Key Legal Documents Your Startup Needs

Under specific circumstances a startup may provide investors with a term sheet — in most cases, a term sheet is provided to early-stage investors, to friends and family, or in a seed round. Should an investor decide to invest in a startup, they will typically provide a term sheet.

When reviewing a term sheet, it’s important to develop an understanding of the following key terms:

Investment & Valuation
This term to the amount that an investor is willing to invest in a startup — specifically the maximum and minimum investment. Investment and valuation can also define whether a startup is able to raise more money from additional investors. Other key factors covered in this term can include the pre-money valuation for the round.

Vesting
This term refers to whether the shares held by founders will vest. In most cases, founders’ shares are vested for a four-year period with a one-year cliff in Series A round. This means that none of the shares held by a founder will have vested if they leave the startup within the first year.

25 percent of the founder’s shares will vest after the one-year anniversary of the startup, with the remaining 75 percent set to vest over the subsequent three years. This typically occurs on a monthly schedule.

A founder may want to negotiate a leaver provision within the vesting terms of an agreement. A founder that leaves a company within 12 months but leaves the company due to events outside of their control, such as health reasons or other unforeseeable circumstances, may be able to ensure 25 percent of their shares automatically vest. It’s also important to attempt to ensure that accelerated vesting occurs on an exit event, which protects the founder’s shares during the event.

Board and Control
This term determines whether investors will take a board seat and define what kind of and how much control investors will have over the decision-making process.

ESOPS and Valuations
Valuations are often conflated with ESOPS by founders. A VC that states they will invest $5 million pre-money, for example, is referring to a $5 million investment inclusive of any ESOP a startup sets astute for future employees.

A startup that decides to set aside 20 percent of their stock for future issuance via an ESOP will therefore receive a pre-money valuation of $4 million, not the total $4 million. Startups that are aware of the relationship between ESOPs and valuations are able to overlook this key term. A startup seeking a $5 million valuation without including the ESOP, however, will need to negotiate a higher pre-money valuation in order to achieve their startup capital raise goal.

Anti-Dilution
This term should dictate whether any anti-dilution rights are provided to investors, if any. As a general rule, it’s best to avoid offering anti-dilution rights to investors. This ensures that all shareholders are diluted on a pro-rata basis should a company issue additional shares.

In most cases, early-stage VC investors will require broad-based weighted average anti-dilution rights. This refers to a scenario in which a startup issues shares at a lower price than the VC pays in the future — the VC, in this case, will receive additional shares that reflect an adjusted share price of all the preference shares they possess.

The adjusted share price in this scenario is calculated based on the average of the price they paid and any lower price paid by later investors. Startups bringing on investors that demand anti-dilution rights should consider engaging the services of a professional startup advisor or lawyers that can provide them with a nuanced understanding of how anti-dilution rights operate and the various different types of anti-dilution rights available.

Dividends
A startup that issues preference shares is unlikely to offer any preferential dividend rights to investors. A startup that does want to issue preferential dividend rights, however, should aim to offer non-cumulative rights as opposed to cumulative preferential dividend rights.
In this context, non-cumulative preferential dividend rights mean that, in the scenario that a company does not pay any dividends in a particular year, the investor loses the right to receive a dividend. Cumulative dividend rights, however, mean that in the scenario that a company does not issue dividends in a particular year, the investor carries over the right to receive a dividend. A company operating under the latter agreement with regards to dividends must pay the investor all dividends before paying any ordinary shareholders.

Legal Documents
A term sheet typically defines all of the legal documents that will be used to establish a deal. In Australia, the general trend is weighted heavily toward AVCAL documents for seed and series A sounds.

AVCAL Documents
The Australian Private Equity and Venture Capital Association Limited, or AVCAL, is an Australian association of sophisticated investors that primarily consists of private equity and venture capital investors. AVCAL has issued a suite of documents entitled “Open Source Seed Financing Documents,” which are available for public use by Australian startups and investors.

A shareholder’s agreement is the most important document for any startup, and should explicitly define the relationship between directors and shareholders. A shareholder’s agreement will define factors that include:

● The issuance of new shares
● The sale of existing shares
● Any duties assigned to directors
● How board or shareholder meetings will be conducted
● Dispute resolution processes

Some startups choose to draft an entire shareholder’s agreement before seeking external investors, or delay drafting a shareholder’s agreement until rasing a round — the time a startup drafts this document may change based on the term sheet.

Subscription agreements define and formalize the terms of an investment by a specific investor. This agreement is based on the final term sheet in most cases and will specify factors that include:

● The total number of shares a startup will issue
● The subscription price for each share
● The time at which the startup will issue shares
● Any company or, if relevant, founder warranties

Company warranties are statements that allow investors to ensure that all actions performed in establishing the agreement are above board.

The intellectual property, or IP, of a startup is critical to its value. Startup founders often own the IP of their startup personally in early stages. It’s important, however, to ensure that any intellectual property is assigned to the same company an investor is investing in.

To achieve this, an IP assignment agreement is necessary, which transfers the ownership of the intellectual property to the company. Some startups may also require an IP assignment agreement if they use external developers without a developer agreement, or if they incorporate a holding company that will hold the assets of the operating company.

In some cases, startups may raise around without first establishing employment contracts for founders, but this scenario is rare. As a general rule investors will want to ensure that a startup has formally employed its founders.

The capitalisation table or cap table of a startup is a spreadsheet that explicitly defines who owns shares in a startup and how much. While the formulas used to determine shareholdings in a cap table are relatively straightforward, incorrect cap table calculations are common within the startup ecosystem.

Accurate cap table management relies on precision in recording all transactions that affect the valuation of a company. These transactions can include sales transfers, option issuances, conversions of debt to equity, or any exercises of options.

Taking control of and accurately managing equity is a critical element of legal preparation for any startup. It’s important to analyze and compare new financing rounds in order to gain insight and make the best decisions regarding capital raises.

If using cap table spreadsheets or other pre-drafted solutions to generate a cap table, it’s best to work with templates that allow founders to view and manage startup shareholding and options, minimise the amount of time spent on time-consuming calculations, track all types of equity events, and calculate both pre-money and post-money valuations.

Ensuring that your startup has the correct legal documents organized before they become necessary can have a significant impact on the future health of your business. Understanding the key legal documents your startup needs will help you create a strong legal foundation that will grow alongside your startup.