You’re ready to raise money. Is your business too risky for investors?
When we work with companies preparing to raise money, they often have a good idea of what terms they want to offer to investors. But what you may not realize is that there are risks hiding in plain sight – incorporation or governance errors that could scare otherwise eager investors away. We work with companies to prepare for, negotiate, and close investments – with an eye to ensuring that there won’t be any surprises during the diligence process that could torpedo the deal.
Once you’ve started your company and market-tested your idea, raising money is often one of the next items on your to-do list. Lots of startups – especially those in the tech sector – rely on investments from outside investors to scale their business.
But aside from the challenge of actually finding and pitching investors, there are a ton of legal considerations that you’ll need to navigate before you get to the closing table. And many of them are more mundane than you might expect: investors are much more likely to walk away from a potential deal because of something they find during the diligence process than they are to sneak a poison pill into the documents and take over your company.
Let’s dive into the intricacies involved in raising money for your startup: options for how to structure the deal, the diligence process, and the steps you need to take to keep your company in legal compliance.
Structuring the Investment
First, let’s discuss how to structure the proposed investment. If you’re an early-stage company, chances are you’ve heard about a convertible note and a priced round, and you may have a sense of the broad differences between the two. But let’s dive into those differences a bit, and the key advantages and disadvantages of each.
A convertible note is a form of short-term debt that can convert into equity in the future. It’s essentially a loan that is intended to convert into equity upon a specific trigger event, often the next funding round.
- Key features of a convertible note include:
- Interest: Convertible notes typically accrue interest, which can be added to the principal amount or converted into equity.
- Conversion trigger: The note usually specifies the conditions for conversion, which is commonly tied to a subsequent financing round, often referred to as the “qualified financing.”
- Valuation: Convertible notes don’t require an immediate valuation of the company, making them a quicker and simpler option for early-stage startups. Valuations are not only expensive, but they can be notoriously unreliable for early-stage companies, especially those with minimal or no revenue. Kicking that can down the road can help ensure that you don’t give away the farm or have to raise a later round at a lower price.
- Discount or valuation cap: Investors using convertible notes often receive a discount on the price per share or a valuation cap, ensuring they get a better deal upon conversion.
- Advantages of a convertible note:
- Speed: Convertible notes are a faster way to raise capital since they don’t involve a complex valuation process.
- Flexibility: Convertible notes allow startups to delay setting a valuation until a later date, which can be advantageous for both the company and investors.
- Disadvantages of a convertible note:
- Uncertainty: The final ownership percentage that investors will hold isn’t known until the conversion event occurs.
- Debt liability: If the conversion event doesn’t happen, the note remains a debt obligation that the company must repay.
- What about a SAFE? You may have also heard of a “SAFE,” or “Simple Note for Future Equity.” A SAFE is similar to a convertible note, except that:
- No interest: A SAFE doesn’t accrue interest the way a note does. Rather, in the event of a cash repayment, the investor will typically get a multiple of the amount invested.
- Simpler paperwork: The SAFE is typically a standalone instrument, while a note usually (but not always) includes several agreements. The SAFE was designed for quick and relatively easy investment, ideal for early-stage companies.
A priced round, also known as an equity financing round, is when a company sells a specific number of shares at a predefined price to investors in exchange for cash.
- Key features of a priced round include:
- Valuation: In a priced round, the company and investors agree on a specific valuation, which determines the price per share.
- Equity ownership: Investors receive ownership shares immediately, and there is no debt component involved.
- Advantages of a priced round:
- Transparency: Priced rounds provide a clear valuation and ownership structure, which can be appealing to both investors and the company.
- No debt obligation: Unlike convertible notes, there’s no debt that needs to be repaid if the company doesn’t achieve a conversion event.
- Disadvantages of a priced round:
- Valuation challenge: Setting a valuation can be challenging, especially for early-stage startups with limited financial history.
- Complexity: Priced rounds can be more complex and time-consuming due to the need for a detailed valuation process. Diligence is also a bit more involved for priced rounds, even for early-stage companies.
We mentioned “diligence” a bit in the previous section, but what does that really mean? Just like any buyer of a major asset, investors will want to take a look under the hood of your business to make sure it’s sound and that there are no major issues lurking. Below are some of the most common things that investors look for – and how to make sure they aren’t overly concerned with what they see.
- Team: Investors will evaluate the founders’ and key team members’ backgrounds, credentials, and experience, as well as their level of commitment to the company and its mission.
- Business model: Investors will want to understand the market size, growth potential, customer segments, and competition of the company, as well as how the company plans to make money and its scalability.
- IP and technology: Investors will evaluate the company’s intellectual property rights, patents, and any proprietary technology, including whether and how well it’s been protected.
- Legal structure and compliance: Investors will review your company’s incorporation papers, bylaws, shareholder agreements, and past financing agreements to make sure everything is in order and up-to-date. This is one of many reasons it’s so important to ensure that your company holds regular board and shareholder meetings and keeps good records of all decisions it makes.
- Financial analysis: Investors will analyze your company’s the balance sheets, income statements, and cash flow statements.
- Burn rate and runway: Investors will look at your company’s spending rate, budget forecasts and plans, and roughly how long it will survive before it needs more funding.
- Market fit: Many times, investors will look to see how well your product fits the needs of the market.
- Scalability and future prospects: Investors will want to see how the company intends to grow and capture market share, as well as potential exit options and their expected return on investment.
It’s essential to remember that every investment and company is unique, and thus the due diligence process may be adapted to fit the specifics of each situation. Additionally, early-stage investments often come with a higher degree of uncertainty and risk, making thorough due diligence even more critical.
In most cases, it will be necessary for your company to make certain securities-related filings once the round has closed. Typically, a Form D (or similar filing) is made with the Securities and Exchange Commission (SEC), with a similar filing made with the relevant state(s) where the company and investors are located. Many entrepreneurs are unfamiliar with this requirement, or don’t know what it involves. Let’s take a closer look.
The Form D is a notice of an exempt offering of securities under Regulation D of the Securities Act of 1933. It’s a crucial requirement for companies seeking investment to claim an exemption from full SEC registration. Filing a Form D provides transparency and essential information to regulators, investors, and the public about the investment offering. There is disagreement about when a Form D is required, but in almost all situations, it’s wise to file as soon as you’ve closed a round of funding.
Blue Sky Notices
Blue sky laws are state-level regulations that govern the sale of securities within each state. After securing an investment, it’s essential to ensure that your company in compliance with the specific blue sky laws of each state where you have investors. This may require filing blue sky notices or registrations with state securities regulators to avoid legal issues.
Communication with Investors
Once your round has closed, your investors will be entitled to certain information about the company. What information they receive, and on what schedule, depends on a number of factors, including how the investment was structured, what type of entity you have, and the state where you are incorporated. Talk to your attorney to determine what information your investors will need so you can be sure to keep them up-to-date.
Seeking and closing investment is an exciting and pivotal moment for any growing company – but it’s a complex process and the groundwork needs to be laid months if not years in advance. Book an exploratory call with us to make sure you’re ready.