Investing in a software start-up by convertible loan: what the IP due diligence found

At a glance

Our client, an established trading company, agreed to advance a low six-figure convertible loan to a software start-up that needed funding to reach its next milestone, secured by a debenture over the company. Before the money moved, we carried out corporate and intellectual property due diligence on the start-up. The report identified several issues that changed the terms of the investment, the most significant being that there was no written assignment of the intellectual property in the platform from the external developer who had built it.

The client and the objective

The investor wanted downside protection first and upside second: a loan that ranked ahead of other creditors if the company failed, with the option to convert into shares if it succeeded. For a software company the only real asset is the code and the data, so the investor's security is worth nothing unless the company owns what it is pledging.

The structure

• A convertible loan note: a loan that converts into shares on a funding round, a sale or at the investor's election, at a discount to the price paid by later investors.
• A debenture giving the investor fixed and floating charges over the company's assets. An earlier charge had been satisfied, so the new debenture would rank first.
• Conditions precedent to drawdown, so that identified problems are fixed before the money is advanced.

What the due diligence found and how we dealt with it

Who owns the platform

The software had been built by an external development company and there was no written assignment of copyright to the start-up. Under UK law the author owns the copyright unless it is assigned in writing, so the start-up was operating a platform it did not legally own. We made a written assignment from the developer a condition precedent to the loan, with the investor's security over the intellectual property only meaningful once that was in place.

An undisclosed earlier investment agreement

The company's articles referred to an investment agreement with an earlier investor that had not been disclosed. That agreement gave the earlier investor consent rights over new share issues and pre-emption rights, both of which bite on a convertible loan when it converts. We obtained the agreement, identified the consents needed, and built them into the conditions.

A cap table that did not add up

The fully diluted share capital shown to the investor did not match the company's commitments: there were allotments agreed but not made, shares reserved for others and an option pool, all of which would dilute the investor on conversion. We required a complete and warranted capitalisation table and adjusted the conversion terms to protect the investor's percentage.

Trade marks and licences

The company's word mark application had been withdrawn, leaving only a figurative mark, and a key software licence was unsigned. Both went into the list of matters to be put right, with warranties covering the position.

Cash position and ranking

The company had very little cash against a large contingent order. That is why the investment was needed, and it is also why the debenture mattered: with the previous charge satisfied, the investor's security would rank first.

Outcome

The legal due diligence report and a set of supplemental enquiries were delivered to the investor, and the transaction is proceeding on revised terms with the conditions precedent described above. This page will be updated once the investment has completed.

What this deal shows

• A software company that used outside developers may not own its own product; ask for the written assignment before anything else.
• Read the articles. If they refer to an agreement you have not seen, it exists and it matters.
• A convertible loan is only as good as the cap table it converts into.