Start-ups offer unique investment opportunities
Start-ups offer exciting opportunities for investors. If you want a direct role in a business’s growth, start-up companies are an appealing choice. By investing early, you can also benefit from the potential for higher returns as the company’s value grows.
This guide outlines the key steps for investing in a start-up. It explains the basics of the process, including due diligence and the legal documents you’ll need.
In the UK, investing in growth companies can be tax-efficient through schemes like the Seed Enterprise Investment Scheme (SEIS) or the Enterprise Investment Scheme (EIS). These schemes were created to encourage private investment in early-stage businesses. They offer attractive tax benefits, making them popular for those who want to support new ventures while reducing their tax liability.
What questions to ask before investing
1. Investment amount and risk appetite
The first step is deciding how much capital you are willing to commit. This depends on the company’s funding needs, your expected returns, your risk tolerance, and the role you want to play as an investor. Smaller investments may limit your say in company decisions, while larger stakes can give you more control over its strategic direction.
It’s also essential to consider your risk appetite and how easily you may need to access your funds. Start-up investments are high-risk, and it is often impossible to sell your shares unless the company is sold, raises more funds in a way that lets shareholders exit, or launches an initial public offering (IPO).
2. Agreeing the company pre-money valuation
Before investing, you must agree on the company’s pre-money (pre-valuation) with the founders.
What does a company’s pre-money valuation mean?
A company’s pre-money (pre-investment) valuation is its value before adding new capital. This valuation determines how much of the company your investment will buy.
Setting a start-up’s pre-money valuation can feel like an art and a science, especially when the business has little financial or trading history. Factors that influence the valuation include:
- The uniqueness of the company’s product or service.
- The size of the market opportunity.
- The strength of the management team’s skills and experience.
You will also want to consider the company’s projected revenue, profit, and potential sale value.
A fair pre-money valuation should balance the interests of founders and investors. It needs to give the start-up enough resources to grow while offering you enough ownership and potential returns to justify the risk.
With the investment amount and pre-money valuation agreed, what comes next?
3. Percentage equity represented by the new investment
Once the pre-money valuation and investment amount are agreed, you can calculate the percentage of equity (ownership) you will receive. The formula is simple:
New investor percentage = Investment amount ÷ (Pre-money valuation + Investment amount)
4. Determining the number of new shares
After calculating the investment amount and pre-money valuation, you can determine how many shares will be issued for the new investment. This calculation is based on the company’s pre-investment fully diluted share capital.
5. Calculating the company’s pre-investment fully diluted share capital
The pre-investment fully diluted share capital includes all existing shares, plus any options, warrants, or agreements that could result in new shares being issued. For example, the company may have granted share options to employees or third parties in exchange for services. These options must be included when calculating the company’s total share capital before the new shares are issued to you.
You can use the new investor percentage to calculate:
- The percentage of the post-investment share capital that will consist of the pre-investment fully diluted share capital.
- The total post-investment fully diluted share capital, including the new shares.
- The number of shares to issue to the new investor.
- The price per share for the new investment.
Additional investment terms you need to know about as an investor in a start-up
As an investor, you may need additional terms to protect your financial interests and influence key decisions. These rights often come with a new class of preferred shares and typically include:
6. Liquidation preference
A liquidation preference protects your investment during certain exit events, such as a company sale or winding-up. It ensures you recover your initial investment—or potentially a multiple of it—before other shareholders receive any returns.
This gives you an added layer of security. If the company exits at a low valuation or goes into liquidation, you are more likely to recover some or all of the capital you’ve invested.
7. Anti-dilution
An anti-dilution right safeguards your investment if the company later issues shares at a lower price than you paid (a “down round”). In this situation, your ownership percentage is protected. This is achieved either by issuing you new shares or by adjusting the formula used to convert your preferred shares into ordinary shares.
8. Preference dividend
A preference dividend ensures you, as a preferred shareholder, are paid before other shareholders when dividends are distributed. Your dividend may be set at a fixed percentage or a specific amount.
This priority gives you extra security on your investment. If dividends are declared, you are guaranteed to receive your return ahead of other shareholders.
9. Pre-emption rights
Pre-emption rights give you, as an investor, the first chance to buy new shares when a company issues additional equity. This allows you to maintain your proportional ownership and avoid dilution.
If the company raises capital by selling new shares, you can choose to buy a portion of them—usually based on your current stake—before they are offered to new investors.
10. Consent matters
Also known as “reserved matters”, these are areas of decision-making where your consent is required before the company can act. These often include significant expenditures, changes to share capital or shifts in the company’s business model or direction.
By retaining these consent rights, you protect your investment and ensure the company avoids decisions you view as harmful or too risky.
11. Director appointment rights
As an investor, you may have the right to appoint one or more directors to the company’s board. This gives you a direct way to influence decisions and ensure the company’s operations align with your strategic goals.
NOTE: If you invest under the EIS or SEIS schemes, your investment will usually involve ordinary shares with no preferred rights. Otherwise, you could lose the valuable tax benefits these schemes offer.
The due diligence process
What is investment due diligence?
As an investor, you will need to carry out due diligence on the target company. This includes reviewing commercial, financial, and legal aspects of the business. The scope of due diligence depends on the nature and history of the company. For start-ups, due diligence is often simpler than for established businesses with a trading history.
Key areas for legal due diligence include the company’s share capital, contracts with customers, suppliers, and employees, compliance with legal requirements, any ongoing disputes, and ownership of assets and intellectual property.
During this process, you (or your advisers) will present the company with questions and request supporting documents. You may also need to ask follow-up questions to clarify their responses.
You should look for warranties in the investment agreement that confirm the accuracy and completeness of the company’s answers and documents. These warranties help protect your position and minimise the risk of issues like misrepresentation or breaches of warranty.
The information and materials provided will also form the basis for the disclosure letter, which the company or other warrantors will submit alongside the investment agreement.
What are the key documents for investment in a private limited company?
The key documents in any investment transaction are the Subscription Agreement, the Shareholders Agreement, and the company’s new Articles of Association.
1. Subscription agreement
The Subscription Agreement is the key legal document where you agree to subscribe for shares in the company. Its main terms usually include:
- Subscription: The number of shares you will acquire and the terms and process for subscribing for them.
- Conditions: Any requirements that must be met before the investment can proceed.
- Completion: The finalisation of the investment, including issuing shares to you and your payment for them (also called “closing”).
- Representations and Warranties: Promises made by the company—and possibly the founders—about the company’s business, financial performance, prospects, assets, contracts, and liabilities.
- Limitations on Liability: Restrictions on the liability of those providing warranties, protecting them from excessive claims.
2. Shareholders Agreement
The Shareholders Agreement will define your relationship with the existing shareholders after the investment is completed. While it addresses many of the same issues as a standard agreement between business partners or joint venture partners, it is specifically tailored to protect your rights as an investor.
If you are a minority shareholder, the Shareholders Agreement will typically include terms designed to safeguard your position.
- The business and purpose of the company.
- Confirmation of shareholders and shareholdings, including any granted share options or share option pool.
- How the company will secure further funding if required.
- Your right, as an investor, to appoint a director or board observer.
- How board proceedings will be conducted.
- Shareholder rights to dividends.
- The process for issuing new shares, including your pre-emption rights as an investor.
- The process for transferring shares, including your pre-emption rights.
- Actions that require your prior approval as an investor (“reserved matters”).
- Your right to receive regular updates about the company and its financial performance.
- Restrictive covenants placed on founders or executive shareholders.
3. Articles of Association
As part of an investment transaction, the company will usually need to adopt new Articles of Association or amend its existing ones. These changes typically address the following:
- Preferred Share Rights: If you, as an investor, receive preferred shares with rights superior to ordinary shares, these rights will be outlined here.
- Directors: Your right, and the rights of other shareholders, to appoint directors to the board.
- Board Proceedings: Rules for how board meetings are conducted, including voting rights and quorum requirements.
- Shareholder Meetings: Guidelines for shareholder meetings, including voting rights and quorum requirements.
- Issue of Shares: Your pre-emption rights as an existing shareholder to purchase new shares before they are offered to others.
- Transfer of Shares: Rules for transferring shares, such as:
- Permitted Transfers: When shares can be transferred, such as to family members or within the same corporate group.
- Pre-emption Rights: Your right to purchase shares before they are transferred to an external party.
- Compulsory Transfers: Circumstances when shares may be forcibly transferred, such as when a founder or employee shareholder leaves the company, whether as a good or bad leaver.
- Tag-Along Rights: As a minority shareholder, these rights allow you to sell your shares on the same terms and at the same price as majority shareholders when they sell theirs, ensuring you aren’t left behind in a change of ownership.
- Drag-Along Rights: These rights let majority shareholders require minority shareholders to sell their shares as part of a sale of the company, ensuring the buyer can acquire 100% ownership and preventing small shareholders from blocking the deal.
Conclusion
Investing in a start-up can be both rewarding and challenging. It offers the potential for significant returns and the chance to support an innovative venture. However, it is also high-risk, with returns typically dependent on a future sale or IPO.
To protect your interests, it’s essential to conduct thorough due diligence and customise key legal documents, including the Subscription Agreement, Shareholders Agreement, and Articles of Association. Well-drafted preferred rights and governance controls can help align incentives and reduce the risks of an early-stage investment.
A carefully negotiated investment gives the start-up the tools, guidance, and motivation to grow while giving you, as an investor, the opportunity to achieve meaningful returns.
