Written by Lee Bagshaw, partner at Simmonds Stewart
Whilst presenting at Creative HQ recently the teams appeared to be both surprised and delighted that my slide deck didn’t have a lot of law in it. Lawyers aren’t often credited with providing strategic advice. Rather, we are generally seen as a necessary evil, soon to be replaced by robots.
Here at Simmonds Stewart, alongside the paperwork, we help steer startups through their life cycle like any other mentor. My conclusion from 15 years of advising tech businesses in the UK, Asia and NZ is that startups are bloody hard. And disrupting the financial services sector is maybe the toughest of all. Aside from determining your product market fit, hiring the right talent, building a brand and finding customers – you also have the regulatory environment to consider.
In case the robots do come along soon, here’s my two cents’ worth:
1: What are you really building?
What’s the problem you’re solving (presumably by technology) and where are your customers that will pay for this solution? This sounds obvious but it really is key, particularly here in NZ – a small market. If you intend to take your product or service global – where and when are you going and what’s the strategy? This may impact on how you build your team, pick advisors, hire and incentivise staff and even approach investors.
In the case of a fintech business, consider what are the regulatory barriers to entry based on your proposed business model. What can you do without becoming a regulated entity, or alternatively what licenses or exemptions are necessary? Can you even test the market to validate the product? Regulatory approvals, once secured can, of course, provide a real competitive advantage, increasing the company’s valuation. How much time and cost you spend on the regulatory piece is a key issue to think about early on that may determine the shape of the business.
2: Get the basics rights
Easy to overlook but good record keeping and admin will save you time and money in the long run. Sloppy record-keeping quite simply will put off investors. Looking after your cap table is a good place to start. Avoid informally promising shares, or having undocumented incentive arrangements. Investors expect 100% clarity on the cap table, and any discrepancies in shareholdings will need to be tidied up before closing any investment.
The most valuable asset of most tech startups is, of course, its intellectual property (IP). IP assignment deeds, transferring all relevant intellectual property from the founders to the company are key. As are contractor/employment agreements for founders which document IP ownership, confidentiality and non-competition/restraint of trade.
Most disruptive financial products and services have some regulatory implications even if it is just know-your-client (KYC) compliance requirements. No seed investor will expect you to have already secured regulatory approval or exemptions to enable you to sell to customers. But they might expect some degree of research, i.e. you have started to map out your regulatory journey.
3: Good governance
Take governance seriously. We generally recommend that startups adopt a constitution to streamline the company’s administration. It also deals with scenarios where an offer is made for the company, or where a shareholder wants to sell his or her shares. If you are planning to raise capital in the near future, maybe hold off entering into a shareholders’ agreement as it will be replaced.
What we do recommend however are founder vesting agreements to protect you if a founder moves on. Under typical NZ vesting arrangements, a founder who leaves the company within a set period (often 3 years) forfeits a portion of their shares back to the company. This type of vesting arrangement is now very common in New Zealand.
Once you have obtained any licenses and exemptions from the relevant regulator, you may be subject to ongoing compliance or audit. That adds an additional layer of governance for fintech companies in terms of reporting so ensure you have systems in place.
4: Incentivising the team
If you talk to founders who have successfully exited startups companies (particularly in the US), they emphasise the impact of employee incentive arrangements. Such arrangements can come in the form of sweat equity and employee share schemes. Both of these require some consideration from a tax and Financial Markets Conduct Act 2013 (FMCA) perspective.
From the NZ tax side, the best time to allocate equity to team members is on the incorporation of your company. If necessary, vesting agreements can be used to claw back shares from a team member who moves on from the business.
Employee share schemes (ESS) are now very common in NZ startups. Take advice on the scheme documentation as the terms can vary a lot. For example, one of the key considerations is what happens when your company is sold. Options are intended to reward employees on a sale so your ESS documentation may provide that all unvested options immediately vest. However, potential buyers (particularly from overseas) sometimes prefer to see other mechanisms than 100% accelerated vesting.
Our experience is that fintech startups have higher capital requirements than other software or online businesses due to regulation. You will, therefore, need to raise seed money and have a clear route to follow-on capital. Those considerations will play into the usual discussions on valuation, amount and structure (eg. equity vs convertible note). Plus, who you even approach for seed investment.
As ever when raising money, remember some key principles:
- take independent advice on the terms – the investors’ lawyers are not independent!
- remember we are in NZ, and not Silicon Valley and so your valuation should reflect that
- don’t sign documents unless you understand them
- simplicity and speed are key for startups – 3 months to close a small seed round is about 2 months too long!
- giving up too much equity early on to seed investors may put off VC firms from investing in the future
- think about the next funding round when you are negotiating the terms of the current one
Lee is a partner at Simmonds Stewart, a corporate and commercial law firm helping technology companies do business and raise venture capital globally. For more information, check out Simmonds Stewart’s guide on legal basics for startups