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A company’s need for substantial amounts of capital is intensified when looking to grow quickly, or develop an innovative product that will disrupt the market in a meaningful way. This is true to any company, and is especially true to innovative and disruptive startups, which aim at creating new markets, revolutionizing existing ones and prevailing over traditional market participants. To be disruptors, a startups’ product may need to go through testing, the startup may need hire experts in a particular field to assist in the development of a product, or invest heavily to gain scale in the short run and be competitive in a specific market. Thus, raising capital is, without a doubt, a key element in the life of a startup. Initially, when founders are jumpstarting the company, they will have no other option but to use their own funds. However, as the business grows, and expenses pile up, the founders will need to turn to other methods of financing. Two mechanisms by which startups may raise capital are (i) equity financing, whereby shares of the company are sold; or (ii) debt financing, in which the company may be required to put its assets as collateral to secure the debt. The latter may not be a viable option for a seed stage startup given that it may not have any assets, or the assets that it has are not an adequate guarantee for the loan. Consequently, convertible debt (which we shall discuss in a subsequent article) or equity financing are typically the most viable routes that startup founders take when looking to finance the operations of the startup. In this new Startup Series’ article, we will summarize the particularities of startup fundraising, the participants, and the terms that a founder should be paying attention to when negotiating with investors in a financing round or series. The Players: After founders have exhausted the seed capital, and require additional funding to keep financing the operations of their company, they will likely look for investments from close friends and relatives. At that moment, funding rounds involving friends and family, which will usually be informal compared to later rounds, will come into play. Because there is a certain level of trust between the investors and founders, the terms of the investment in a friends and family funding round will potentially be much more favorable to the founders, and investors will most likely not ask for special rights and protections such as voting rights over major decisions (or voting rights in general), board seats, or to be involved or actively participate in the management and operation of the company. However, founders must be sure to document every investment from friends and family, and have in writing all rights that are being granted to such investors. In addition, ideally there will be:
Nonetheless, there are certain rights that, due to their long term implications, founders should pay special attention to when thinking about granting them to friends and family investors, such as anti-dilution rights or the right to block subsequent rounds of financing, which might destroy the attractiveness of the startup from an angel investor or a venture capital investor’s perspective. Consulting a lawyer, even at these early stages, would be advisable so that founders may understand the reach of these provisions and will help save time and money down the road. Next up, are the so-called “angel investors”. These are high net-worth individuals that will invest much more money into the startup than friends and family, will contribute their expertise, and will, occasionally, serve as mentors to the founders. Consequently, angel investors will likely require a certain level of control over management, and will ask for special approval rights over at least certain major decisions of the company, such as the sale of the business or a substantial part of its assets to a third party, or an exit to capital markets (an initial public offering or “IPO”). Although some angel investors may not be very sophisticated, they will often have legal counsel involved to assist them in negotiating better terms in a subscription agreement, or even bargain for convertible notes. Similarly, the founders must make sure to have a lawyer looking out for their best interest during negotiations with an angel investor. Finally, the venture capital firm or “VC Firm” is where startups get the biggest investments from (if they get to that stage). VC Firms are highly sophisticated and will negotiate intensively to get the best deal possible from their perspective. They will often require the startup and past investors to agree to certain terms in exchange for their investment. For example, a VC Firms will often negotiate for drag-along clauses in which other shareholders of the startup will be required to vote in favor of resolutions that a majority of the shares voted for. This is designed to ensure that minority shareholders will not be able to veto acts that the majority of the shareholders are in favor of. Typically, these key terms, and others which we discuss below, are negotiated through a term sheet, which will serve as a basis to be used to draft the documents that will be signed in order to formalize the VC Firms’ investment. The Terms: Every time a startup founder decides to go through a financing round, he/she must be prepared to negotiate the economic and control aspects contained in the securities or financial instruments being offered. Thus, below we list the most important terms that we consider should be taken into account when a startup is raising capital, regardless of whether it is friends and family, an angel investor or a VC Firm.
Keep in mind that each business and its financial needs must be evaluated taking into account their particular situations (amounts being raised, number of investors and shareholders, among others), so as to determine what economic and control terms deserve the most attention. We are at your service for any queries you may have on these issues. For more information on these topics, please contact:
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