Last week, with General Assembly, Priori Legal hosted a seminar for entrepreneurs looking to raise funding for their startups. The event concluded a three-part series in which Priori’s network lawyers educated startup founders about the legal aspects of getting their business up and running.
In the final seminar, Priori lawyer Gary Ross and Galvanize Venture Capitalist and Director Kate Shillo detailed the stages and instruments of fundraising, what’s needed before seeking investment and how to structure your relationship with investors. If you weren’t able to join us, below we detail the five key takeaways that every startup founder needs to know about fundraising.
5 Key Takeaways That Every Startup Founder Needs to Know About Fundraising
1. The Rounds of Financing
- Bootstrapping - running your business solely on the contributions of founders. Founders typically contribute financially with personal income and savings and/or with their own labor or “sweat equity.” Bootstrapping might be impossible for certain types of businesses that require large amounts of capital early. But if you are able to run your business without raising funds, you’ll be able to maintain ownership and control.
- Friends and Family - reaching out to your personal network can provide a great source of early funding for your business. However, be wary of letting the informality of your relationship prevent you from taking the necessary legal formalities to memorialize the terms of the agreement.
- Seed - from firms or individual investors, commonly referred to as angel investors, who provide financing to early-stage companies in exchange for equity or convertible notes. Because this round occurs while companies are still in their infancy, investment involves a high degree of risk for investors and therefore may require a high rate of return and/or significant involvement. Some post-seed round companies may also attempt to raise a bridge round to utilize additional capital to gain traction or scale prior to the first round of series funding.
- Series Rounds (A, B, C, etc.) - venture capitalist and other institutional investment occurs in a series of rounds that reflect a company’s valuation. For growing businesses with higher valuations, a later round raise will result in higher contributions from investors for smaller stakes. Alternatively, for less successful companies or companies who didn’t meet their growth projections, later rounds can be ‘down’ rounds where the price decreases with a lower valuation.
2. The Instruments of Financing
- Equity Financing - raising funds through the sale of an ownership stake or stock in your corporation. While equity financing avoids showing debt on your books and the risk of needing to pay back a loan, it also requires you to give up an ownership stake in your company. Moreover, the actual cost of the equity given can be unknown until determined by future valuations or sale of the company.
- Common Stock - the stock provided to founders (and any other stockholders) at the outset of a corporation's creation. Common stock provides voting rights and should be accompanied by a Stock Option Plan that defines the vesting schedule. Common stock is diluted by all subsequent equity investment.
- Convertible Preferred Stock - a form of stock that can only be issued after valuation and that gives the holder the option to convert preferred shares to fixed number of common stock. Usually, convertible preferred stock is offered during series rounds to give VCs voting rights and the ability to convert to common stock when they are ready to exit.
- Debts/Note Financing - enables you to retain your business’s ownership, control and profits, but requires repayment of loan at a set installment plan and a specified interest rate, regardless of the business’s success or failure. Unlike equity financing, debt/note financing does not require you to determine a valuation for your company. Rather, to secure debt financing the business’s assets, and even a personal guarantee from a founder, may be necessary.
- Bank loans - there are local and regional banks that specialize in loans for small businesses. There is also U.S. Small Business Administration loan program; however, to qualify your business’s net income must be positive.
- Convertible Promissory Note - a form of short-term debt, that does not require the company to make regular payments, but instead allows the investor to convert the debt into equity at some point in the future. Typically, the period for conversion is based on specified length of time (maturity term) or the raising of a specified amount in a future equity round (qualifying financing), or whichever comes first. If the trigger or triggers for conversion are not met, then the investor can call in the debt and the company must pay the loan back with interest. Despite its growth in popularity, convertible debt carries some risks of which founders should be aware. Because it may be converted to equity, a convertible note carries the same risks of dilution and ownership as equity shares. In addition, convertible notes show up as debt on your balance sheet, which may make seeking investment from other lenders more challenging.
- Simple Agreement For Future Equity (SAFE) - an instrument that converts to equity like a convertible promissory note, but removes the debt component of a convertible note. With a SAFE, an investor provides capital to a company in exchange for the promise of receiving future equity in the company. But, unlike a convertible promissory note, if the trigger to convert the debt to equity is not met, the company is not required to pay off the original loan.
3. What You Need Before Approaching Investors
- Get your financial house in order! Before you start raising funds from outside investors, you’ll need to have your financial books in order. Investors will want to review your balance sheet, your cap table (your record of shareholders) and your future projections. Understanding your financials will enable you to clearly convey your short and long term business plan to investors. It will also allow you to better understand your business fundraising needs, including how much you should raise and through what instruments.
- Get your legal house in order! It’s necessary to have completed legal formalities prior to seeking investment. This includes properly forming your business as a legal entity (most VCs prefer Delaware C-corps), having corporate bylaws or an operating agreement in place, protecting your various forms of intellectual property and ensuring your business complies with tax regulations and any other regulatory requirements. Hiring a lawyer to help start your business will prevent you from scrambling to establish your legal foundation when you need to fundraise.
- Know your investors! You should research any investor you are meeting with to develop an understanding of their experience and background. Investors want to know why you are meeting with them as opposed to the other investors. Being able to highlight why a particular investor is the right fit for your company with concrete examples from his or her past investments or advisory roles will go a long way in successfully raising money.
4. How to Structure Your Relationship With an Investor
Prior to seeking investment, a lawyer can draft a term sheet that details the basic relationship between you and a prospective investor. The term sheets will outline the broad parameters of an investment agreement to make it easier for the parties to negotiate. Here are are some of the key components that may be included in your term sheet.
- The Basics - a term sheet will first include the details of the investment. Depending on the type of raise, this may include the total amount of financing to be raised in the round, the purchase price, interest rate and the terms of maturity.
- Valuation - one of the most important and negotiated provisions of a term sheet. It establishes, often through estimation, the value of your company before the investment. A lower valuation increases the cost of investment for founders because it creates greater dilution of ownership. You’ll need to clearly demonstrate to potential investors on what your valuation is based or you may want to consult an independent valuation firm to determine your company’s value.
- Board of Directors - details the makeup of the board and whether the investment includes a seat.
- Liquidation Preference - provides an investor with the right to receive a return on investment prior to other investors in the event of a liquidation or sale of the company. This term will usually specify a multiple on the original investment on which the return shall be paid (1x, 2x, etc.)
- Protective Provisions - commonly referred to as veto rights because these provisions give the investor the right to oppose specified corporate actions, such as the sale of the company.
- Founder Vesting - if not already in place as described below, investors will require founders to reinvest their equity over a schedule of time to ensure the commitment of the founding team. For example, a founder might have access to only 25 percent of his or her shares at the time of the investment, and then an additional 25 percent of the shares with the passing of each year if still working for the company.
- Antidilution Protection - protects the investor from future sales of preferred stock at a lower valuation, which usually means adjustments to the price at which preferred stock converts to common stock.
- Exclusivity - prevents founders from talking with other investors for a specified period of time after the term sheet is signed.
While you can familiarize yourself with the term sheet terminology and even use an online resource to generate a term sheet for your company, there is no substitute for legal advice, drafting and advocacy at the negotiation table from an experienced lawyer.
5. The Common Pitfalls to Avoid When Fundraising
- Not having a vesting table! Your company should establish a vesting table for issued stock to employees. Without a vesting table, employees (or even cofounders) can cash out the total number of shares received without working long enough to contribute the equivalent value of those shares. Your vesting table should detail when and what percentage of the shares vest, as well as address whether there are any events that might accelerate the vesting schedule, such as early termination without control or change in control.
- Failing to communicate with investors! You want to have an honest and open line of communication with your investors from the outset. Transparency with your company’s financials, assets and team will enable investors to better understand your company’s vision and whether it’s the right fit. In addition, it will open up a line of communication that may lead to invaluable advice throughout your company’s life. Your investors can provide connections and expertise to help your business to grow. If your company falls on hard times, investors can also help with bankruptcy, the active mergers and acquisitions market and even assist or fund your next venture.
If you have any questions on how your company can prepare for its first or next round of financing, a Priori lawyer can guide you through the steps needed to approach investors and structure your investments to best prepare your company for success.
To learn more about how to start your company up the right way, review our recaps from Phase 1 and Phase 2 of 'Starting up Smart! A Legal Foundation for Entrepreneurs’.