There are two principal aspects to consider when working out whether your company is correctly structured and ready to raise money. The first is whether you should have a limited company and the second is how the equity should be structured within the limited company. If you get this right, it will save you stress and money down the line and you will impress investors with your foresight.

1. Why start a Ltd Company?

Setting up as a sole trader and simply registering your business name is the quick and easy solution if you are the only owner of the business. By doing this, you maintain complete control over the business, keeping all the profits after tax. In the eyes of the law, you and your business are the same thing which means that if the business runs into trouble, you will face all the legal and financial responsibility.

In contrast, a limited company is a separate legal entity to its directors, limiting how much the owner is liable if the business runs into trouble. This structure could be more tax-efficient: the profits belong to the company not you; consequently you are paid as an employee, as well as a shareholder, if you take that option, which allows you to take dividends as well. 

Setting up a limited company is more expensive and time-consuming than registering as a sole trader, but ultimately, it mitigates your personal risks. If you are registering a limited company for the first time it may be wise to seek a professional advisor like an accountant.

Running your business as a limited company can create a solid foundation on which to grow and provide a good legal and financial base to start from. It is an exciting moment when you form something that is yours to develop; and it brings with it the opportunity for financial gain as your business grows.

Pros:

 Credibility

 Higher take-home pay

 Lower personal financial risk

 Various Tax planning options are available which can save you money

Cons:

 Administration- statutory obligations (e.g. submission of annual accounts, corporation tax returns, VAT Returns) can be a real headache

 Costs - higher accountancy costs and higher penalties if you get things wrong

 Directorship - Directors are obligated under the Companies Act 2006

 IR35 - you have to prove that you are genuinely self-employed

Information on how to set up a Ltd Company in the UK can be found here.

In conclusion, if you see your company growing into a large operation with multiple investors and employees then it is probably a good idea to register as a limited company before your fundraise. This will have the added benefit of making your equity structure (see below) easier to work out.

2. Equity Structuring:

To avoid costly and potentially fatal arguments down the line, it is essential to get your equity structures right from the start. To an outsider, these structuring tools can seem complex and intimidating, but once you get your head around them, they will likely save you a headache later on. The principal equity structure between founders and partners is called vesting; this is common practice in the US, but some law firms in the UK still claim it is unnecessary.

This is because it is not standard legal practice as it is in the US and so has to be written into the shareholders’ agreement. Lawyers see it as an over complication when in fact it is fairly simple and makes everyone’s lives easier down the line.

When it comes to terms of equity, there are three things to understand:i. Vesting, ii. Cliffs, and iii. Acceleration. (For all the examples below assume there are two co-founders splitting their company 50/50).

These three equity terms avoid the issues that arise if one of the co-founders decides to quit early on, running off with half the company’s stock/equity. If that were to happen with no equity terms in place, the remaining founder would be in trouble, left without sufficient equity to incentivise new team members and/or offer to investors; and even if he succeeds against the odds under these circumstances, the other co-founder who ran off and contributed nothing still owns half the company!

i. Vesting:

Vesting solves this issue. Everyone with equity should therefore be vested.

In our example of two co-founders, vesting means that instead of each person getting their 50% immediately, they are given it regularly over a period of 4 years. That way, if one leaves after 6 months, he would have only earned 1/8th of his 50% equity stake (6.25%). If he leaves after 3 years, he is entitled to ¾ of his 50% (37.5%).

This works to motivate founders to contribute and commit to the project in order to earn their full equity share.

ii. Cliffs:

The only problem with vesting on its own is that it can lead to lots of people owning small percentages in the company. This can make any future legal work time-consuming and generally unpalatable.

Cliffs solve this.

Cliffs allow you to ‘trial’ a hire or partner without immediately committing equity. You can agree on the equity amount and the vesting period from the start to help motivate the new team member, but if you part ways, for whatever reason, during the agreed cliff period, then they are not entitled to their equity.

If we add a 1 year cliff to our 4 year vesting period between two co-founders, then if one leaves after 6 months they receive no equity. But as soon as 1 year is reached and the cliff period is over, they receive a full ¼ of their 50% equity share. Then the regular instalments of equity are drip fed over the remaining 3 years of the vesting period until the end when they are entitled to their full 50% irrespective of whether they then leave or stay.

iii. Acceleration:

Advisors get an extra term to their equity agreement. This is called ‘acceleration’ and is usually termed ‘full acceleration on exit’.

This simply means that if the company is sold, merged or achieves IPO, any advisor immediately receives 100% of their promised equity, even if their vesting period is not finished.

This is the standard format and for good reason as it makes logical sense as both a security and motivational structure.

There are more complicated versions called ‘triggers’ whereby equity is delivered not on a time passing basis but by hitting pre-agreed revenue targets, for example. This can make sense but obviously is less simple and less reliable as a structure than time.

Further tips:

Founders are often tempted to give themselves shorter vesting periods, using the logic that you get more equity more quickly. There are two risks associated with this: 1. One of the founders can run off with a large proportion of the company at an early stage; 2. Potential investors will often take a dim view of an overly generous vesting structure- they want to see a founder who cares about the company not about himself!

Cheat sheet for Equity Structures:

Founders: 4 years vesting, 1 year cliff for everyone

Advisor terms (0.5-2%): 4 (or 2) year vesting, optional cliff and full acceleration on exit.