Our "Protect Your Startup" series (presented by ) is a how-to guide for young startup founders in search of legal advice for their business. Each month we'll focus on different threats and the preventative measures that should be taken.
So you're finally ready to raise a round a funding. It's an exciting moment for any young company, but the excitement can often times overshadow the potential dangers that come along with raising money.
Who should you talk to? How much do you need? Amidst the hundreds of questions that are tied to fundraising many people fail to ask one of the most important: “Am I protecting the future of my business?”
We spoke with Sam Edwards, a partner at Holland & Hart, to better understand how companies can ensure they are getting the best deal for their company now and five years down the road:
Know who you are talking to
Investors can make great advisors for a growing startup or be a detriment to your business. Knowing the difference is simply a matter of research. Take the time to learn your potential investors’ history and understand which ones are right for your business at that time. Once you have found the right match, make an effort to use the relationship to your advantage.
“One of the most important things is maintaining credibility with your investors,” said Edwards. “I think that's something that a lot of new entrepreneurs who don’t have a lot of experience in the business world might not think about. If you tell them where you are and project where you’re going to be and hit those numbers, they will have confidence in you and may come back to put in more money in a Series B. They can also back the founders in other ways like keeping them in key management roles even if there are some bumps along the way.
“Whereas if the investors feel like the founders aren’t giving them the whole picture and they keep making mistakes, or there are things going on that the investors were not aware of, those can be really damaging to that relationship and can lead to situations where investors tend to be more bottom line oriented and turn the screws on the founders or force people out.”
The pitfalls of equity financing
In comparison to other types of financing, equity has a reputation of being trickier due to the wide variety of terms that normally accompany the deal. Many founders in this situation get fooled by what appears to be easy math. For example, if you sell your company for $20 million and you have 50 percent of the shares, you aren’t always going to walk away with $10 million. Commonly used terms like liquidation preference, accruing dividends, whether it's participating or not, or anti-dilution preferences can impact what the remaining amount for the common shareholders is at the end of the day.
“In equity financing, I encourage people to not focus on the top line number (or pre-money value) as the end all be all of what they’re looking for,” Edwards said. “Instead, they should dig in on the terms of the financing because you can have preferred stock that is either very rich for the investors or very onerous on the company because of different control elements or approval requirements that could impact a founder’s ability to run the company or the amount that is left for them at the end of the day.”
Important notes on convertible notes
“With a debt financing like a convertible note financing, the terms are simpler,” said Edwards. “They are used more in the early stage, it's higher risk, but it's investor favorable. At that stage you want to focus on how much you want to raise initially and selling your investors a little more on the concept.”
Founders will want to look out for three things:
- The interest rate on the note
- The discount rate (usually convertible notes will convert into the next equity round at a 10 percent to 30 percent discount which can be important in terms of how much dilution that’s going to cause)
- A potential cap to the max pre-money value you might get in equity financing
A common (and potentially fatal) mistake
A lot of rookie startup founders will issue their founder shares with help from internet guides like those provided by Y-Combinator or one of many tech-focused law firm websites. But Edwards warns that many of these “how to” guides forget one crucial step:
“One of the biggest pitfalls is when founder shares are issued and those founder shares are subject to vesting, you need to do an 83(B) Election, which is a tax election that can be critical in that context. It’s not something you can do later or fix so I’ve had companies come to me that have been around for 12 months who have issued these types of shares right when they formed and they can no longer do the 83(B) election which can be a major problem.”
Have a question that wasn't answered? You can ask H&H here.
