In August 2015 we have shared our experience with young and ambitious companies in the article “7 legal tips for startups”. Now we offer you to look at legal transactions through the eyes of an equally ambitious investors the earliest stages, which are also known as business angels. Lets start with the legal checks and finish basic tax considerations. Usually performed several types of audits — at least commercial, financial and legal.
The amount of legal due diligence can be divided into two parts. The business model. A good example of a problematic business models — anything related to cryptocurrencies. More mundane examples include online pharmacies or online stores, alcoholic beverages.
As you know, the implementation of such goods remote way is prohibited. The project company. Legal due diligence of project companies at the stage angel investments is rather formal, because the company either just recently established and did not have time to accumulate historical risks or institution will generally only.
As a rule, use standard checklists. During the inspection can be identified two categories of risks. Serious (deal-breakers) and correctable. Serious risks can be a barrier to entry into the project — the rest can be relatively easy to fix or to pass on to the party that can best bear such risks.
For example, if a company has hidden problems with taxes, but the founder assures that the tax office never made any claims, you can provide that he shall compensate any loss to the company if it still happens (tax indemnity). The entire venture capital can be divided into share capital (equity) and debt financing (debt). The final choice depends on the preferences of particular business angel and founder.
However, it is understood that the classical model of angel investments is entering in the capital that provides a high profitability potential. It is possible to visualize the diagram where equity and debt are in different ends of the spectrum with opposite parameters of profitability and risk. Share promises a greater return, but risk losing everything — the yield on debt financing remains within the interest rates, but the losses can be limited.
This dilemma leads to a search approach that would combine the best of two options. The most common instrument convertible loan. First, the company provided a loan, which is in achieving certain positive indicators converted to shares (shares). Through a convertible loan the investor provides funding for the project at an early stage, but assumes the risk of the member or shareholder only when the project proves its worth.
Contrary to popular opinion, in Russian legislation there are no fundamental obstacles to structuring convertible loans — the main problem is the lack of positive enforcement practice. The ultimate goal of any investment is to obtain a certain yield, therefore, an important question out of the project. In venture transactions, unlike the dividend model, the yield is achieved, usually through sale of shares (stocks). A classic exit strategy.
Put option. Redemption is perhaps one of the most effective ways to get out of the project. In accordance with the terms of the put option by the founder or any other person upon the occurrence of agreed circumstances obliged to redeem the investors share at a certain price. This price is determined by the formula taking into account the desired yield.
For example, in the famous dispute of the JSC “RUSNANO” with one of its project companies, the investors share is subject to redemption by the formula, providing an annual yield of 25%, when it became clear that the project has not reached KPIs on sales. Redemption price = A1 * (1+0,25) B1 / 365 + A2 * (1+0,25) B2 / 365.
Where A1 is the sum of the first tranche A2 — the amount of the second tranche, the number of days from the date of the relevant tranche of the share capital. The founders, as a rule, are not interested in such a scenario and are ready to provide the investor with a put option only if it is in a strong negotiating position. Why a business angel should consider other exit strategies from the project. The sale of shares to a third party and IPO.
An initial public offering of shares. Startups in Russia are extremely rare on the IPO, so you have to rely on the sale of its stake to a third party. Sale of shares to a third party.
In this case, of fundamental importance are the provisions of the Charter and the shareholder agreement on the procedure of alienation of shares (shares) third parties. In the interest of a business angel to provide at least the following. At the heart of many modern business models is one or another result of intellectual activity (RIA). For the investor entering the capital, it is important to ensure that such result is assigned to the project company, not its founders or third parties.
Making REED on the project company, usually installed as a pre-condition for the involvement of investors in the project. The most common results of intellectual activity for new projects. Works.
The first three REID programs, databases and websites are subject to copyright or works. Right in their attitude originally arise from the author, i.e. the person who created the result of their creative work. In other words, if the founder or an external programmer wrote the app for iPhone — it will belong to all rights in respect of the application, including the exclusive (property). In practice, in respect of already created works executed contracts for the complete transfer of all exclusive rights in favor of the project company.
Also enter into employment contracts or commissioning contracts, which in the future all exclusive rights are automatically transferred to the company. Domain name. On the legal nature of a domain name, you can bet, but you need to ensure that his administrator was made by the project company. This is important because in 99% of cases, a domain is registered at an early stage in the name of the founder or his friend — if this person leaves the project, the domain can “get away” with it.
Trademarks. The value of a trademark is a derived value from its popularity and recognizability. Trademarks start-up companies with zero sales, as a rule, are not of great value. However, if the trademark is already known or planned significant investments in its promotion — the application for its registration must file as soon as possible.
To motivate people not come up with anything better than a personal financial interest. In the transactions of the early stages of the majority of shares (stocks) as a rule remains with the founders and business angel only gets a small percentage. This provides the motivation of the founder, but do not forget about the key employees.
There are two main mechanisms of motivation. Through bonuses and through the provision of shares (stock). The divide is where the employee becomes a participant business owner. In the case of award this does not occur, limiting the long-term potential of such a motivation. The award can be structured as the classical position about awarding, and through the more interesting mechanisms, such as phantom shares (shares).
Both options are tied to specific KPIs. The provision of shares (stocks) can also take one of several forms. From the point of view of the motivational effect of more attractive just attracting key personnel to the owners.
However, there are some risks. First, employees gain the right to vote — this may complicate the process of making some decisions that require unanimity. Secondly, there is the risk not to achieve the effect. If the employee decides to sell his share, he will encounter difficulties due to low market liquidity of shares (stock) of private companies.
Investment in the early stages vysokoriskovanny, so in the interest of the investor to negotiate and fix the provisions on the control and monitoring. Such provisions are usually included in the constituent documents of the project company and the corporate agreement between participants (shareholders). Decisions on key issues. In the Charter of the project company should provide, what questions can independently solve the founder — which, as a rule, is the General Director, — and which must be solved taking into account the views of the investor.
Leadership rule. Decisions on the most important issues should take into account the views of the investor (unanimously or by qualified majority). To these important questions may include, for example, the conclusion of large transactions and deals, with exclusive rights to intellectual property, appointment of key personnel, financial transactions (loans, sureties, guarantees and so on) and other issues. The specific list depends on the features of the project.
However it is important not to overdo it, because due to the nature of early stage investors a business angel is interested in saving for the founders of a significant share of independence. Regular reporting. The investment documentation should also ensure that the duty of the founders and project managers to regularly report to investors on the results of the work.
Reports can be provided monthly on a pre-prepared template that addresses the main indicators of the project. The number of visitors to the site, new clients, the stage of writing code and so on. The expenditure of funds. Every investor wants to understand how money is spent given to them.
If large transactions can explicitly include the right to vote for the investor, control over less essential expenses can be made via a special Bank account. Provided the funds can be credited to the special account in respect of which the investor has different rights. Right to receive statements, the right to approve certain expenses, and so on. Tax considerations are usually not of crucial importance, when the decision to invest in a promising project, but to forget them is not worth it.
The question of taxation of transactions is considered the early stages, usually with two positions. Taxation of the project company. The goal of the investor is to make sure that at the stage of entering the investor the company has no problematic spots in its history, and in the future it intends to use the most advantageous tax regime and to apply all available tax benefits.
Certain benefits are there in many industries of the Russian economy. It companies can save on the insurance premiums, the agricultural sector provides large-scale grants, residents of Free port of Vladivostok are exempt from income tax. Taxation of investments. The investor also should be aware of the tax treatment of its own investments.
The specific mode depends on a number of factors. Does the business angel directly or through a legal person, in what form is the return on investment (redemption price per share, dividends, interest on loans) and so on. If we adopt the standard scenario in which a business angel a natural person acquires a share in the project company (LLC) and sells it after 6 years, the mode of taxation will be as follows.
Until recently many Russian entrepreneurs preferred to structure the transaction through an offshore structure due to favorable taxation, foreign rights and anonymity. It is easy to see that the recent steps of the Russian legislators is aimed at reducing the significance of these advantages. The legislation on controlled foreign companies, the new rules on residency, the amendments to the Civil code of the Russian Federation and the exchange of tax information with other States. Features deals business angels are not limited to the above advice, but they will help novice investors navigate the legal aspects.
As we wish to highlight the importance of elaboration the legal side of the transaction, increasingly, we see that the success of investments predetermine sound commercial logic, expertise and trust relationships between the parties.