As we discussed in Part 1 of this series, startup fundraising allows companies to obtain the capital that will be critical for future success. Early funding rounds to raise capital help the startup get off the ground, while later startup funding rounds (Series B & Series C) are meant to help the founders take things to the next level. This can be especially crucial for companies that aren’t yet making a profit. Replenishing the coffers with fresh capital ensures that things won’t fizzle out just as they’re truly starting to come together.
Series B Startup Funding Rounds
The Seed and Series A funding rounds helped develop the startup’s product or service by raising seed capital. The Series B funding round will help expand market reach and continue building the startup’s momentum toward success. Think of the ‘B’ as standing for “building.” B series financing rounds are all about ramping things up for a growing company and are especially helpful to get past that initial development stage. The Series B round gives the venture capitalists considerable insight into whether or not their investment will pay off.
Series B rounds allow the company to focus on acquiring even more great talent to continue driving their momentum forward. These new teammates can help the founders and early staff members continue developing their products or services in a way that positions the startup for further growth. One of the differences between the earlier rounds and a Series B round is that the Series B round will often bring in new venture capital firms who do not typically invest in very early stage deals (seed and Series A).
Venture capitalists tend to specialize. Some do that by industry, almost all do it by financing round. Part of this is a personal preference around what interests them (concepts vs. growth) and part of this is a function of risk. Seed stage investing carries greater risk and upside than later stage investing. Notice that I am only talking about venture capitalists. By the B round, few angel investors are left in the game. The amount of capital raised in B rounds makes it less efficient to collect the relatively smaller checks that most angels cut compared to VCs.
Also, venture capital economics drive the decision regarding the round(s) a VC focuses on. A venture capital fund will typically invest in 30-40 companies. This limit is because the VCs can only actively assist so many companies. VCs like to be involved, sometimes taking board seats and providing strategic value. Most will reserve some capital for follow-on investments in those of the 30-40 companies that are doing well. If a venture capital firm is investing a $300 million fund and allocates half of the fund to 30 new investments, each investment much be, on average, $5 million (half of $300 million = $150 million; $150 million divided by 30 = $5 million per investment). Seed deals are in the $250 thousand to $1.5 million range. You can’t efficiently spread a $300 million fund around in seed deals or the partners and associates in the firm won’t have adequate time to spend with each portfolio company.
There are several areas that a startup may want to focus on building even further during a Series B round:
- Talent acquisition
- Business development
- Advertising
- Sales
- Tech and support
Series C Funding Rounds
During a Series C round, investors often pump even more capital into the startup’s war chest in the hopes of seeing even greater returns on their investments. The B round was for building and putting in place the people, advertising and systems and processes necessary for rapid growth. The C round is all about that growth – scaling the company steeply and quickly.
One example of this type of scaling is to acquire a second company in another region that would allow the company to increase its range. Of course, this must be done in a smart and well-planned manner (after careful business planning and market research) to avoid an overly risky acquisition that ends up costing huge amounts of money without bringing any positive returns. This is a place where an experienced startup lawyer may be able to help the startup maximize their potential.
Series C funds could be used to finance this endeavor and help merge the two companies into one synergistic whole. Another way the company could scale is to grow on a global basis, assuming that the product or service is in demand in another country. As the startup truly begins to take shape, even more investors may be willing to get in on the action. This could mean the addition of groups like investment banks and private equity firms.
By the Series C round, the venture capitalists are funding growth, not ideas. In fact, this change happens usually in the Series B round, although definitely by Series C. This later money is intended to scale the company. The risk has been greatly mitigated because, at this point, it will be clear to everyone that the company has a product or service that the market values and will buy. So, the risk of investing shifts from the risk of not finding product-market fit to the risk of not operating and scaling well.
The Importance of Having a Seasoned Securities Lawyer
The rise of LegalZoom and all the information available online are empowering to business owners. I always encourage clients to use their limited funds wisely and am never offended if that means not asking me to do certain things. However, one area of the law that is still not ready for the DIY approach is securities law. The risk of noncompliance is high and it’s a very confusing area of the law. Startup founders should seek experienced legal counsel when raising money. This is true in financing rounds with venture capitalists, although at least there the VCs will have counsel looking into securities law compliance. They won’t be doing it on your behalf if you’re a startup founder, but it will still help. When it comes to another type of startup fundraising – crowdfunding – there is no one out there looking closely at compliance.
Crowdfunding
Crowdfunding is also sometimes called crowd investing or equity crowdfunding in order to distinguish it from crowdfunding on sites like Kickstarter and Indiegogo where people donate money to projects in return for an item or a memento or something along those lines, but not stock or other equity interests. Crowd investing is an increasingly popular method for startup fundraising. It is a very different approach from raising money through venture capitalists and angel investors. This approach involves raising money from the public, or the “crowd.”
The idea is that there is wisdom in the crowd. While certain individuals may not know what they’re doing, overall the aggregate of all individuals yields intelligent decision-making. Plus, when it comes to spotting good businesses, who better to do it than the customers of those businesses, people interacting with the business on a day-to-day basis? Then, as part of a virtuous cycle, those customers-turned-investors, will become even more committed customers of the business.
Equity crowdfunding allows people to contribute money for the simple reason that they care about whatever service or product the company provides (that and they’d like to make a return on their investment).
Until May 2016, it was difficult to raise money from unaccredited investors. An accredited investor is a term defined in Rule 501 of Regulation D of the Securities Act of 1933. It essentially means a person who either:
- has made an excellent income (at the time of writing this article, $200K or $300K with a spouse) for the last couple years and expects to do the same this year; or
- has a high net worth (at the time of writing this article, $1MM+ without including the value of their primary residence).
New rules went into effect on May 16, 2016, allowing the general public (unaccredited investors) to contribute funds to startups. The new rules are known as Title III to the Jumpstart Our Business Startups Act (the JOBS Act). Title III introduces Regulation CF (“CF” for crowdfunding).
Regulation CF is fairly tightly restricted. All investing needs to happen through approved online portals. The portals are intended to play a gating and screening role. Whether or not they do this adequately is debated. At the very least, the crowdfunding portals help manage the process and ought to help with securities law compliance, although don’t rely on their compliance only. This is definitely an area of the law where startup founders should hire experienced lawyer to make sure a company doesn’t violate any of those rules.
A company may only raise $1 million in a 12-month period. Investors who make less than $100,000 per year may not contribute more than the lesser of (1) 10% of their annual income and (2) 10% of their net worth.
This type of startup fundraising usually occurs early on, and for that reason can carry a significant amount of risk for investors. The JOBS Act sets out certain provisions with the goal of informing investors so they truly understand their potential risks. There are certain disclosures and filings that need to be made in order to comply, including a Form C document, which will include the following information:
- A business description that includes an anticipated business plan that contains its name, legal status, and both physical and website address
- Risk factors that make investing in the company risky or speculative in nature.
- The company’s financial condition
- Information including the names and positions of the directors and officers, the identify of all beneficial owners of 20% or more of the company’s outstanding voting equity securities; and information regarding officer and director business experience of over the past three years
- How the investment funds will be used
- The price or method for determining the price of the securities involved
To pull off a successful crowdfunding campaign, it helps if the company has a strong and very engaged social media network. The portals have followings, but it’s always helpful for the company raising the money to have its own following, as well as customers that will contribute.
The startup must file the Form C document and upload it to SEC’s Edgar system so investor and crowdfunding intermediaries may access it. In cases where certain amounts of money are raised due to JOBS Act crowdfunding, securities issuers may also be required to disclose financial statements and specific income tax return line items. There are also rules around required review by accountants of the company’s financial statements.
These issues can be complicated to navigate during the startup fundraising process. For this reason, a company could benefit from consulting a startup lawyer in the Austin, Houston, Dallas or San Antonio areas that has experience in helping clients through these and other rounds of startup fundraising. While a startup attorney is not required, it can take a lot of stress off entrepreneurs as they attempt to successfully chart a course through SEC and FINRA regulations without running afoul of these rules in a way that could prove costly.
If you have any questions about crowdfunding, startup funding rounds, raising venture capital or angel investment or anything at all related to starting, growing and buying and selling businesses, please get in touch.
Be Sure and Read Part 1 – Seed Funding & Series A Rounds – Raising Capital for Startups – Part 1
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.