Investable Companies Series: Capitalization
When a high-growth company sets out to do its first venture capital financing (typically, either a Series Seed or Series A financing), they’re often unprepared for what’s expected of them.
This Article is part of a series where we aim to highlight areas you need to be prepared for in order to be investable and avoid due diligence surprises.
We are pulling each of these topics directly from the standards you’ll be expected to meet, as set out in the standard VC financing documents used in Canada.
CAPITALIZATION
Capitalization in this context primarily refers to the topic of Company ownership and rights to ownership.
Investors want to know how the Company has managed and structured ownership interests, to ensure that it has been consistent with industry norms, properly papered, and fully compliant with the related regulations and contractual obligations.
Here’s a list of specific areas within this topic that investors pay attention to:
1. Share Structure
Do you have a share structure that is customary for high-growth companies?
Share structures are not all created equal.
We very often see share structures that are not investable. Perhaps they are more appropriate for an owner-managed company, or perhaps they involved too much creativity, customization or complexity (characteristics that aren’t typically rewarded in this context).
An investable share structure is a simple one. Think Vanilla ice-cream, not Neapolitan.
Critical to work with a lawyer that understands these nuances to ensure you’re structured properly for this kind of a financing.
2. Ownership Split
Is your Cap Table free of any surprises?
Your Cap Table summarizes ownership interest in the Company.
Investors will have certain expectations of what that should look like before they first see it – based on what’s been pitched to them about the business. Will they be surprised by anything? If so, that could affect your ability to raise capital.
Examples of common issues include:
(a) A founder has too little ownership, when accounting for the conversion of all securities and the dilution caused by this financing.
(b) An ex co-founder has too much ownership that hasn’t been resolved.
(c) There are too many investors (side note: exercise caution when considering crowdfunding).
(d) There are too few shares issued in the Company (i.e. thousands instead of millions in total), giving less flexibility around dilutive events in the future.
3. Stock Option Plan
Do you have a stock option plan and has it been administered properly?
You’ll need a stock option plan. VC financings almost always assume that this is already in place. There will also be an expectation that it will be topped up (with 10% post-money being the typical benchmark).
You’ll also need to demonstrate that the stock option plan has been properly administered throughout its life. That includes having stock option agreements in place with each person that has been granted or promised options, having correct exercise forms for exercised options, and having an accurate and up-to-date tracking system for your option pool that reflects grants, exercises and expirations.
This is a common area of clean-up during financings that can be avoided with simple good practices early.
4. Securities & Purchase Agreements
Have you properly papered, approved and complied with all the securities issued by the Company?
Are there any unusual provisions that might put off an investor?
Every time you promise, sell or issue a security (shares, SAFEs, convertible notes, warrants, options, tokens, etc.) you need to have proper paperwork in place.
You also need that properly approved by resolution of the Company’s board of directors (and potentially multiple layers of approval).
And finally, the terms of each security, and the regulations applicable to that security, put obligations on the Company that need to have been complied with.
All of this needs to be demonstrated and will create issues if not discovered until the due diligence stage.
If you have properly papered every investment, the focus will then be on whether there’s anything unusual in that paperwork that could spook an investor. Investors are cautious of acceleration clauses, redemption obligations and repricing rights, for example. Surprises like this might be found in advisor agreements, accelerator agreements, shares-for-services agreements, and investor side letters, particularly if an experienced lawyer wasn’t involved in their drafting or review.
5. Subsidiaries
Do you have any subsidiaries, joint ventures or partnerships?
If your corporate structure involves more than one company or legal relationship with another company that is core to its governance and ownership interests, then these will be closely reviewed.
There could be good reason for having these set up (like a US subsidiary for employing US personnel), but the review will focus on whether these other companies have been properly set up, follow business norms, and are ultimately under your Company’s control.
6. Prospectus Exemptions
Have you complied with all applicable securities laws and can you demonstrate that compliance?
Securities can’t be sold in Canada without a prospectus (i.e. going public), unless you’re in strict compliance with a select few exemptions to that rule. It’s these exemptions that investors want to ensure you’ve been in compliance with throughout your history.
They’ll also want to know whether you’re a “private issuer”, which is a type of business that is able to distribute securities simply and without much regulatory oversight. The answer to that question depends on your history of compliance with the private issuer exemption’s criteria. So you’ll want to ensure that’s known before you kick off your financing journey to avoid surprises.
Investability Report
Ink LLP provides new clients with an Investability Report.
To prepare this, we review their corporate records to ensure that everything has been set up as expected from both a legal and investable perspective.
The Investability Report summarizes those findings, identifies any gaps that could affect the company’s ability to raise capital, and is paired with recommendations for how to resolve any identified issues.
Contact us if you’re interested in ensuring that your company has been well set up for your next financing.
Ink LLP provides legal counsel to high-growth companies and those that build them.
Contact one of our lawyers to discuss your business and how our team might be able to help you tackle the challenges of your business and the opportunities for growth.
This information is provided for informational purposes only and is not legal advice.