Financing a startup business may seem straightforward, but it’s a complex process, and not a do-it-yourself project. Startups need to consider federal and state regulations when raising funds in order to avoid penalties.
There are other risks, too, such as choosing investors poorly, or failing to negotiate the deal terms and documents in a way that protects your business. By approaching financing in a thoughtful and systematic way, startup founders can maximize the chances of success.
Before Talking to Investors
Startup founders must do their due diligence before diving into a financing round. So, before seeking financing from investors, here are some key factors worth familiarizing yourself with to ensure the success of your fundraising endeavors.
Choosing the appropriate investment vehicle. While there are plenty of methods to raise capital, it’s crucial to select the most appropriate option for your situation and the amount of money you are raising. Here are several common investment options entrepreneurs use when fundraising:
- Convertible notes have been widely used by startups raising less than $1 million. They are loans that will convert into equity through a future triggering event (typically an equity financing), and the legal fees to close a round are relatively low. Plus, you can postpone equity valuation, which can be particularly difficult for an early-stage startup. The drawback is that convertible notes are still debt with a maturity date, by which you must either repay the invested amount plus interest, or negotiate an extension with your investors.
- Simple Agreement for Future Equity (also known as SAFEs) also are commonly used in early stages. They are not loans and therefore don’t have an interest rate, but they convert to equity through a future triggering event. Legal fees to close a SAFE round are generally pretty low. There are several versions of SAFEs, and you should work with an attorney to choose which one is best for your company, rather than just downloading something from the internet. Post-money SAFEs can cause excessive dilution to founders, if used without modifying certain provisions.
- Preferred stock is often used when raising over $1 million. Preferred stock gives investors more rights than common stock, such as liquidation preferences, anti-dilution protection, co-sale rights, etc. The terms and documentation associated with preferred stock financings are highly complex and detailed. Because of the time and expertise required to formalize the deal, legal fees are typically much higher than for convertible notes and SAFEs.
Selecting Suitable Investors
Talking to the right investors is vital. Ideally, you should work only with “accredited investors” – investors that have a net worth or annual income above a specified level. Because accredited investors have a special status under SEC regulations, you can avoid having to put together extensive disclosure documents about your business.
You also don’t want to talk to all investors. You need to identify investors that are appropriate for your business. Someone who invests solely in biotech startups will not be interested in an eSports startup. By narrowing the pool of investors to those who have previously financed startups in your industry, you make it easier on yourself to target the most likely investors.
The final aspect of choosing the right investors is taking the time to vet your investors. You should be examining the types of companies a potential investor has invested in previously, and what kinds of value-adds the investor brings to you beyond just money. In addition, you should be talking to the founders of other startups the investor has invested in, to find out what their experience with that investor has been like.
“The investor is investigating your background and experience, and you should be doing the same with your investor.” – Paul H. Spitz, Kinetic Law
Negotiating a Term Sheet
A term sheet is a non-binding document that summarizes the terms and conditions of the deal between you and the investors. It irons out the agreement’s details before placing those terms into a legally binding contract. Although it is largely non-binding, certain terms will be considered binding, such as confidentiality provisions. In addition, although non-binding, the term sheet tends to constrain the parties from trying to deviate from what has been agreed to, when preparing the definitive deal documents. Not understanding the provisions of the term sheet can result in a founder agreeing to terms that are unfair, or inappropriate for the size of the deal.
Let’s say you are doing a SAFE financing, and the investor added a term requiring your company to pay up to $60,000 of the investor’s legal fees. If this term sheet is your first rodeo, you might not know if this is excessively high or inappropriate (it is!). There are many other complex terms involved in financings, and taking the time to work out the details at the term sheet stage will benefit you later when preparing the definitive deal documents.
One common trap startup founders may encounter is when the potential investor says either “you can just use my lawyer for this deal” or “you should use so-and-so as your lawyer.” You might assume that because investors and founders have the same objective when negotiating a deal, using the investor’s lawyer or someone recommended by the investor will be fine. However, investors are pros when it comes to making deals. They look at term sheets every day and have seasoned attorneys who know their way around deal negotiations when financing a startup business.
In addition, the investor’s attorney has an inherent conflict of interest, and cannot truly represent both the startup and the investor (no matter what they tell you). This dynamic puts startup founders at a disadvantage right off the bat if they choose to use the investor’s attorney, or even an attorney recommended by the investor. That attorney that the investor recommends is dependent on those referrals from the investor, and will be reluctant to negotiate well on your behalf, for fear of cutting off the deal flow. Therefore, having your own experienced startup attorney on your side of the table will ensure terms are favorable, and the deal benefits all parties.
Drafting and Negotiating the Investment Documents
After the term sheet has been signed, the parties will begin drafting and formulating the legally binding contracts. While the term sheet provides a blueprint of the terms and conditions of the final agreement, the investment documents will go more in-depth and provide the detailed terms of the financing.
The type of transaction will determine the amount of documentation involved. For example, convertible notes and SAFE financings usually only need one relatively short document – the convertible note or SAFE itself. On the other hand, preferred stock financings require numerous, complex investment agreements.
Closing the Financing Transaction
Closing is a crucial time in the financing – it’s the home stretch. Legal due diligence, including reviewing contracts and confirming the accuracy of the information in each document, is vital to closing the deal and avoiding any post-closing issues with investors. Getting all the documents signed and money wired into your startup’s account is the culmination of all the hard work, giving you the runway to take your business to the next level.
Paul H. Spitz is the founder and owner of Kinetic Law LLC. Paul has years of experience counseling entrepreneurs and startup founders on business and corporate law issues. He has helped many startups with business formation and structure, debt and equity financing, drafting, reviewing, and negotiating essential documents and contracts, and general counsel services. Kinetic Law is based in Cincinnati and serves clients throughout Ohio, the US and other countries via its virtual platform.