As a FinTech are you ready to raise equity for funding?

Raising equity by issuing shares is often the first step for a FinTech in raising funds from investors. The process is generally straightforward. However, some common mistakes made at the early stage can come back to haunt founders and shareholders.

Are you ready to raise equity?

Ensuring that your business is structured appropriately is critical to attracting capital. The following items should be resolved prior to seeking to raise equity:

• Is there an entity capable of receiving equity investment? The most common entity is a private company (i.e., proprietary limited) that is able to issue shares to a limited number of investors.
• Does the company own the key assets? Investors will be concerned to see that the company is the owner of the core assets of the business. These assets include intellectual property (IP), the key contracts and employment of the key staff members.
• Are your records in good order? Investors will want to be able to review the key documents before investing. This includes evidence of the shares on issue, any agreements to issue further shares, the constitution, ownership of IP, employment agreements and financial accounts (which generally do not need to be audited).

What do I need to do to raise equity?

The simplest form of equity financing is issuing ordinary shares. A common initial class of investors is friends and family or high net worth individuals who join as ‘seed investors’. Following the seed round, venture capital funds and corporate investors commonly invest as ‘Series A’ investors on preferential terms to the seed investors through preference shares, which carry different rights to the ordinary shares if a liquidity event occurs.

Although raising funds by issuing shares is a simple form of financing, legal advice needs to be taken to ensure that the company is able to issue shares without a prospectus in Australia (or without breaching foreign securities laws).

The documentation required for an equity raise for a proprietary company is relatively straightforward. A confidentiality agreement is essential before you share information with investors. Once they have decided to invest, a simple subscription agreement is required to set out the basic terms of the investment. Several simple legal formalities are also required, such as producing share certificates, updating the members register and notifying the Australian Securities & Investments Commission (ASIC) of the change in capital structure. The most important and complex document is the shareholders agreement.

Why do I need a shareholders agreement?

A shareholders agreement is essential to govern the relationship between the shareholders and the company itself. The following are key aspects of the shareholders agreement:

• Who will run the company? How many directors will there be? Who has the power to appoint directors? Typically, the founder has the majority shareholding and will chair the board, and investors of a certain size (e.g., those holding 20 percent of the shares) will also have the right to appoint a director. Often, a negotiated list of ‘reserved matters’ requires either unanimity at the board level or a supermajority (e.g., 75 percent of directors).

• Minority shareholder protections: To give some protection to minority shareholders without director appointment rights, some material matters will require shareholder approval (e.g., a listing on the Australian Securities Exchange or the sale of substantially all of the company’s assets).
  Another important protection for shareholders is anti-dilution rights, under which the company agrees not to issue shares unless it first offers the existing shareholders the opportunity to invest before going to new shareholders.
• Restrictions on transfer: Typically, transferring shares will be restricted unless the selling shareholder has first offered the shares for sale to the current shareholders. Shareholders are also restricted from using their shares as security. These mechanisms aim to balance keeping the shareholder base as a known quantity and giving some ability to shareholders to sell.
• Drag along/tag along rights: To allow for the sale of the company, a majority of shareholders (say, 75 percent) will often have the power to force the minority shareholders (the remaining 25 percent) to sell to the chosen buyer on the same terms (known as a ‘drag along’ right). This gives the majority the power to exit where the buyer is seeking 100 percent of the company.  The flip side to this right is that if a majority of shareholders (say, 60 percent) want to band together and sell to a buyer, the minority shareholders have the right to sell on the same terms so that they are not left behind with a new controlling shareholder (known as a ‘tag along’ right).

• The founder: Founders are often asked to agree to non-compete provisions or buyback arrangements if the founder leaves the business. These arrangements are to protect the investors where the founder is a ‘key person’ and are often sought by more sophisticated investors.

• The all-important exit: In addition to the drag along/tag along regime, a good shareholders agreement will have a mechanism that allows the shareholders to vote to pursue an exit — either via an initial public offering or a sale of the company or business. If approved, then all shareholders must work together and take all necessary steps to ensure that the exit event occurs, including legal mechanisms to drag along troublesome or unresponsive shareholders.

Can I issue my employees shares?

An employee share ownership plan is an effective tool to align the interests of the employees and the business. Some real tax advantages can be seen if the plan is correctly structured. However, pitfalls with these plans can occur whereby staff with shares leave on bad terms and can become a thorn in the side of the business.

Importantly, once the company has more than 50 shareholders, it is regulated by the complex takeover provisions in the Corporations Act, which can impede an exit event. Accordingly, advice and careful structuring need to take place to ensure that the share plan works from a tax perspective, dovetails with the shareholders agreement and does not hamper an exit event.

Author:  Stuart Dullard, Partner and Samantha Robson, Senior Associate.