24 March 2015 Swimming with Sharks: how to avoid getting bitten when it comes to funding start-up businesses

By Andrew Draper, Senior Associate

In Brief

As business confidence continues to grow, recent research has shown that the number of start-ups in Australia is also on the rise, increasing by as much as 23% during the second quarter of 2014.  The forces of popular culture are also helping focus the interests of both entrepreneurs and investors on start-up businesses.  Shows like the popular Network Ten series Shark Tank put a series of hopefuls in front of a panel of potential investors and give them the chance to pitch their product or businesses ideas, with the hope of securing funding to get them started on the road to success.  But even if your deal does not have the added pressure of being on national television, what form should your business funding take and how do you make sure you are sufficiently protected? 

Debt Funding

Everyone is familiar with the concept of borrowing money to establish a business, expand the scale or product lines or to provide working capital for a business, and then repaying that money at a given rate of interest. 

Of course, it goes without saying that whether you are the borrower or the lender, any debt funding arrangement should be formalised in a written agreement.

At a minimum, the loan agreement should detail the following:

  • the total amount of the funding;
  • whether the funding is to be by way of a lump-sum or if it will be drawn down in instalments at certain times or on the occurrence of certain events;
  • whether the funding may only be used for a specific purpose, such as product development or manufacturing, capital expenditure or securing intellectual property rights;
  • the applicable rate of interest, including whether this rate may increase or decrease as a result of any event or circumstance;
  • how and when the loan will be repaid – including whether repayment is to be made on a temporal (e.g. monthly, quarterly, yearly or at the end of the loan term) or milestone basis (e.g. following receipt of the first major product order or execution of a distribution agreement);
  • whether interest must be repaid or will be capitalised onto the loan amount;
  • whether the loan will be secured, or if any guarantee will be put in place, including the details of any collateral to be offered and provision for registration of security interests on the Personal Property Securities Register; and
  • what happens if the borrower defaults on a repayment, or looks likely to do so.

A tailored loan agreement cements the business relationship between the parties and ensures that both parties are appropriately protected from the necessary risks that accompany borrowing and lending.

Equity Funding

The equity funding model, as shown on Shark Tank and similar shows, involves the entrepreneur offering an ownership interest in their business or idea in exchange for the required funds. 

This model is not necessarily as straightforward as the debt funding model.  Here, the entrepreneur is giving up part of their ownership of the business (and reducing their share of any future returns).  Entrepreneurs can often be wary of the loss of control and influence that comes with giving up equity.

At the same time, this model does have significant advantages over the debt funding model.  As well as obtaining the required funding, the entrepreneur also gains the benefit of the investor's experience and business nous.  This experience can be invaluable in making the business a success.

This equity funding model necessarily involves a negotiation to determine the value of the business: how much cash does the entrepreneur want and what percentage of the business will the investor get in return?  The parties may have quite different opinions on what is the correct valuation.

Whatever valuation the entrepreneur and investor finally arrive at, as with debt funding above, the arrangement should be formally documented in a written agreement to establish the relationship between the entrepreneur and the investor and manage their respective expectations in relation to the business.

Ultimately, it is a choice for the parties as to the exact nature of their relationship.  It may be a traditional "silent partner" relationship, where the investor simply provides the money and leaves the running of the start-up to the entrepreneur.  Alternatively, the investor may take a more expanded role, including direct input in the management, decision making and operation of the business, to bring the benefit of their experience to the business and hopefully increase the chances of success.

A suitable investor agreement should include sufficient detail on areas such as:

  • how much the investor is investing and the percentage interest in the business that the investor will receive, including the number and type of shares to be issued in any corporate vehicle;
  • if there is a corporate vehicle, whether the investor will have the right to appoint one or more directors of the corporation;
  • information and reporting obligations of the entrepreneur – for example the frequency of scheduled meetings between the parties;
  • critical business matters for which the investor will have input – for example changes to the business plan, capital expenditure above a certain level and the decision whether to pursue future funding and the source(s) of that future funding;
  • ownership of and rights to use any intellectual property;
  • whether the investor should be able to sell or assign their interest in the business to a third party, or if they should have to offer to sell the interest back to entrepreneur first;
  • whether the majority owner of the business should be able to force the minority owner to sell its interest, and whether the minority owner should be entitled to tag-along if the majority owner decides to sell its interest;
  • the consequences if either party breaches the investor agreement; and
  • exit strategies – whether there should be an obligation to consider a business sale, share sale or initial public offering after a specified period of time or following the achievement of specified milestones.

An appropriately drafted investor agreement provides peace of mind to both entrepreneur and investor in relation to the equity investment.

Hybrid Funding

While the debt and equity funding models are well known and understood, many people are not familiar with the concept of hybrid funding.

Available to those entrepreneurs with a corporate vehicle, hybrid funding involves the provision of funding by the investor in exchange for "convertible notes" issued by the corporate vehicle.  Funds are provided to the company by way of a loan and may accrue interest, however on the occurrence of certain events or at the election of either the entrepreneur or the investor, rather than the funding being repaid, the notes may be converted into shares in the Company at a predetermined rate.

The major advantage of the hybrid funding model for entrepreneurs is that it does not involve the immediate reduction of equity.  If the business is successful and shows a return, the funds can be repaid (with any accrued interest) and the entrepreneur retains total control.

For the investor, there hybrid funding model has the advantage of providing security for the investment and initially lower risk, whilst also retaining the opportunity to convert the investment into equity if the business proves to be successful.

The hybrid funding should be formalised in a written agreement which sets out:

  • the funding provided and the number of notes issued;
  • whether the funding will be secured;
  • the rights and obligations of the noteholder;
  • the conditions of issue;
  • the interest rate, and payment terms;
  • repayment of funds and "redemption" of notes; and
  • the rules for converting the notes into shares.

When considering funding a start-up, it pays to get good advice on the available funding models to determine which is the best fit and will be of most benefit to you in making the start-up a success.

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This article is not legal advice and the views and comments are of a general nature only. This article is not to be relied upon in substitution for detailed legal advice.

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