Redress Risk Management (post until May 31/19)

Mills & Mills LLP: Daniel Thomson

The cart before the horse – so you want to raise capital, do you?

 

“Let’s go raise some money so we can grow the business!”

This, or some similar phrase, often uncovers a series of unknown and unintended challenges or obstacles lurking beyond the consciousness of entrepreneurs who have worked very hard in and on building their business and not looking behind it or at its legal foundation.

A story that has often come across my desk goes something like this: “My friends and I started a company and have developed a great mobile app. We need to raise money now to further develop the app and to build scalability”. That sounds innocuous enough, right? The problem though often lies in the background. What company? Who are “your friends”? Who built/did what?

All too often, the answers are some version of “we haven’t formally incorporated a company yet but we started the company two years ago” and “buddies of mine from the university” and “Mike took care of sales and marketing. I was in charge of operations and Sarah built the app”.

This all sounds great and you might even be scratching your head reading this wondering to yourself, “So, what’s wrong with that?” You would be in very good company.

The lurking unintended “problem” is that there is no company and therefore Sarah owns the only real valuable asset (the app). Therefore, the investors you wanted to target will refuse to invest any money unless and until a company exists that can issue them shares, the company owns the intellectual property (the app) that offers value and potential return on investment for the investors and that each of you has a formal employment contract with clarity around contextually reasonable salary and bonus limits (so the investors will believe you are in it for the long haul and not simply get a large salary and bonus with their investment dollars).

The point is, in these circumstances, it is too soon to approach investors. Any value proposition you promise them in your discussions will quickly fall apart as their legal and accounting teams begin their due diligence and whatever pricing you were able to negotiate initially will be negatively affected by making it appear as though you don’t know what you’re doing – whether or not that’s a fair conclusion to draw.

Investors invest in ideas, sure, but the larger gamble they take is on the people in charge and whether or not they believe those people will do the right things the right way in order to generate growth and value in the short term and in the long term, beginning with their investment dollars. If you give them any reason to doubt your ability to manage and operate the business and the company’s affairs, they’ll take their money elsewhere or offer you less money or on far more restrictive and dilutive terms.

Understand, further, that this gets more complicated as more value accrues to the app itself. If Sarah has any reason to believe she is the one who has contributed the most to what the investors are interested in, then Sarah may expect to own more of the pre-investor money company. She will likely assert her position as “I own the app. The company doesn’t own the app. So, if you want me to transfer it to the company, then I need to own 50% of the company’s shares and the two of you can split the remaining 50% between you” (or some other version of “we’re not equal – I’m more valuable so I get a larger piece of the pie!”).

She may not do this, I know. But she might and is that really a risk worth taking simply to avoid setting things up the right way? I doubt it.

If you have questions about raising capital, investor relations, or to benefit from the superior business law knowledge that Mills & Mills LLP offers, contact us at 416­-863-0125 or send us an email.

 

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