Updated as at 1/8/2001.

1. FUNDING ALTERNATIVES

Information technology and other growth-oriented businesses may achieve cost effective capital raising through:

(a) private capital raising;
(b) government innovation initiatives;
(c) venture capital funding;
(d) Initial Public Offering (IPO); or
(e) strategic alliance.

2. PRIVATE CAPITAL RAISING

(a) General prohibition on new capital raising without a disclosure document

If an offer of securities requires disclosure to investors, a person must not make an offer of securities or distribute an application form for an offer of securities unless a disclosure document is lodged with the Australian Securities and Investments Commission (ASIC) (1).

Generally, all offers to issue securities require disclosure unless exempted by the Corporations Act 2001 (2).

(b) Types of disclosure document

The most likely form of a disclosure document for start-ups is either a prospectus, or offer information statement (OIS), depending on the offer (3). However, most start-up funding is undertaken without a disclosure document, instead relying on one or more of the Exemptions.

(c) Securities offers not requiring a disclosure document under the Corporations Act 2001 (4)

Any offer under the following do not require a disclosure document:

* "20/12/2" rule
* Sophisticated investors
* Executive officers
* No consideration.

Other exemptions not covered here are provided for in Corporations Act 2001 (5).

* "20/12/2" Rule

No disclosure document is required:

(i) if the offers made are personal and the result in that fewer than 20 people have been issued securities in any 12 month period.

An offer is personal if:

* the person who accepts the offer is the person who received it; and
* the making of the offer is a result of previous personal or professional connection with the offeror or from statements or actions by that person indicating an interest in receiving offers of that kind (6).

(ii) if the issue of securities to 20 or fewer persons raises no more than $2 million in a rolling 12 month period. In working out the amount raised, included are amounts payable on exercise of options, possible calls on partly paid shares, and any amounts payable on conversion of a convertible security.

* Sophisticated investors

No disclosure document is required to raise funds from sophisticated investors.

Sophisticated investors are those who:

(i) invest at least $500,000 either in the present issue or when added to past investments in the offeror by that investor exceed $500,000; or

(ii) have net assets of at least $2,500,000 and have gross income in the previous two years of at least $250,000 per annum (proved by a certificate from a qualified accountant no more than 6 months old to the date of issue)(7).

In calculating the $500,000 amount, any amount payable in the future, such as on exercise of options or payment of calls on partly paid shares is not included.

* Executive Officers

No disclosure document is required for an offer to an executive officer of a company or his or her spouse, parent, child, brother or sister, or an offer to a body corporate controlled by any of them (8).

* No Consideration

No disclosure document is required if no consideration is given on issue of the securities (or in the case of options on exercise either)(9).

(d) Security Hawking

It is an offence to offer securities for issue or sale during or resulting from an unsolicited meeting or telephone call with another person unless the offer is made to a sophisticated investor (see above) or is an offer of listed securities made by telephone by a licensed securities dealer (10).

(e) Disclosure Documents

* General prospectus disclosure test

In broad terms a prospectus must disclose all the information that investors and their professional advisers reasonably require to make an assessment of:

(i) the rights and liabilities attaching to the securities offered;
(ii) the assets and liabilities, financial position and performance, profits and losses and prospects of the body that is to issue (or issued) the shares, debentures or interests.

Profit forecasts and other forward-looking statements in a disclosure document must be based on reasonable grounds.

* Persons liable for all statements in a prospectus

The issuer corporation, its directors, persons who have consented to become directors, and the underwriters of an issue will be liable to investors for misleading statements in or material omissions from the prospectus (subject to the due diligence defence described below). They are also liable for the failure to make investors aware of new material information that comes to light after a prospectus has been lodged with ASIC.

* Professional advisers and experts

Professional advisers and experts involved in the preparation will be liable to investors only for misleading statements attributed to them in the prospectus (subject to the due diligence defence described below).

* Due diligence defence

A defence is available to the offeror corporation, its directors, underwriters, experts and advisers if they made all reasonable inquiries and after doing so, believed on reasonable grounds that:

(i) in the case of a misleading or deceptive statement, the statement was not misleading or deceptive, and
(ii) in the case of an omission from the prospectus there was no omission from the prospectus in relation to that matter (11)

A director or expert who has consented to being listed in the prospectus may publicly withdraw that consent and avoid liability.

* Fundraising up to $5 million under an Offer Information Statement (OIS)

A corporation can use an OIS to raise up to $5 million (during its life). The $5m. amount includes all amounts raised by a related body corporate; or an entity controlled by a person who controls the body or an associate of that person.

An OIS must identify the offeror, the nature of securities and the nature of its business and describe what the funds are being raised for. It must also state the nature of risks involved in investing in the securities and give details of amounts payable in respect of the securities (including fees and commissions and charges). The document must also expressly state that it is not a prospectus and has a lower level of disclosure than a prospectus and state that investors should obtain professional investment advice before accepting the offer. The due diligence inquiries imposed on the body making offers under the OIS and its directors are less onerous than those for a prospectus, turning principally on actual knowledge of the person rather than knowledge after specific enquiry.

An OIS must include a financial report for the body for a 12 month period with a balance date within 6 months of the date the securities are first offered under the OIS, and must be prepared in accordance with Accounting Standards and must be audited (12).

* Electronic disclosure documents

See Corporations and Securities Law fact sheet.

3. GOVERNMENT INNOVATION INITIATIVES

The Commonwealth government currently maintains Innovation Investment Funds (IIF), provides Research and Development (R & D) Start Grants and administers the Building on IT Strengths (BITs) program.

AusIndustry http://www.ausindustry.gov.au. administers the IIF program. The first round of the IIF involved $130 million Commonwealth funding matched on a maximum 2:1 basis with private capital. A second round of $91million is now underway.

BITs is a $158 million initiative administered by the Commonwealth Department of Communications, Information Technology and the Arts (see http://www.dcita.gov.au/bits). It has three core elements:

(a) Incubator Centres in each State and Territory to assist IT&T small to medium enterprises ($78 million);
(b) support for the development, trial and demonstration of test-beds and advanced information infrastructures ($40 million); and
(c) development of Tasmania as an intelligent island($40 million).

The R&D start program administered by AusIndustry provides grants and loans of up to $15 million for research and development. Grants typically range between $50,000 and $5 million. The recipient of an R & D start grant will generally be required to commercialise project intellectual property (IP), meet project milestones and restrict dealings with project IP. A recipient in breach of funding conditions may be required to repay the grant and the government may be entitled to claw back project IP. Applications can be submitted to AusIndustry any time throughout the year. The Industry Research & Development (IR&D) Board's committees meet regularly to consider projects, with smaller projects being considered every two weeks and larger projects every six to eight weeks. Further information can be found at the R&D Grants and Loans section of the AusIndustry website.

4. VENTURE CAPITAL FUNDING (13)

(a) What is venture capital?

Venture capital involves funding high growth private companies, particularly in the information technology and e-business industries. Venture capital offers medium term equity finance and does not require regular interest payments. Venture capital can provide a number of value added services including mentoring and the introduction of strategic alliances.

Venture capitalists, that is the high net worth individuals or companies who provide the capital, generally take a substantial but minority share in the company and usually do not seek day to day control of a business. They generally appoint a representative to the board of directors and require input and in many cases retain veto rights over key strategic decisions.

(b) Stages Of Growth

Venture capitalists categorise companies into four stages of growth:

* Stage one, Seed: the business is little more than a concept, the product is in development and the company is concentrating on research and producing a working model or prototype. The founders will fund the business from personal funds, typically requiring between $50,000 to $500,000.

* Stage two, Start-up: known as the "Angel round", the concept or product has been developed but the company has no track record and often has not made a profit, thereby making more traditional funding difficult to obtain. This is the riskiest stage for investors. The company needs a large amount of capital (typically between $500,000 to $2 million) but has no reliable indicators of its future success. Many businesses fail during this phase.

* Stage three, Expansion: known as the "second round" and may comprise multiple rounds before stage four. The company is fully set up, has usually received some funding and is building a financial track record. The company however, needs further funding (typically between $2 million to $10 million plus) to expand existing operational and marketing capacity. Some companies choose to meet financing needs with traditional bank finance (note that a bank will usually require personal guarantees from directors together with collateral).

* Stage four, Mezzanine: known as pre-Initial Public Offering (IPO) funding (typically between $10 million to $50 million and up). Funds are used to prepare for IPO, including strategic acquisitions. Mezzanine investors may provide experience in the IPO process; for example, the company is "dressed up" for listing by introducing recognised business people to the board.

The steps typically involved in a venture capital investment are:

(c) Prepare a business plan

Business plan should include: a company background and looking forward statement, a product or service description, a market analysis (industry size, competitors, market share, customers, barriers to entry and growth, distribution channels), a marketing plan, a description of the manufacturing process and participants, the status of research and development, a management profile, a risk analysis, a summary of past and projected financial performance, a statement of funds required, capital and corporate group structure before and after financing and company details (directors, shareholders, lawyers etc).

(d) Select suitable venture capital funds

A company seeking funds should consider the investment preferences of the various venture capital funds, the quality of the relationship between the management team and the investor, the ability of the fund to provide future funding, the investment exit horizon and the value the investor can add through industry experience, contact networks and expertise in start-up financing.

The fund should be a member of the Australian Venture Capital Association Limited (AVCAL), which has adopted an industry Code of Conduct.

(e) Submit your business plan for evaluation

Submitting unsolicited business plans is unlikely to secure funding. Attract an investor's attention by way of introduction by a third party who has a relationship with the fund.

(f) Negotiating valuation

Valuation is generally based on management's own projections and deals negotiated in the industry by other companies, supported by the financial and legal due diligence and based on reasonable assumptions.

Other issues include: restrictions on the founder's shares, the investor's ability to introduce strategic partners and the preferential rights attaching to the investor's shares.

(g) Negotiate a Terms Sheet

A terms sheet sets out the terms of the deal until parties negotiate detailed legal agreements. Term sheets can be legally binding and care must be taken to be certain of the legal status of the term sheet. A term sheet typically includes provisions on:

* Form and size of the investment in the number and amount of ordinary shares, preference shares or convertible notes;

* Investor Protection - any preferential right to dividends, preferential right on a liquidation or winding up of the company, right to convert preference shares into ordinary shares, anti-dilution measures to prevent diminution in price or underlying value of shares resulting from any future share dividends, share issues at a discount, share splits, reverse splits or similar recapitalisation;

* Investor board representative - the investor typically wants a board representative and may recruit additional management executives. It may specify that certain decisions have to be made by a special majority of directors (ie a majority including its board appointees);

* Information rights in the investorís right to financial statements, budgets, business plans;

* Pre-emptive rights - the investor's right to invest in future issues of shares or debt raisings in preference to a third party;

* Exit strategies - the investorís right to force a trade sale or IPO on a public stock exchange if such an event has not occurred within 3 or 4 years of the investment; and

* Exclusivity period - in which the venture capitalist may conduct due diligence inquiries and negotiate the investment and management agreements.

Venture capitalist may require the following:

(i) investment made in stages (tranches), each stage conditional upon the company achieving certain milestones;

(ii) the company must buy back or redeem the venture capitalist's shares if an IPO or trade sale has not occurred by a certain date;

(iii) a "drag along" clause compelling all shareholders to sell their shares if more than a specified percentage of shareholders (usually a majority) accept a third party offer;

(iv) founding shareholders agree to a standstill provision which prevents them from selling their shares in the company for a period of time;

(v) key executives sign appropriate executive service agreements;

(vi) assurance that the company has sole legal and beneficial ownership of the intellectual property rights.

When negotiating terms for early round funding, note that future investors may want the same or similar rights as those granted to early-round investors.

(h) Due diligence investigations will then be undertaken by the fund

Upon signing the terms sheet, the investor (or its agent) examines the company's corporate structure, assets, intellectual property, financial statements, material contracts, employment agreements and any actual or threatened litigation (due diligence).

(i) Negotiate and execute formal investment documentation

Upon completion of due diligence, parties typically prepare and sign the following formal legal documentation:

* Subscription Agreement in sets out the number and price of shares, funding tranches and dates of subscriptions, detailed warranties concerning the company, rights attaching to shares, and conditions precedent to funding;

* Shareholders Agreement in sets out ongoing relationship between the Shareholders and the company as agreed in the Terms Sheet;

* Intellectual Property Acknowledgment Deeds - acknowledgment by other parties they have no rights in any intellectual property which they developed and assign all such creations to the company; and

* Executive Service Agreements - will bind "key" employees to the company for a period (usually two or three years), and will set out the employees' terms of service, remuneration, and bonus entitlements.

5. STRATEGIC ALLIANCE

A company considering a strategic alliance with another company should ensure the following issues are covered in the agreement establishing the venture:

(a) Business vehicle

May be incorporated or unincorporated, partnership, trust or company, agency or representative relationship. Seek tax advice before deciding.

(b) Business issues

The contributions of services and capital and responsibilities of each shareholder to the joint venture (JV), provision for further funding and other contributions, and default financial provisions to ensure venture continuity.

(c) Shareholder relationship

Share purchase or share issue, identity of shareholders, constitution, rights attaching to various classes of shares, number and class of shares to be subscribed for by each shareholder and any restrictions on transfer.

(d) Board of directors and company officers

The number, nomination and removal process of directors, director's fees and expenses, powers and responsibilities and procedures for holding directors meetings and making resolutions.

(e) Other issues

Control provisions such as minority rights, dividend policy, financing, general exit strategy and termination provisions, management of the company and customer ownership.

(f) Regulatory issues

E-commerce spawns joint ventures and alliances between competitors. Such alliances must not infringe the per se prohibitions against price fixing and group boycotts under the trade practices legislation.

Price fixing for the purpose of a joint venture or in relation to pricing by joint buying groups or joint advertising of sale price of goods or services collectively acquired may not infringe the trade practices legislation.

Consider structuring the venture as follows: the competitors are related corporations in relation to venture, vertical exclusive dealing conditions are imposed and a right to terminate exists in the event of conduct against the interest of the joint venture or alliance (14).



Other relevant Fact Sheets:

Sources of Law
Trade Practices Act 1974 (Cth)
Corporations Act 2001

End Notes
1. Section. 727(1) Corporations Act 2001
2. Sections 706 and 708 Corporations Act 2001
3. Section. 705 Corporations Act 2001
4. Ibid section 708
5. Section 708 Corporations Act 2001
6. Section 708(2) Corporations Act 2001
7. Section 708(8) Corporations Act 2001
8. Section 708 Corporations Act 2001
9. Section 708(15) Corporations Act 2001
10. Section 736 Corporations Act 2001
11. Section 731 Corporations Act 2001
12. Section 715 Corporations Act 2001
13. Based on N Humphrey Venture Capital Guide (2000), Gilbert and Tobin
14. Sections 45(8), 45(6) Trade Practices Act 1974 (Cth)