Monthly Archives: July 2019

Before you sign the lease…

Houston we have a problem! To avoid such words after having signed an agreement to lease it is important that tenants get advice before signing the agreement.  Once an agreement has been signed it is binding and therefore difficult to negotiate any amendments.

Here are some tips that tenants should consider before entering into an agreement to lease:

Rent Reviews
Rent reviews play an important part in any lease. Look to limit exposure to large rent hikes. Reviews are undertaken through a market review or increased in line with CPI. A tenant should look to impose a cap on any increase e.g. no increase in rent should be greater than 2%.
Rent disputes are resolved by valuers and arbitration. To avoid these costs tenants may consider having CPI increases or fixed rent increases. However, the risk is that these increases will leap ahead of the market. It is often advisable to have a mixture of CPI reviews and market reviews.

Another large expense is outgoings. Outgoings are expenses that are incurred through the running of the premises and include such things as insurance, rates, utilities and service or maintenance contracts. The landlord will usually pay these costs and seek reimbursement from the tenant. Outgoings are often payable in addition to rent.
Tenants should review the list of outgoings carefully and undertake an inspection of the premises and the building services to ascertain whether they are in good repair. If anything needs fixing, the costs will often be passed on to the tenant as part of the outgoings.

Reinstatement Obligations
Tenants who are excited about taking on new premises often forget about their obligations when the lease ends. This oversight can be costly.
Leases often require a tenant to reinstate the premises to its original condition, which can be expensive. This can be resolved by the insertion of a clause in the agreement outlining that the landlord agrees that the tenant shall not be required to reinstate the premises at the expiry of the lease.

It is common for landlords to require a guarantee of some sort; either a personal guarantee from the directors or a bank guarantee.  Guarantors should be wary that if the lease is assigned their liability will continue until the next rent renewal. Accordingly we often recommend that any guarantee given, whether personal or bank, be limited to a certain period ranging between three and 12 months depending on the lease term.  This is something that needs to be inserted into the agreement to lease and is something that landlords commonly concede.

Lease incentives
Tenants should negotiate some form of incentive into a new lease but it can be tricky to know what is acceptable. It is important to remember the agent is working for the landlord and is therefore unlikely to advise a tenant as to how much they should be seeking or what form it should take. Examples of incentives are a rent free period or fit out contribution. Experienced property lawyers will know what is acceptable in the market and will be able to provide guidance.
Tenants should obtain tax advice as some incentives will be regarded as income and therefore might not be as valuable as they first seem.

These are just a few examples of where an experienced property lawyer can save a tenant money, and future headaches.


Seed Funding Options for Start-Ups

In the early stages of a start-up, founders typically seek to bootstrap (i.e. self-fund) their operations in order to preserve value through their hard work and expertise. At some stage, most start-ups will need a cash infusion to grow their business and take it to profitability. That’s where investors come in.

Before raising capital, it is important to understand the most common forms of seed investments: equity and convertible debt. Each form of funding has its own pros and cons, and is a better fit for certain situations than others.

Equity represents an ownership interest in the company.  While equity doesn’t provide as much certainty of repayment as compared to a loan, it gives the investor a greater chance of participating in the upside in a profitable company or a future sale.

The size of an investor’s shareholding in the company will be negotiated based on the amount of the investment and the agreed valuation of the company. It generally involves a compromise between the investor’s eagerness to invest in the company and the founder’s desperation to raise funds.

Equity typically takes the form of ordinary shares or preference shares.

Ordinary shares have various rights attached to them (such as voting and dividend rights), but they usually rank behind other securities in terms of priority.

Preference shares differ from ordinary shares because of the additional rights (preferences) that attach to them. They typically confer on the investor:

  • A liquidation preference, which entitles the investor to recover an additional amount (ahead of all ordinary shareholders) in a liquidation of the company; and
  • An entitlement to receive dividends in priority to the holders of ordinary shares; and
  • An ability to convert the shares into ordinary shares on a future exit.

Preference shares are typically used for more substantial investments as their terms are generally complicated and heavily negotiated.

Convertible Debt
A convertible debt instrument involves the company borrowing money from an investor in the expectation that the debt will convert into equity in the company in the future (such as after a capital raising or a sale event). It is essentially a mix of equity and debt.

Here is a basic example of how convertible notes work:

  • An investor invests $200,000 in a start-up by way of a convertible note.
  • The terms of the convertible note are a 20% discount and automatic conversion after a future capital raising exceeding $1 million.
  • When the next capital raising occurs at a $2 million valuation, the convertible note will automatically convert into equity.

Let’s assume the shares are issued for $1 per share.  As a 20% discount applies, the investor can use their $200,000 investment to purchase shares in the next funding round at the discounted rate of $0.80 per share. This gives the initial investor $250,000 worth of shares for the price of $200,000 (representing a 25% return).

Convertible debt has become a popular form of seed funding for a number of reasons.

  • Valuation: Issuing equity requires you to value your company. This can be a difficult exercise for a company in its early stages. A key advantage of a convertible note is that it doesn’t require the company to be valued until a larger equity round is raised.
  • Cost and speed: Convertible debt is simpler to document than equity financings. This means that they are generally less expensive and that funding rounds can be closed more quickly than equity raisings.
  • Control: Many founders are (naturally) concerned about relinquishing control of their company. Holders of convertible notes typically receive minimal control over the company (for instance, no veto rights or director appointment rights). This is especially helpful for start-ups wishing to undertake a further capital raising without investor interference.

As early stage investment is risky, investors often sweeten their deal by asking for a valuation cap. A valuation cap limits the price at which convertible notes will convert into equity. It is used to protect early investors in case the company’s value skyrockets in the next funding round. For instance, if the valuation cap is $1 million, but the company’s valuation at the next funding round is $1.5 million, then the amount invested will convert into equity at the $1 million valuation cap.

Summing Up
Every situation calls for a different type of investment structure.  It is important to understand the subtleties of the various structures and balance the particular needs of the company against the risks and rewards available to the investor.