You’ve built a credible business plan and convinced funders or potential customers that your solution will work out of the lab. Now is the time to incorporate your spinout!
Before spinning out
Creating a spinout is a challenging enough process without the added complications of a badly set up business. Whilst you might feel that your hard-raised funds are better spent on a few extra hours of development instead of legal fees, signing legally binding agreements without representation can have serious consequences for future fund raising. For example, investors could end up avoiding your spinout at the second funding round if the agreement you signed with the first-round backers makes decision-making unbalanced for subsequent investors or if the shareholders are not properly recorded in a register of members. This is not only disadvantageous for second-round investors, but also for yourself and your company, now constrained to work with a limited pool of investors under unfavourable terms.
So avoid the damage to your brand and future legal nightmares by ensuring you have legal representation very early on (or at least from the moment you receive your first term sheet). A legal service would not only be able to draft documentation for your spinout, but would also interpret offers and contracts and represent you in negotiations. This need not be expensive or have a massive impact on your cash levels: some law firms offer capped fee start-up packages that fit the limited budgets of young companies, and some agree to only invoice after funding has been received.
Portico Ventures can point spinouts to firms that offer deals or start-up services, so speak to the team as early as possible. Moreover, we require you to have representation when the UCLB IP licence is reviewed and executed.
Agree licence terms
Following the Portico Ventures Heads of Terms, an IP licence is drafted for agreement between UCLB and your spinout. It is then reviewed with yourself and your lawyers to ensure that all clauses are well understood and agreed.
A milestones schedule and adequate due diligence requirements for the spinout are recommended for inclusion in the licence agreement, to ensure that the IP is actively exploited.
A term sheet is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made. This is the first sign of commitment your investors will show, and it will likely include key terms around any assets, an initial purchase price, often accompanied by contingencies that may constitute a change in the aforementioned, and the form of payment that will be supplied. Often, there is an acceptance period, providing a time frame for a response beyond which the offer is no longer valid. A term sheet serves as a template to develop more detailed legal documents following further due diligence.
The valuation is a key element in any term sheet, as it gives you a rough estimate of how much the investor believes your company is worth. It generally takes two forms: pre-money (the value of the company before the investment comes in) and post-money (the initial value plus the amount of investment). Agreeing on a valuation is essential, but expect at least some negotiation, as investors will try to obtain as large a shareholding as possible for their investment. For arguments in your favour, look at valuations for companies comparable to yours (at comparable funding rounds), as reflected in investment announcements or Companies House records.
Branding and domain
Your brand can allow your product or service to stand out. This can be developed long before incorporation either by your team or by an external consultancy. If you do outsource your branding (even if it’s to a non-professional), you will need to ensure that your spinout owns the designs for your logo/corporate image.
Ideally, you should have a basic web presence established before your investor roadshow, to act as a professional storefront when introducing your team to VCs. The minimum information to include on the website are contact details, as well as a brief description of your solution and the challenge it aims to tackle. Ensure you check at least the UK IPO Trademark database as well as web domain availability as you consider company names, to make sure your preferred name is not already protected / in use. Also consider the fact that some domain names are owned by domain trading businesses, which might charge substantially more for transferring the domain to you. If you expect to run a multinational business, it is worth checking foreign trademark databases also.
Once you have chosen your company name / product name, consider at least registering your trademark at the UK IPO (it’s inexpensive) to protect your brand in the UK.
Steps in incorporating the company
1) Articles of Association
The articles of association set out the basic management and administrative structure of the company. They are required at incorporation and are legally binding. They lay down the rules of how decisions are taken by shareholders and directors; they also deal with matters connected with shares and associated rights.
Most spinouts initially adopt model articles – a standard rulebook that covers all the basics. They are set out in schedules 1-3 of The Companies (Model Articles) Regulations 2008 and are available on Companies House. On incorporation, your company can adopt either the model articles in their entirety, or the model articles with amendments or it can draft its own bespoke articles. While the law gives freedom regarding the articles of association (subject to the relevant provisions of the Companies Act 2006), you might want to simply amend the model articles to include more specific rules, instead of completely re-writing the rulebook. Should you decide to proceed with bespoke or amended articles, it is advised that you take legal advice before incorporating.
You might want your articles of association to include answers to some of the questions below:
- How are shares distributed across shareholders and are they all ordinary shares? Most companies initially issue only ordinary shares, but shareholders’ agreements allow for the creation of other classes of shares with e.g. different rights to vote, to dividends or to participating in the capital of the company on a sale. Do take into account the fact that more complicated share structures also come with the added cost of managing them at every investment step.
- Which shares have anti-dilution rights attached? Following incorporation, whenever new shares are issued, the existing shareholders’ percentages are diluted in proportion (unless the equity is subject to non-dilution provisions as is the case with UCLB’s 6% founding stake of Portico Venture companies – although this right only persists until the company raises £1 million of funding).
- If one founder leaves and forfeits shares, will that founder’s shares be first offered to the remaining shareholders? In what proportion and at what price? Can shares be transferred and under what conditions?
- What proportion of votes are required to approve certain corporate actions?
Note that articles of association can be (and are often) amended during the company’s lifetime – subject to the relevant approvals, so it is not unusual to adopt model articles at the time of incorporation and then develop a more customised set, with professional legal advice, at a significant event, eg a funding round.
Articles of Association are public documents that must be registered at Companies House within days of formal adoption by the Company.
2) Shareholders’ Agreement
All private companies limited by shares are owned and controlled by their shareholders, who have the right to set key rules and appoint directors. Their rights and the rules that govern their relationship are typically laid out in the Shareholders’ Agreement especially with regards to decision-making and financial matters. Although it is not a legal requirement, it is recommended to have a Shareholders’ Agreement; you might want it to include answers to some of the questions below:
- What are the roles and responsibilities of the founders? How much time commitment to the business is expected of each founder? What salaries or payment (if any) are the founders entitled to? How can that be changed? What happens if one founder isn’t living up to expectations? How will this be resolved?
- How often will Board meetings be held? Who will have the right to appoint additional Directors or remove them? Under what circumstances can a founder be removed as an employee of the business?
- How will shareholder decisions be made? Majority decisions are appropriate for day to day matters, but where something pertains to key company processes, or materially affects the interests of individual shareholders, you might foresee different voting requirements. A shareholders’ agreement can specify situations where special resolutions need to be passed or particular consents need to be obtained.
- How will a sale of the spinout be decided?
Shareholders’ agreements are private documents that do not need to be registered with Companies House, thus ensuring confidentiality of contents between the parties who have signed it.
To set up a private limited company you need to register with Companies House. This is known as ‘incorporation’.
At this time, you will need:
- a suitable company name, that is distinctive and does not infringe the rights of other registered companies or includes words that have been deemed ‘Sensitive’ by the Secretary of State and may require permission to include (words such as Association, King, Commission, British etc. See: https://www.gov.uk/government/publications/incorporation-and-names/annex-a-sensitive-words-and-expressions-or-words-that-could-imply-a-connection-with-government )
- an address for the company, be it at a private office where your business is located, your home address or the address of the person who will manage your Corporation Tax
- at least one director, whose name will be public
- details of the company’s shares – you need at least one shareholder and you have to provide information about the distribution of shares
- to specify one or more SIC codes – these identify your company’s main business activity(ies) in broad terms.
You’ll also need the finalised Memorandum and Articles of Association and details of Persons with Significant Control (PSC) in your company, for example anyone with more than 25% of all the shares or of voting rights.
Once you have these details and have signed all relevant documentation, you can register your company with Companies House for a small fee. This usually takes less than a day to be confirmed and a company registration number (and incorporation certificate) issued.
4) Issue shares
Your company’s ‘statement of capital’ will detail the share structure of your company and will reflect the shares issued upon incorporation. It includes:
- the number of shares of each type the company has and their total value – known as the company’s ‘share capital’
- the names and addresses of all shareholders or members – known as ‘subscribers’
Most companies only issue ordinary shares on incorporation and prior to receiving equity finance: these give the right to one vote per share, are entitled to participate equally in dividends and receive an equal portion of the assets (after debt has been paid) if the company is wound up. Although other classes can be created, spinouts should carefully consider the benefits of a more complex share structure versus the time and expertise their management would require.
When issuing shares on or after incorporation, you will need to consider, as a minimum:
- Founders. While the initial split of founder shares might represent e.g. the knowledge that each founder brings to the table, you should consider incentivising the founders to continue their active contribution to the business as it grows. You could address this by splitting each Founder share slice into two parts: one part issued as non-conditional shares that reflects what each founder brings in at the outset (e.g. IP), and one part that has to be “fully earned” over time (e.g. 3-5 years) through a mechanism such as reverse vesting of issued shares. This incentivises continued contribution as the spinout grows.
- UCLB. UCLB should be issued its 6% shareholding at the same time as the company receives the IP licence.
- Option pools. Young companies often face a human resourcing challenge before they secure investment, as they often cannot afford to pay enough for the highly-skilled talent they need to grow. Option pools are a widely-used solution to motivate staff at the start of the road, allowing employees to become shareholders in the company following sustained engagement. Moreover, they help extend your cash runway, leaving more money for activities that will allow your business to make a profit. Most start-ups prefer to set aside between 10 and 20% of their stock for these purposes; as part of Portico Ventures, we recommend as a minimum an initial 10% option pool aimed at incentivising early employees.
5) Hold first board meeting
The incorporation formalities should be completed at a first meeting of the board of directors. Here, among things, you will appoint your other director(s). All limited companies need to have at least one director. A director can also be a shareholder.
Directors are legally responsible for running the company and making sure company accounts and reports are properly prepared. They come in two flavours:
- Executives, with a specific role, such as CEO, CTO, Finance Director etc.
- Non-executives, who are usually business generalists brought in to augment the managerial skillset.
Together, the directors form the board, responsible for establishing the strategic direction that the business takes. Decisions are generally made by a vote, with both execs and non-execs getting involved with the full array of company matters.
Directors can sometimes be held personally liable for the company’s activity (e.g. failing to act in the face of insolvency) and risk financial penalties and removal. Therefore, if you plan on taking a directorship in the spinout, you will want to consider your duties and responsibilities, and it is highly recommended that Directors’ (and Officers’) liability insurance is taken out by the company.