If you’re thinking to yourself, “how do I raise money for my startup or new business?” this article is intended to be a very basic overview of the process. You will learn some of the terminology involved in business startup funding.
Getting startup money for a new business is crucial for all startups, including startups in Austin, Dallas and Houston where I do a lot of my Texas work (as an aside, I also work for startups in other cities and states given that I am still licensed in Delaware, the hub of corporate law). A great startup lawyer can make things easier for entrepreneurs who may not know the difference between a seed round and a Series A round. Even old pros at early-stage startup fundraising will benefit from consulting a business attorney who is experienced in helping new businesses handle all the agreements and securities law compliance that startups need.
Bootstrapping: The Anti-Approach to Startup Funding
Some budding entrepreneurs believe they will be able to go the distance by just using the old “bootstrapping” method of funding. Bootstrapping refers to using the money and savings you have to build your startup from the ground up. This method is not right for a lot of startup founders because many of them don’t have the amount of capital it takes to start (even if that is a very small amount of capital, hence “bootstrapping”) and—more importantly—sustain a new company. Plus, bootstrapping generally means the growth of the business will be slow because there are things the cofounders won’t be able to do because of their lack of capital.
Startup Funding Rounds
Which brings us to raising startup capital. Most companies will go through multiple rounds in order to obtain sufficient funds to fuel their business’s growth. Understanding the ins and outs of these various rounds can give you a leg up on the competition and might mean the difference between success and failure (between raising money for their new business and not raising money for their new business).
Some examples of common funding rounds include:
- Family and friend rounds;
- Seed funding rounds;
- Series A funding rounds;
- Series B funding, Series C, Series D and so on …
Different Types of Startup Investors:
Friends and family: This is usually the first group of people you approach in the early stage of your business. Although the investment capital is usually not very high it can be essential to help get your business going.
Angel investors: Angel investors invest in small startups or entrepreneurs and are focused more on helping you get started than making a profit. They are also known as angel funders, private investors or seed investors. You might call them the opposite of a venture capitalist.
Venture Capitalist: These type of investors are willing to invest in businesses with the potential for high returns. They also will seek or demand large stake in company
Equity Investment (Selling Stock to Investors)
Equity financing is the process of raising capital through the sale of shares ie ownership interest to raise funds for a new business. Equity financing is an increasingly popular fundraising option. You might already know this, but equity is the very lifeblood of pretty much every business out there. Giving away too much equity can spell a death knell for a startup founder; but hoarding it too closely can kill the entire company before it even gets off the ground. Finding the perfect balance can be absolutely crucial. A great startup lawyer can provide key advice at this stage. While desire and a great personality fit are important, it is absolutely essential when considering how to choose a lawyer for your startup business, that you find one with plenty of experience with the different ways to raise startup capital and help startups navigate all the securities law issues that arise in that process.
Startup founders need to attract the right talent to their business and the investors who will provide the equity funds to get and keep that talent working hard on your behalf. Maybe you have a key person in mind who you know will help make your company a success. You may able to pull them in as a co-founder or equity investor by promising them a certain percentage of equity in the company. This can give them the best incentive to work hard for the company’s future.
Still, if you are a small business or startup and want to attract angel investors or venture capitalists, then you must offer equity to early stage business investors. Venture capital investors and angel investors are looking for big hits – companies that can return them 10, 20 even 100 times their investment! Obviously 100x return is not common, equity capital investments or even the actual target return, but now and again an angel investor or venture capitalist needs to hit a homerun of that magnitude to make early-stage startup investing a good bet. Venture investing is all about hitting homeruns since the estimates are that over half of their portfolio companies (startup venture investments) will be failures. The actual statistics reveal that over 75% of venture investments are outright failures in that they go out of business or they are sold for a negligible amount.
Family and Friends Rounds
A family and friends round can be as literal as obtaining funds from friends and family to get the company going. Of course, these early-stage investors don’t have to be literal friends and family; but they do need to meet the standards set out by state and federal laws when it comes to qualifying as accredited investors. Should someone fail to meet these standards, you could face severe penalties and may even be required to repurchase your stock.
The most important thing for most family & friends financing rounds is that the people who you offer stock to have a close relationship with you or your cofounders. The SEC and state security boards look closely at private stock offerings to be sure they are private, which means many things depending on the context. Securities law compliance is tricky because the laws are so tough to interpret because the securities regulators expand and contract them to fit situations. Generally speaking, a private offering is one with few offerees (and, of course, few actual stock purchasers) and one where the company doesn’t cast a wide net to find those offerees, but rather finds them naturally through their network. This means, of course, that email blasts and billboards are out of the question!
It is possible to raise funds from unaccredited investors. Most securities lawyers, myself included, don’t recommend it. Unaccredited investors have the most to lose (hence, more likely to raise issues if and when they lose their investment) and there is usually a lot of disclosure required to raise capital from unaccredited investors. But, it is possible. That is something you and your startup founders will want to carefully consider along with your securities attorney.
While this article talks mainly about offering stock or other equity to investors, family and friends often invest using convertible notes. Convertibles notes are debt instruments that convert to equity at a later financing round. Convertible notes are useful because they are quicker to negotiate and sign up than a true equity deal and founders and the investors can avoid having to value the startup when using a note. The valuation for the conversion of the note to equity is done at the price of the next financing round (i.e., the future valuation is used). Sometimes notes contain a cap, which sets a maximum price for the conversion and/or a discount to the valuation that is used to reflect a benefit to the investors who offer capital during an earlier, riskier round. The Y-Combinator SAFE is similar to a note without certain of the more stringent terms that come with a note (e.g., guaranteed conversion or interest rates).
Seed Funding Rounds for Startups
A seed round is an early investment stage that allows a startup’s founder to truly determine the strategic goals and direction that their business will follow. Seed funding (also referred to as seed money or raising seed capital) seeks seed investors and is used to raise funds to support the initial research and may include determining what the product will be and identifying the targeted audience. This round can be considered far more speculative than the rounds that follow and may actually see the startup bringing a product to market.
Seed investments may help you accomplish the following:
- Product Identification: The startup founder can use the seed investment money to nail down the design details and vision for the product or services they plan to offer.
- Marketplace Orientation: The seed stage may allow the startup founder to do key research into identifying the market for their products and how they will best bring their product or service to that market.
- Demographic Targeting: The startup may need to dig down deep to really target their key demographic, including market research and other measures to obtain the information they so critically need.
- Team Creation: Seed investment money may go toward employing key personnel beyond just the founder (or founders) of the startup company. Sometimes it is vital to employ certain personnel (such as sales or marketing representatives) early on in order to take the right steps forward.
Not every company will need to do all of these things, because they could already have a lot of this infrastructure established. For those startups truly in their infancy, however, these steps will be crucial.
Series A Funding Rounds
Most commonly, startup founders call me when they are planning to do a Series A financing round. A Series A round refers to the first stage when venture capital firms step in to provide funding in exchange for company ownership. Several factors must be present in order for valuation to be done at this stage:
- The product or service’s proof of concept;
- The progress accomplished with the seed capital;
- The quality of the startup’s executive team;
- The size of the market involved; and
- The level of risk involved.
Generally, Series A rounds take place once actual revenue is being made or is very close, although the company may not yet be making a net profit. In fact, for high growth technology companies, they are rarely profitable at this stage. The Venture Capital funding stage carries a lot of risk in startup funding. It can also be one of the most important stages in pushing a startup toward success (or failure).
Compliance with Securities Laws
I cannot stress enough the importance of understanding the securities laws that apply to startup fundraising. Unless you’re the rare startup founder who plans to never grant any equity, stock options or other types of equity awards (including notes!), you absolutely must know the relevant state and federal securities laws that apply to your business. This is one reason that consulting with a startup lawyer is preferred, because the potential penalties for violating securities laws can be harsh and costly.
Here is what every founder needs to know about complying with securities laws when they are raising money. Any time you sell securities, which include both stock and convertible notes (among other things), you must comply with federal and state securities laws. Yes, this includes the Y-Combinator SAFE (simple agreement for future equity). Complying means that you either register the securities with the SEC and state securities boards or you find an available exemption from securities registration. You have to comply with the laws of every state where you issue securities. Some federal exemptions, such as Rule 506(b) of Regulation D of the Securities Act, trump state laws. In that case, you still need to file a notice filing in each state, but you don’t have to find a state-level exemption.
Not only can you unintentionally lower the value of your company should you step afoul of these laws, but you could also expose both your startup and yourself to civil and criminal liability. An experienced startup lawyer will be able to help arm you and your cofounders with the knowledge you need to stay on the right side of the law in this arena. This will help you focus on the day-to-day running of your startup as you work hard to bring your visions for the future to fruition without the fear of violating the often-complex securities laws.
If you are wondering “how do I find a great startup lawyer?” look first for one with experience working with startups, ones that are raising capital in seed and Series A rounds. Personality fit is important, too. Referrals are always a great way to go whenever looking for any professional, although if you locate one in a different way, do a little research to confirm where the attorney went to school, practiced and get a sense for their personal style to be sure it matches with yours and your cofounders. Like accountants, some attorneys are extremely technical, others more practical and they come in varying shades of conservative vs. out-of-the box thinking.
The Business Side of Fundraising
To raise money from angel investors and venture capitalists, you will need a great pitch deck, which is a fancy PowerPoint presentation that tells a compelling story about your business and the opportunity it has. You will also need a detailed financial model, a forecast of the future, that shows possible results over the next three to five years. Angel investors and venture capital investors know that the projections are guestimates, particularly when you project out as far as three, four or five years. Still, investors will want to see the assumptions you use for your startup’s future finances and test those assumptions to determine if you know your numbers.
Before you approach investors for your small business or startup, be sure you have all your founder agreements in order. For my number one reason to create founder agreements (not the one you’re thinking of), read The Most Important Reason to Create a Business Contract.
As an experienced venture capitalist, I have personal experience borrowing, lending and investing money in/to businesses. On the legal side, I’ve drafted and negotiated hundreds of early-stage equity financing deals, convertible notes, promissory notes, unsecured and secured credit facilities and other financial arrangements.
What Next
If you have questions about raising capital for your startup or business, please get in touch. I help clients all over, including Texas and Delaware, the hub of US corporate law. As an experienced venture capitalist, I have personal experience borrowing, lending and investing money in/to businesses. On the legal side, I’ve drafted and negotiated hundreds of early-stage equity financing deals, convertible notes, promissory notes, unsecured and secured credit facilities and other financial arrangements. I help clients all over, including Texas and Delaware, the hub of US corporate law.
Be sure and read Part 2 Series B and C Funding Rounds – Raising Capital for Startups – Part 2
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.