Pakistan is among the youngest countries in the world with a median age of around 23 years and approximately 64% of its over 220 million population aged below 30. With a large pool of English-speaking professionals with expertise in current and emerging technologies, Pakistan is set to become “the next powerhouse of information and communication technology (ICT) sector” as recently noted by Japan International Cooperation Agency.
Pakistan’s ICT sector is going through a rapid evolution. A blooming startup ecosystem has emerged in the country due to favorable government policies, an enabling regulatory environment, participation of private sector through local and foreign venture capital firms, and establishment of many reputable incubators and accelerators in the country.
As conventional banks continue to show reluctance in lending to startups, venture capital firms remain the main sources of fundraising for the founders of tech startups.
The success of startups like careem, daraz, zameen, pakwheels, and rozee.pk has not only brought foreign investment in the country but has also attracted attention of local investors who are now taking keen interest in the tech startup ecosystem.
Founders are dynamic people, motivated by their vision of unique idea, and the drive to make that idea a successfully reality. However, given the fact that establishing a successful company is very different from working in a company, many new founders are unfamiliar with the legal issues involved in setting up a company and early-stage venture capital fundraising.
Venture capital firms offer support to founders in structuring investments, and related steps including company formation. Founders readily accept such support without realizing that the interest of venture capital firms is quite different from their interest. A venture capital firm’s main interest in investing a company is to maximize profits for its shareholders. Its goal is to make the company a commercial success and exit from it with the maximum return on its investment. There is always a conflict of interest between venture capital firms and founders.
It is very unsafe for founders to solely rely on the advice they get from venture capital firms. A founder should develop a good understanding of applicable laws and implications of the terms on which venture capital firm is offering to make investment in his startup company. Yet the best recourse is to engage a lawyer while negotiating with a venture capital firm.
The purpose of this guide is to help young tech founders develop a general understanding of the concept and process of early-stage venture capital fundraising, and to forewarn them about certain terms which they should avoid while accepting investments from venture capital firms. However, this guide does not constitute legal advice (and the best recourse is to seek proper legal advice) and does not create an attorney-client relationship.
This guide does not cover all the issues that may be faced by founders. Likewise, it is not necessary that every startup company face all the issues discussed in this guide. However, the issues discussed in this guide are based upon our experience in similar matters and are commonly faced by startup companies in Pakistan.
This guide is divided into following three parts:
- Typical questions related to start-up companies.
- Understanding the term sheet offered by a venture capital firm.
- Process following the signing of the term sheet.
1. Typical questions related to start-up companies.
1.1 What is a company?
A company is a legal entity that is separate from the people who own and operate it. The people who own the company are called the shareholders (or members). Each shareholder owns the company to the extent of shares of the company issued to such shareholder. Correspondingly, the liability of each shareholder is limited to the extent of the amount paid by such shareholder for acquiring those shares. A shareholder’s involvement in managing the company is limited to voting on certain important matters in the shareholders’ meetings of the company. A shareholder cannot directly participate in the management and administration of business of the company.
The shareholders elect directors which are collectively referred to as the board of directors of the company. The board of directors is responsible for the overall management of business of the company and appoints the officers who manage its day-to-day business affairs.
1.2 What are different types of companies?
Companies may be broadly divided in below categories:
- Single Member Company which can have only one shareholder.
- Private Company which should have at least two but not more than fifty shareholders. The shares of a private company are not freely transferable. A private company cannot accept deposits from public. A private company has less stringent corporate compliance requirements.
- Public company which should have at least three shareholders. The shares of a public company are freely transferable. A public company can invite deposits from public and its shares or other securities may be listed on the stock exchange (in which case it is called a listed company). Public companies (and listed companies) have very stringent corporate compliance requirements and their affairs are closely monitored by the corporate regulator.
1.3 Why I need to incorporate a company?
Incorporation of a company is an essential requirement for venture capital fundraising. A venture capital firm will make investment in the company and will transfer funds to the company after it has been incorporated. It will not transfer any funds directly to founders.
A company is a separate legal entity, and its shareholders have limited liability. A company operates under a proper legal framework and its affairs are properly regulated. This business structure offers a streamlined procedure for making investment and disinvestment. Therefore, venture capital firms are more comfortable with this business structure.
1.4 When should I incorporate the company?
While there are benefits of incorporating the company at an early stage, many local startups operate as unregistered sole proprietorships or partnerships at early stages.
Venture capital firms have particular investment requirements and require that the constitution documents (the memorandum and articles of association) of the company be tailored accordingly. They may also insist on a particular type of company.
While founders may setup the company before approaching a venture capital firm and subsequently make changes in the structure of the company as requested by venture capital firm, it will cost extra time and money. In some cases, it might be a good strategy to delay incorporation of the company till such time that founders have concluded the deal with venture capital firm and the parties have signed the term sheet. However, it really depends on the circumstance of each case.
1.5 What type of company I should incorporate?
It will depend on your business plan as well as the requirements of the venture capital firm making investment in your company. If the goal is that the company will eventually go public (i.e., it will offer for sale its shares or other securities to public at large), you will probably require a public company since a private company cannot offer its securities to public at large. However, a private company may be converted into a public company and vice versa.
1.6 What is the process of formation of company?
Formation (or incorporation) of a company is now a straightforward and fairly simple process. A private company may be formed within a few hours by submitting an online application form and adopting standard forms of memorandum and articles of association.
However, where the company is to be formed for venture capital fundraising, its memorandum and articles of association should be tailored in the light (or in anticipation) of the commercial terms agreed or to be agreed between founders and the venture capital firm. It should be ensured that the changes in these documents do not violate any provision of the applicable laws, otherwise, such changes will be held unenforceable.
Similarly, the formation of a company alone is not enough for venture capital fundraising. As explained above, venture capital firms require this business structure because a company operates under a proper legal framework.
After the company is formed, its board of directors must take certain actions such as open bank account(s) of the company, obtain tax registration, appoint statutory auditor, and appoint key employees of the company and determine their powers, etc. The board of directors will be required to hold regular meetings to take decisions on all important matters related to the business of the company.
All important actions and decisions of the company should be documented through proper minutes, and by filing required statutory returns. A venture capital firm will require these documents during due diligence following the signing of the term sheet.
Engaging a lawyer to perform these activities will save time and cost.
1.7 What is the authorized share capital?
It is the maximum amount of capital for which shares (of a fixed value which is called the face value) can be sold by the company to its shareholders. For example, if the authorized share capital of a company is PKR 500,000 and the face value of each share is PKR 10, such company can sell a maximum of 50,000 shares of PKR 10 each to its shareholders.
The authorized share capital and the face value of each share are set in the memorandum and articles of association of the company. The authorized share capital cannot be changed without approval of the three forth majority in a shareholders’ meeting of the company.
1.8 What is the paid-up share capital?
The paid-up capital is the amount of money a company has received its from shareholders in exchange for sale of its shares to them.
A company must sell its shares against a legal consideration e.g., cash, property, or services etc. The shares cannot be sold by a company without consideration.
1.9 Can a company have shares of different kinds and why?
A company may have different classes (or kinds) of shares with different rights. The ability of a company to issue shares with different rights is one of many reasons why venture capital firms prefer this business structure.
Typically, for venture capital fundraising, the shares of the company are divided into two classes, the ordinary shares (or the common stock), and the preference shares (or the preferred stock).
The preference shares carry certain additional rights (or preferences) depending on the deal negotiated between founders and venture capital firm (further information on additional rights that may be attached to the preference shares is given ahead). These additional rights should be expressly mentioned in the articles of association of the company.
1.10 What should be the initial capital structure of the company?
The capital structure of a company means the amounts of the authorized share capital of the company, its paid-up share capital, the classes of its shares, and the rights attached to each class of shares. The law does not prescribe any minimum or maximum limits for the authorized share capital or the paid-up share capital.
In case founders have secured funding from a venture capital firm prior to the incorporation of the company, the capital structure of the company will be set in the light of the term sheet signed between founders and the venture capital firm. This agreed capital structure will be reflected in the constitution documents and other statutory records of the company.
In case founders choose to incorporate the company before finalizing the deal with the venture capital firm, the capital structure of the company should be selected in the light of many factors including the business plan, the value of any product or intellectual property rights to be transferred by founders to the company, the number of shares required for founders to retain control of the company, and anticipated requirements of the venture capital firm.
1.11 How will founders get shares of the company?
As explained above, a company cannot sell its shares to anyone without receiving a consideration. Thus, when the company will sell its share to its founders, they must pay a price for these shares to the company.
The price of shares may be paid by founders either in cash or against a non-cash consideration i.e., by rendering services for the company, or by transferring any right, property, or asset to the company. However, where the shares are to be issued against a non-cash consideration, the relevant agreement(s) between the company and founders and a formal valuation of such non-cash consideration prepared by a registered valuator will have to be submitted to the corporate regulator.
1.12 Do I have to transfer my technology to the company?
There could be many scenarios. But, in general, the answer will be a yes.
Where founders have developed a product or technology and secured funding from a venture capital firm based on such technology, they will be required to transfer their rights in such product or technology to the company. Of course, they will be issued shares of the company in return.
In another scenario, founders may have developed a novel and unique idea and secured funding from a venture capital firm based on such idea, their reputation, and their undertaking to stay with the company. In this scenario too, the venture capital firm will require each founder to enter into agreement with the company that any technology developed by him during his time at the company will belong to the company and not to him. Here again, founders will be compensated through issuance of shares of the company to them in lieu of their idea and any services rendered by them to the company.
Where founders own a technology but did not secure funding from venture capital firm based on such technology, they may not be required to transfer such technology to the company. However, its batter to clarify this in the financing documents.
1.13 What does “vesting” of shares mean and why is it required?
To put in simple words, vesting of shares mean that a founder’s right to the shares issued to him will be subject to him staying with the company for a specified period. His ownership right over the shares will become absolute only after he stays with the company for such specified period.
Vesting clauses protect both founders (against co-founders) as well as venture capital firms. Shares issued to founders are subjected to vesting right to keep them on the team and to maintain control over ownership of the company. Vesting also assures venture capital firms that founders are committed to the company and are not just looking for quick cash.
By implementing a reasonable vesting scheme, themselves, founders may forestall venture capital firm from doing so on its own terms.
Usually, vesting occurs over 4 years i.e., if a founder stays with the company for 4 years, all shares become vested in him. A common vesting structure is for 25% shares to vest after one year and the remaining shares to vest monthly in equal installments over the next 36 months.
Vesting schemes clause should be carefully designed and structured to make sure that they are enforceable as, under Pakistani law, private as well as public companies are not allowed to repurchase their own shares.
1.14 What does right of first refusal mean?
Just like vesting, the right of first refusal is also implemented to maintain control over the company. It means that where a founder agrees to an offer to purchase his shares from a third party, the company will have an option to purchase those shares from him at the price offered by the third party.
In Pakistan, the right of first refusal cannot be extended to a private company or a public company due to their inability to repurchase their own shares.
However, the right of first refusal may be extended to other shareholders (venture capital firm, co-founders) of the company and they may be granted an option to purchase the shares of a founder at the same price at which such founder has agreed to sell them to a third party. Such right is inherent in the shareholders of a private company by operation of law.
1.15 What is the buy-back right and who can exercise it?
Buy-back is the ability of a company to repurchase its shares from its shareholders. Typically, the vesting right and the right of first refusal are built upon this ability of a company. However, at present, only a listed company can repurchase its own shares.
1.16 How are the profits of a company distributed amongst its shareholders?
The profits of a company are distributed among its shareholders in the form of dividends. Dividends may be paid either in cash or in the form of additional shares of the company. In ordinary cases, each shareholder is entitled to dividends in proportion to the number of shares of the company owned by such shareholder.
However, when a company issues shares of different kinds (as explained above), the entitlement of its shareholders to receive dividends depends upon the rights attached to the class of shares held by them. For instance, when a venture capital firm invests in a company, it usually requires preference shares with a dividend preference (discussed below). In such case, the ordinary shareholders will be paid dividends only if sufficient funds are available for distribution after payment to venture capital firm.
1.17 How can I retain control of the company?
The business of a company is managed by its board of directors. However, the shareholders are the ultimate decision makers as they can appoint and remove the directors as well as limit their powers. The decisions in the shareholders’ meetings are taken by voting. Typically, each share carries one vote. Thus, it is the number of shares held by a shareholder which determines the ability of such shareholder to exercise or maintain control over the company.
Most of the decisions in the shareholders’ meetings are taken by a simple majority. However, certain decisions require approval from three-fourth majority of shareholders. Thus, the more shares a shareholder owns in a company, the more able such shareholder will be to exercise and retain control over the company. Following are the basic shareholding thresholds of which founders should be aware of:
- Ownership of 75% voting shares will grant you the ability to pass special resolutions which are required for taking decisions on important matters such as amendments in the memorandum and articles of association, placing any restrictions on the powers of the board of directors, and investment in associated companies etc.
- Ownership of more than 50% voting shares will grant you a simple majority in the shareholders meetings and the ability to take decisions on all matters which do not require approval through a special resolution.
- Ownership of more than 25% voting shares will grant you the ability to block any special resolutions.Ownership of 20% voting shares will give you the ability to file a complaint or a petition for investigation of the affairs of the company by an inspector appointed by the corporate regulator.
Of course, there are certain other ways to retain control over the company such as through shareholders agreements and through issuance of shares with special voting rights.
1.18 What is dilution?
A share represents an ownership percentage in a company. Thus, each additional share issued by a company makes an existing share less valuable. The more shares a company issues, the smaller percentage of ownership of that company each share represents.
When a company issues new shares to existing shareholders in proportion to their existing shareholding, it does not affect their ownership percentage of that company.
Dilution occurs when a company issues new shares to its existing shareholders disproportionately or to third parties. This results in a decrease in an existing shareholder’s ownership percentage of the company to whom new shares are not issued. For example, dilution occurs whenever a company obtains funding from a venture capital firm against issuance of new shares. Dilution will also occur when holders of share options, such as convertible debt securities or employee stock options, exercise their options.
Founders should be aware that dilution may result in a decrease in or loss of control of a shareholder or a group of shareholders over the company. Therefore, they should be extremely careful while raising funds through the issuance of new shares. For instance, while deciding the number of shares to be issued to venture capital firms at pre-seed and seed levels, they should bear in mind that the company will need to sell more shares in later investment rounds.
2. Understanding the term sheet offered by a venture capital firm.
2.1 What is the term sheet?
A venture capital fundraising transaction is initially documented through a “term sheet” prepared by the venture capital firm. The term sheet is an important document as it signals that the venture capital firm is serious about making an investment in your company.
The term sheet is foundation on which the whole transaction is built. It covers all important terms on which the venture capital firm will offer finance to your company such as valuation of your company, form of investment, preferential rights demanded by the venture capital firm, details of restrictions on the management, and any veto rights. Therefore, it is very important for you to carefully review it, and properly understand its terms.
2.2 Does valuation of my company matter and how is it determined?
Valuation of the company is a critical issue for both founders and venture capital firms. The higher the valuation, the less dilution founders will encounter. Venture capital firms, on the other hand, prefer a lower valuation of the company as it results in a higher equity stake in the company. Founders should not rush and try to get valuation of the company from more than one sources.
The valuation is typically referred to as the “pre-money valuation” and “post-money valuation”. The pre-money valuation refers to the agreed-upon value of your company prior to the venture capital firm’s investment. For example, if a venture capital firm plans to invest PKR 5 million in a company whose pre-money valuation is agreed to be PKR 15 million, that means that the “post-money” valuation of such company will be PKR 20 million, and the investors expect to obtain 25% equity in the company at the conclusion of the transaction.
Valuation is affected by several factors and is generally negotiable. There is not one right formula or methodology to rely upon for determination of valuation.
2.3 What are various forms of venture capital investment?
Venture capital firms usually make investments in any of following forms:
Convertible debt securities
A convertible debt security is a fixed income security that yields interest payment but can be converted into a predetermined number of shares of the company at a future point in time at the option of the venture capital firm. Since convertible debt securities are debt instruments requiring payment of interest by the company to the venture capital firm at regular intervals, they may adversely affect the company’s cash flow and should be avoided by founders. This form of investment may also require a special permission from the central bank under Pakistani forex laws.
Simple Agreement for Future Equity
Simple agreements for future equity (SAFEs) are alternative to convertible debt securities. However, they are not debt instruments. Unlike convertible debt securities, SAFEs have no maturity date and do not bear interest. In case of SAFE, the venture capital firm makes a cash investment in the company that is converted into shares of the company in the next round of financing. While this form of investment seems attractive from the company’s perspective, venture capital firms are less likely to invest in a company using this form of investment.
Convertible preference shares investment
This is the most popular form of investment by venture capital firms. Typically, a venture capital firm will invest in a company by acquiring its preference shares with rights, preferences, and privileges set forth in the articles of association of the company and related agreements. These preference shares give the venture capital firm preference over ordinary shareholders of the company in many ways (as explained below). These preference shares may also be converted to ordinary shares of the company at the discretion of the venture capital firm.
2.4 What type of preferences are usually attached to the preference shares?
Typically, a venture capital firm may require following preferences to be attached to their preference shares:
In most cases, venture capital firms require that the preference shares should have a dividend preference. Dividend preference means that the venture capital firm will have a priority or preference over certain class(es) of shareholders of the company when it comes to entitlement and distribution of dividends by the company.
There are two types of dividend preferences.
A “noncumulative” dividend preference means that the company cannot pay dividends to ordinary shareholders until a specified amount is paid as dividend to the venture capital firm.
A “cumulative” dividend preference means that the venture capital firm will receive a specific percentage per year of the amount invested by it in the company. It is more like an interest provision since it makes mandatory for the company to pay dividends to the venture capital firm.
Cumulative dividend preference clauses are not frequently used as they may adversely affect the company’s cash flow and put it at a competitive disadvantage and should be avoided by founders.
Liquidation preference means that upon winding up (or a similar event such as a merger) of the company, the venture capital firm will receive a specific amount before any proceeds from the sale of assets of the company can be distributed among the shareholders.
Typically, the liquidation preference is expressed as a multiple of the original amount invested by the venture capital firm, usually at 1x. It means that in the event of winding up of the company, the venture capital firm will be entitled to receive back PKR 1 for every PKR 1 invested, in preference over the ordinary shareholders.
Some venture capital firms may ask for multiple return on their investment, say 2x or 3x. This is termed as a “super liquidation preference” and should be avoided by founders.
Venture capital firms will sometimes require that their preference shares be designated as “participating”. Where a venture capital firm owns participating preference shares, after it has received its full liquidation preference amount out of proceeds from sale of assets of the company, it is again entitled to a share in any remaining sale proceeds along with the ordinary shareholders of the company.
For example, if the company’s assets are sold for PKR 100 million, the preference shares have a liquidation preference of PKR 20 million and the preference shares represents 25% of the total number of outstanding shares of the company, then they will first receive PKR 20 million as per their liquidation preference and another PKR 20 million against their participation rights.
A common way to limit participating liquidation preference is to set a cap on the participation amount. Where a cap is set, the venture capital firm will receive all benefits flowing from participating liquidation up to a specified amount, called a cap or a ceiling. Once the venture capital firm has reached that cap or ceiling, it can no longer share in the remaining payment distributions with the ordinary shareholders of the company.
Sometimes, venture capital firms require a provision allowing them to cash out of their investment. This is called the redemption right. There are two types of redemption provisions.
A mandatory redemption provision lets the venture capital firm require the company to repurchase its’ preference shares at the purchase price plus a redemption premium. Founders should avoid mandatory redemption because the investment is more like debt than equity.
An optional redemption provision lets the company repurchase or redeem the preference shares at their purchase price plus a redemption premium. It allows the company to force the venture capital firm to convert its preference shares to ordinary shares or face redemption.
It is important to remember that a private company or a public company cannot repurchase its own shares. Therefore, it may be difficult to enforce the redemption right.
In almost all cases, the preference shares can be converted into the ordinary shares at the option of venture capital firm. There may also be a provision for an automatic conversion of the preference shares into the ordinary shares upon an initial public offering or some other agreed event. The typical conversion rate is one preference share converts into one ordinary share.
It is typical for a venture capital firm to obtain protection against the company selling its shares in future at a lower price than the valuation made by the venture capital firm at the time of making investment in the company. This is achieved by increasing the conversion rate of the preference shares i.e., by increasing the number of ordinary shares into which each preference share converts.
There are two main types of anti-dilution protection: weighted average anti-dilution protection and ratchet anti-dilution protection.
A weighted average anti-dilution protection increases the conversion rate of the preference shares based on a formula that is intended to consider overall economic effect of sale of new shares by the company.
A ratchet anti-dilution protection increases the conversion rate of the preference shares based on the price per share at which the company sells its shares in the future, regardless of how few or how many new shares are issued at the lower price.
The most favorable anti-dilution protection clause from the founders’ perspective is weighted average anti-dilution.
It is equally important for founders to get exemption from anti-dilution protection in respect of certain transactions, such as employee stock option schemes, shares issued in acquiring other companies, and shares issued in connection with bank financings, etc.
The preference shares may have same voting rights as the ordinary shares. However, a venture capital firm may insist on additional voting rights to be attached to the preference shares to enable it to have representation on the board of directors of the company despite being in minority.
A venture capital firm may also require veto rights on certain strategic actions that could adversely affect its investment. The types of actions where a veto right may apply include:
- Amendments in the memorandum and articles of association of the company.
- Increase or decrease the paid-up share capital of the company.
- Winding up of the company.
- Incurring liability exceeding a specific limit.
- Declaration and payment of dividends.
- Change in the composition of the board of director of the company.
A veto right does not mean that the company cannot take the actions that are subjected to veto right. In most cases, the venture capital firm will agree to waive its veto right if it will receive a legitimate request from the company. Still, founders are advised to carefully evaluate any veto rights demanded by venture capital firm and make sure that the same will not unduly interfere with their ability to manage the company.
2.5 What is the co-sale right and why is it included in the term sheet?
Venture capital firms may also require “co-sale rights” in respect of any sale of shares by founders. This will give the venture capital firm the right to participate in any proposed sale of a founder’s shares to third parties. The reason for a co-sale right is that venture capital firms generally do not want the founders to “cash out” without giving them the same opportunity.
2.6 Why the term sheet requires the company to give stock options to employees?
Venture capital firms require that the company has an option pool to attract and retain employees, advisors, and board members. They will almost always insist that this option pool be included as part of the pre-money valuation of the company. However, founders must realize that any increase in the option pool will come at their expense, reducing their percentage ownership of the company.
Venture capital firms will also expect that all employee stock options are subject to a “standard” four-year vesting schedule: one year of employment required before any vesting for 25% of the options, and then monthly vesting with continued employment for 36 months.
2.7 What is “Pay to play” clause?
Pay-to-play clauses impose penalties on venture capital firms for not investing their full pro-rata share in the next funding round— typically only if the next funding round is a down round. The more severe version of these penalties is to provide that if the venture capital firm does not invest it’s full pro-rata amount it will have its existing preference shares converted into ordinary shares, resulting in the loss of all special rights attached to the preference shares.
2.8 Why the term sheet includes a vesting schedule?
As explained above, a venture capital firm will want to make sure that founders have incentives to stay and grow the company. If the shares sold by the company to founders are not already subject to a vesting schedule, the venture capital firm will likely request that the founders’ shares become subject to vesting based on continued stay with the company. The key issues that founders negotiate in this regard are:
- Should a vesting schedule apply at all?
- Will the founders get vesting credit for time already spent at the company?
- Will vesting schedule apply to any shares they purchased from the company against a cash or non-cash consideration?
- What will be the duration of vesting schedule?
- Should vesting accelerate, in whole or in part, on termination of employment without cause, or upon a sale of the company?
2.9 Is the term sheet a binding agreement enforceable at law?
The term sheet does not constitute a binding and enforceable agreement (except its confidentiality and no shop clauses) and does not guarantee that the deal will be consummated. However, after the term sheet is signed, it usually results in a completed transaction.
Although it is not binding, the term sheet is by far the most important document to negotiate with the venture capital firm as it will cover almost all significant issues leaving smaller issues to be resolved in the detailed investment documents that follow. A founder should think of the term sheet as the blueprint for his or her relationship with venture capital firm and should give it proper attention.
2.10 What rights do I have to surrender in negotiations with venture capital firm?
Typical venture capital fundraising deals include basic liquidation and dividend preferences, and weighted average anti-dilution protection. Founders will have to agree to certain restrictions on how they run the company. Actual terms will vary depending on negotiations between the parties.
2.11 What should I avoid during negotiations with venture capital firm?
Founders should avoid ratchet anti-dilution protection, mandatory redemption, redemption premiums, super liquidation preferences and excessive restrictions on how they run the company.
2.12 Do I need a lawyer to represent me during negotiations and how do I select?
Most venture capital firms will offer legal assistance to founders through their own lawyers. However, a lawyer representing a venture capital firm will be looking to get the best deal possible for his client, even if it comes at your expense.
You must engage your own lawyer to advise you. A lawyer’s job is not just to make sure that the structure of the transaction complies with the applicable laws. His main job is to promote and protect his client’s interest.
3. Process following the signing of the term sheet.
Typically, below steps by step process is followed after the parties have signed the term sheet:
3.1 Where the startup company has already been incorporated.
- The venture capital firm will carry out due diligence to make sure that:
- Representations made by founders to the venture capital firm are true.
- The company has obtained all required approvals, registrations, and licenses for commercial operations.
- The company maintains proper corporate records and is up to date on its corporate filings.
- All the assets and contracts belonging to the company are in its name.
- Founders as well as other employees have signed proper agreements with the company containing the required restrictive covenants including the requirement to maintain confidentiality and the assignment of intellectual property rights to the company.
- The company does not have any undisclosed liabilities.
- The venture capital firm will identify the required amendments in the memorandum and articles of association of the company. The company will make these amendments after complying with the applicable legal formalities.
- After the required amendments have been made in the memorandum and articles of association of the company, the company and the venture capital firm will enter into a share subscription agreement.
- The company will comply with legal formalities for issuance or sale of new shares to the venture capital firm pursuant to the share subscription agreement.
- After the company has issued the shares, the venture capital firm will transfer the investment amount in the company’s bank account.
- The venture capital firm and founders will enter into a shareholders’ agreement.
- Necessary changes will be made in the board of directors of the company.
3.2 Where the startup company is yet to be incorporated.
- Founder will incorporate the company against a nominal paid-up capital. The memorandum and articles of association of the company will be drafted in the light of the term sheet signed between the parties.
- The company will appoint the chief executive officer, the statutory auditor, legal advisor, and, where applicable, the company secretary.
- The company will open a bank account.
- The company will comply with legal formalities for issuance of new shares to founders and the venture capital firm.
- The company and founders will enter into a share subscription agreement whereunder the company will sell its shares to founders against a non-cash consideration. The company will get a valuation of the non-cash consideration from a registered valuer. The company will issue shares of corresponding value to founders.
- The company and the venture capital firm will enter into a share subscription agreement.
- After the company has issued the shares, the venture capital firm will transfer the investment amount in the company’s bank account.
- The venture capital firm and founders will enter into a shareholders’ agreement.
- Necessary changes will be made in the board of directors of the company.
Majeed & Partners, Advocates & Counsellors At Law is a Lahore-based law firm. We provide a full range of legal services to clients, amongst others, operating in the information and communications technology sector in Pakistan. We have represented a number of growth-oriented companies from inception and throughout a full range of complex transactions. We have helped several young tech entrepreneurs in setting up tech companies and advised them during early-stage fundraising as well as subsequent funding rounds. If you require further details about the scope of our services, please feel free to Contact Us.