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Housecleaning tips to attract investors

Many businesses, especially in the technology sector, are started with the idea of selling them one day. Even if that isn’t on the cards, it’s a rare company that won’t one day want outside investment to grow the business, whether they are seeking venture capital from an international fund or a new partner to take up a shareholding.
In either case, the task as a business owner will be immeasurably easier if they lay some basic legal groundwork early on.
The essential principle to keep in mind is this: complication and clutter can alarm investors. The less complex the capital structure and financial statements, the more reassured they can be that they know exactly what they’re getting themselves into.
So here’s a checklist of things to put in place before the company ever needs to open their doors, and books, to a potential investor:
Keep things tidy – startups and young companies typically have multiple loans and elaborate contracts designed to help fund growth in the early days, for example, loans which are convertible into shares or even by granting an option to a landlord in return for lower rent. Take action now to consolidate the balance sheet, especially loan funding, as much as possible.
* Maintain a clean shareholding structure – where there are lots of “rats and mice” minority shareholders, there is potential for uncertainty and confusion for investors. Beware of giving real shares to employees (as opposed to phantom shares or other instruments that track the value of the company). However, fundamentally valuable members of the management team must have an equity incentive of some sort.
* Allocate shares to founders and anchor investors early on – the later it is left, the more value they have, and the greater the tax hit will be (gifted shares can be taxed as income, so tax may be payable now, on a share that can’t be sold for years).
* Give up any thoughts of recouping all that sweat loan account in cold hard cash – this is to do with salaries sacrificed or other money foregone. It’s very unlikely the company will find an investor prepared to treat sweat loans by a founder as a true cash loan.
If the founder dipped into their own pocket for cash to fund operations there’s a better chance, but in reality almost all the founders’ sweat loan funding may be written off when a new investor comes in. Rather pay founders decently from the start – then loan that cash back to the business, and keep a written record of the loan arrangement.
* Take a good hard look at the board – do the directors add real value to the business or are they largely family members, angel investors and other founders with experience as limited as the founder? Look for board members who can provide useful advice and guidance, and whose CVs will make the company look credible to potential investors – remember, they are buying into the executive team.
* This is especially relevant for software and other IT companies – check who actually owns the fundamental means of production. If a company has built a product, be extremely careful that they own the “building blocks” and/or have a valid license to use those components.
In the case of open source software, is the business within the licence terms? Also make sure that employees have properly assigned the intellectual property rights to anything they develop in the course of their employment.
* Pay attention to all the standard due diligence issues – make sure all existing contracts (employment, supply, lease and so on) are in place and up to date, are not overly skewed against the business and that incorporation documents are up to date.
While much of this looks like basic common sense to lawyers, in reality many entrepreneurs just don’t get around to these details – they’re too busy doing the work. It’s time to seriously consider interviewing some lawyers to find out what they can do for the company. If nothing else, it could save businesses a fortune in a few years’ time.