All new businesses need money, and many entrepreneurs are only too eager to start raising funds for their new venture before taking time to understand the legal ramifications and to work out answers to the basic questions they will almost certainly face in conversations with potential investors. Funding for most new businesses comes from a variety of sources, including self-funding, friends and family, angel investors, venture capital investors, private equity investors, and strategic investment by companies in your same industry. Understanding the terminology, structure, timing, and return expectations associated with these various potential sources of capital will help you make better choices in selecting the source of funds for your new venture. The terms upon which you receive investment capital will impact you and your business at various points along the journey. Understanding how to source and utilize these resources wisely will position you to enjoy the fruits of your labor in a more lasting and meaningful manner.
Raising the capital required to launch your new venture is often the first of many challenges that you will face in your great adventure as an entrepreneur. While there is not a one-size-fits-all trail map for the startup company lifecycle, most entrepreneurs should be familiar with the following basic concepts.
Types and Source of Funds
Bootstrapping your new venture through credit cards and second mortgages is certainly an option, but most entrepreneurs prefer to raise initial investment capital from third party “friends and family,” which often provide a sympathetic audience willing to invest in you as a person even if your “sound business plan” has obvious gaps. This stage of funding is sometimes referred to as a “seed” round of financing. Early-stage companies occasionally issue common or preferred stock (corporation) or common units (LLC) to seed-round investors, but more commonly issue convertible and straight promissory notes. A convertible note is a debt obligation with a principal amount that accrues interest at a fixed rate and is payable on a specified maturity date, but the note will convert into equity either in your company’s next equity financing or upon a change of control. Entrepreneurs and investors focus special attention on various issues related to the timing and terms of the conversion events, including whether conversion is mandatory or optional, whether accrued interest must be paid in equity or cash, whether the note will convert into equity at a discount, and what happens if the company fails to complete an equity financing before the stated maturity date.
In 2013, the Silicon Valley accelerator Y Combinator created the “simple agreement for future equity,” or SAFE, as a new financial instrument to simplify the process of investing in an early-stage company. In concept, the SAFE is a warrant to purchase stock in the future. The SAFE concept has been expanded to include many of the same attributes available to investors in convertible preferred notes, except that SAFE investments generally do not have a maturity date and do not accrue interest.
A seed round may also include investment by an angel investor network such as AIM, a network of early-stage technology investors, and other early-stage investors. Equity-focused early-stage investors often prefer to invest in convertible preferred stock, which are equity securities that convert to common stock on the occurrence of certain events in the future. As discussed below, convertible preferred stock is an equity security that has rights, preferences, and privileges senior to common stock. Seed-stage convertible preferred stock usually does not include some of the more complex features referenced below that are customary for institutional investors.
Once your company starts to build momentum, you may be able to attract attention from institutional venture capital funds that focus on investing in early-stage companies and from private equity funds that typically invest in growth-stage companies. In most cases, institutional investors structure their initial round of investment as Series A convertible preferred stock. The basic terms and conditions of a Series A preferred stock investment are largely standardized today, in many cases using a variation of the model legal documents made available by the National Venture Capital Association. The initial terms are usually set forth in a term sheet, which describes key concepts such as the (a) liquidation preference, which defines the priority return to be received by preferred stock investors prior to distribution of the proceeds of a sale or liquidation of the company to holder of common stock, (b) dividend yield, which often accrues and compounds, (c) terms upon which the preferred stock will or may convert to common stock, (d) anti-dilution protection, which adjusts the purchase price of the preferred stock if the company later issues common or preferred equity at a lower price, and (e) investor protective provisions and governance concepts designed to give holders of preferred stock rights and protections superior to those of common stockholders with respect to certain matters. A Series A preferred stock financing may include some combination of the following documents:
· Term sheet;
· Amended and Restated Certificate of Incorporation;
· Series A Preferred Stock Purchase Agreement;
· Investor Rights Agreement;
· Registration Rights Agreement;
· Voting Agreement;
· Right of First Refusal and Co-Sale Agreement;
· Management Rights Letter; and
· Ancillary documents, including corporate minutes, closing certificates, legal opinions, and related documents.
Depending upon the lifecycle of the company, it is possible that the Series A round will be followed by subsequent rounds of convertible preferred stock, typically named with sequential letters (e.g., Series B, Series C). Each of these subsequent rounds of financing is usually at a higher valuation than the previous round. It is not uncommon for growth-stage companies to move through several rounds of preferred stock fundings, with investors in these subsequent rounds usually focusing on voting thresholds for certain actions, representation on the board of directors, and protective provisions for investors. On occasion, a company may return to use of convertible preferred notes as a form of bridge financing between equity rounds (called “bridge notes”).
Commercial banks rarely make substantial loans to venture stage companies, but there are specialized venture lenders who provide capital to growth-stage companies, normally after they have successfully completed at least one round of preferred stock financing through institutional investors.
Tax and Securities Law Considerations
The sale and purchase of common stock or LLC units by a company raise specific issues under federal and state tax and securities laws. From a tax perspective, investors are keen to ensure that investing in your company will not create a taxable event. For example, investment in a pass-through entity such as an LLC creates the potential for “phantom income,” which no investor wants and will require provisions to protect the investor, such as mandatory tax distributions.
From a securities law perspective, the company is keen to ensure that raising capital through the sale of securities will not constitute a public offering triggering a cumbersome and expensive registration process under federal securities laws. The offer and sale of any security by your company are required to be registered under federal and state securities laws unless the offering qualifies for an exemption from registration. There are a number of exempt securities and exempt transactions, but the most widely-used exemption is the Rule 506(b) exemption under federal law. This exemption pre-empts state scrutiny of the offering, and, if you offer your securities only to accredited investors, Rule 506(b) does not dictate the form of disclosure document to be given to each prospective investor. For this reason, an accredited-only Rule 506(b) offering can usually be done more quickly and with less cost than other exempt offering transactions.
As with each stage in your journey as an entrepreneur, carefully planning, documenting, and executing your funding strategy will yield the best results over time and position your management team and investors well to benefit from your great adventure. Safe travels!