hiatus. In our case, we need to have pre-clearance from HMRC that the structure and documents meet the EIS criteria. Despite best efforts, there can sometimes be a gap between agreeing all the documents and being in a position to fund – teams should factor that into their thinking, especially in subsequent rounds. There are a few different ways to deal with this:
Split exchange and completion without a material adverse clause (MAC): Sounds complicated but simply put, everyone signs as soon as the documents are ready. Those investors who can invest straightaway, do so, everyone else is legally committed to fund just as soon as they have met whatever their requirements are.
Split exchange and completion with MAC: Everyone signs, but no-one funds until everyone is in a position to do so. To protect investors from something bad happening in the interim, there might be a material adverse clause (MAC) which calls off the investment if a problem arises.
Simultaneous exchange and completion: Documents are agreed and no-one signs until everyone is ready to fund. This might be straightaway if investors don’t have any pre-conditions.
My point therefore is that, although the legal processes involved in an investment deal may seem cumbersome and complicated – once understood, they should be embraced. This process is simply a mechanism to protect both parties, and to develop trust, at the start of what should be a long and productive relationship.
Victoria is MMC’s legal counsel. She advises (or advises on) with varying degrees of formality: 1 investment committee, 33 (ish) portfolio companies, hundreds of investors, 4 funds, a couple of soon-to-be portfolio companies, 12 employees, a board of directors and the FCA. On a part time basis.
Further reading: Banks and SMEs need to align interests on funding