Securing seed capital for university spin-outs and how your lawyer can help

Seed capital is money that is used to start and grow your business.  New and growing businesses raise funding from various sources to cover the costs of developing, improving and getting their products or services to market. However, it can sometimes be a challenge for university spin-outs to access this funding, particularly where there is initially no product or revenue or they are in sectors which are research intensive such as Artificial Intelligence (AI). 

Start-up or seed funding comes in various forms, which fall under these main categories:

• Equity financing – the founder will give away a percentage of ownership in their company in exchange for capital.
   
• Debt financing – the founder will get a loan, either from an investor or a financial institution.
   
• Crowdfunding – a group of people will give money towards a project. 
   
• Government grants / loans – the founder gets funding from the government by way of a grant or a loan.

In addition to traditional financial institutions, funding for your business can be provided from the following types of investors:

1. Angel Investors – angel investors are wealthy individuals looking to invest in spin-outs at their earliest stages. An angel investor provides initial seed money for start-up businesses, usually in exchange for ownership equity in the company.
    
2. Venture Capital (VC) – venture capital funds will usually invest in new companies, many of which will not yet be making a profit, but which have the potential for very strong growth. VCs take minority stakes in businesses, very often alongside other VCs and investors.
    
3. Crowdfunding – crowdfunding is a way of raising money to finance projects and businesses by collecting money from a large number of people via online platforms. Crowdfunding is most often used by start-up companies or growing businesses as a way of accessing alternative funds.
    
4. Friends and family – the close personal connection of friends or family members to the founder of a start-up makes them a convenient source of initial funding assuming they have the means and are willing to invest.

For all spin-outs, securing funding is a critical step in their journey towards success. Seeking guidance from lawyers at an early stage can play a transformative role in mapping out the path to successful fundraises.

Here are 5 key areas where Hill Dickinson can help you, beyond advising purely on legal documentation, to send all the right signals to investors. Whatever sector your business is in (such as AI, Robotics, HealthTech, MedTech or otherwise), all of these matters need to be borne in mind.

Intellectual Property (IP) Protection

Intellectual property (IP) is a valuable asset that can make or break a company. Demonstrating strong IP protection not only safeguards innovative technologies but signals to potential investors that the start-up has developed a valuable asset and is serious about its future. Early steps can significantly enhance the perceived value of the company and attract investors who are seeking to back cutting-edge technologies with the potential for substantial returns in the future. In addition, tackling the issue at an early stage will address some of the more risk-averse investors’ concerns and enhance the start-ups’ position.

Protecting Your Intellectual Property: A Strategic Approach

Identifying and documenting IP is an essential aspect for any technology start-up. Seeking guidance from experienced professionals can help start-ups successfully manoeuvre through the IP registration process, draft appropriate agreements and develop strategies to prevent IP infringement. For example, as early as possible, spin-outs should seek advice to develop confidentiality best practices, use adequate non-disclosure agreements with all relevant parties and provide appropriate training for employees to manage the IP and any infringement risks.

Corporate Structuring: Enhancing IP Protection and Flexibility

Depending on the type of products and services, corporate structuring can be used by start-ups to protect their patents, trademarks and copyrights. One effective approach is forming a holding company structure:

• Asset Protection: A holding company can help protect the company’s IP from the operating company’s other liabilities. The objective is to segregate assets to reduce the potential exposure of the company’s IP to creditors or legal claims brought against the operating company.
   
• Financial Flexibility: A holding company will also enhance the company’s flexibility when raising capital. Holding companies can issue their own shares to attract investors, acquire other companies or subsidiaries and engage in various financial transactions without directly impacting the operating company’s financial structure.

Data Protection and Privacy

In today’s data-driven world, data protection and privacy are paramount for businesses of all sizes, including spin-outs. Investors are increasingly scrutinising companies’ data handling practices, recognising that robust data governance is not just a compliance issue but a strategic imperative for long-term success. 

Navigating the Regulatory Landscape

The UK’s Data Protection Act 2018 (DPA) and the General Data Protection Regulation (GDPR) both impose strict requirements on how businesses collect, use, and store personal data. Start-ups that demonstrate a clear understanding of and commitment to these regulations will gain the confidence and trust of investors. Demonstrating awareness and commitment to onerous and complex regulatory requirements will always contribute to gaining investors’ confidence and trust. As technologies such as AI and robotics become increasingly integrated into our economies, data protection and privacy will become even more critical. By establishing robust data protection and privacy practices from the outset, spin-outs position themselves for future growth and expansion, ensuring that they can navigate and adapt to the evolving regulatory landscape and meet the expectations of data-conscious consumers. 

Leveraging Corporate Structuring for Data Governance

Corporate structuring can help spin-outs comply with data protection regulations by ensuring that they have the appropriate data governance processes in place. Adequate corporate structuring can be extremely helpful, even at an early stage. For example, a start-up that develops AI-powered software that collects personal data may need to create a separate data protection subsidiary to manage the data and risks related to it in compliance with the DPA and GDPR. The benefits of a having a data subsidiary are as follows:

• Data Isolation and Risk Mitigation: The ‘data subsidiary’ would have its own separate legal identity which would isolate data-related risks as well as mitigate the impact of potential data breaches and other compliance issues affecting the rest of the business.
   
• Demonstrating Data Protection Commitment: Creating a separate ‘data subsidiary’ can help demonstrate the start-up’s commitment to data protection. The subsidiary can register with the ICO to show investors and potential customers that the start-up takes data protection seriously which in turn will contribute to building trust and confidence.
   
• Scalability for Future Growth: In the medium to long term, relying on a ‘data subsidiary’ can also make it easier to scale data collection in parallel to the rest of the business.

It is important to note that operating a complex corporate structure can be costly and time-consuming, especially for early-stage companies with limited resources. The choice of corporate structure and risk management mechanisms will be determined by the nature of the products and/or services developed by the company. Our lawyers will be able to advise on these specific points.

Share Capital

Preserving ownership and control is crucial at every stage of the journey to protect the company’s vision, strategy and long-term goal. Holding the reins on the share capital table will be critical to attract investors, close future fundraising rounds and maximise potential exit strategies.

• Establishing transparency and good governance will help build confidence with more reputable investors. Investors in highly technical sectors, such as AI and robotics, will expect management teams to have the ability to navigate in complex and evolving commercial, legal and regulatory environments. Demonstrating excellent corporate governance at an early stage is essential to develop those long-term strategic partnerships.
   
• Protecting the rights of minority shareholders is essential (eg voting rights, dividend entitlements, and preferential liquidation rights) to maintain trust, create value for all stakeholders and keep attracting different profiles of investors at every stage of the journey. A well-managed share capital table will help to streamline negotiations by clearly defining the value and ownership interests of each shareholder.
   
• Creating appropriate, tax-efficient incentives will become essential to attract and retain employees. In highly competitive, rapidly growing technology industries, to compete for top talent, start-ups need to offer attractive compensation packages that include more than just salary. A growth share scheme, for example, offers employees an opportunity to take part, financially, in the company’s success by granting them the right to purchase shares of the company at a predetermined price. Top-level talent will expect this type of benefit to feature within their remuneration packages.

Tax

Research and development (R&D) tax credits can benefit technology spin-outs tremendously at an early stage. Understanding R&D tax credit schemes will be essential for any founders looking to claim in the future. Setting up adequate processes early on will maximise potential credits.

Identifying qualifying R&D activities which apply to the company’s activities (eg developing new AI algorithms or software or experimenting with new AI applications or solutions or making technical improvements to existing AI technology) can allow a company to keep accurate records of all R&D activities and clearly classify the data points required for the applications (eg staff time spent or costs incurred).

Start-ups do not need to wait until they are profitable to claim R&D tax credits. Early-stage companies can claim credits against losses, which can provide valuable cash flow and financial support during the critical growth phase.

In addition, the UK tax code offers generous tax benefits to those investing in early-stage companies by means of the SEIS (Seed Enterprise Investment Scheme) and/or the EIS (Enterprise Investment Scheme) regimes.

These regimes offer significant income tax and capital gains tax benefits to UK tax resident individuals investing in companies which satisfy certain conditions.

The conditions to be satisfied include the requirement that the company is: not majority-owned by another company; operates in a qualifying business sector; and meets certain requirements regarding maximum value of assets and number of employees. There are also limits as to the value of qualifying investments and as to the total amount that an individual can invest via the SEIS and EIS regimes.

The SEIS/EIS regimes offer significant benefits to investors and have the potential to make investment in early-stage companies particularly attractive.

Staying attuned to taxation issues is a great signal to send investors to demonstrate a long-term vision, sound governance and excellent internal processes.

Financial Regulation

Financial regulation is relevant both to what start-ups actually do and how start-ups raise money. In terms of what they do, technology spin-outs that operate in highly regulated sectors, for example, the financial and healthcare sectors, will be subject to additional regulatory requirements which can be addressed at an early stage. For example, a start-up that develops AI-powered financial products may need to be licensed by the Financial Conduct Authority (FCA). As AI and robotics are increasingly used in financial services, there is growing concern about the transparency of algorithmic decision-making. Regulatory bodies are considering how to ensure that AI-powered financial decisions are fair, unbiased, and can be understood by consumers.

• Barriers to entry, including regulatory barriers, can be an excellent opportunity for start-ups to establish a strong position inside a market. Although initial costs can be significant, in the medium to long term, demonstrating regulatory compliance will be an obvious green flag to any prospective investor.
   
• Corporate structuring can help these start-ups comply with these regulations by ensuring that they have the appropriate licenses and approvals in place. The subsidiary can make the relevant regulatory application (eg FCA licence for AI-powered financial products) and, going forward, develop the ‘regulated’ products and/or services.

But, no matter what sector your business is in, if you are looking to raise money, financial regulation will be relevant. If you are UK-based or looking to raise money from UK-based investors or looking to meet or communicate with prospective investors in the UK, FCA rules will apply. FCA rules govern what you can say when you are trying to raise capital, what you can say to whom and what you need to know about people before you can even have a conversation about investing. If you engage the services of someone to help you raise money for your business, FCA rules will apply. FCA rules will also govern how you can raise money. If you are looking to raise capital in exchange for equity, FCA rules will apply.

If you are looking to raise money through a token offering, FCA rules will apply. If you are crowdfunding, FCA rules will apply. And even if FCA rules themselves don’t apply to every instance of fund raising, anti-money laundering and ‘know your customer’ requirements will apply before you can accept any money from an investor. We specialise in helping businesses who are looking to raise capital navigate this labyrinth of financial regulation. There’s no one size fits all approach. Some businesses can raise money outside of the financial regulatory perimeter. Others will be within it. But either way, you need to know the rules of the road and we’re here to help with directions. Think of us as your financial regulatory SatNav!

Hill Dickinson has significant experience advising early-stage companies raising capital, particularly university spin-outs in the technology and healthcare sectors. As well as advising on the legal documentation once an investment is secured, we can also provide specialist advice at an early stage in a company’s lifecycle to help position it in a strong position when seeking initial investment.