An idea is hatched a team is formed and the startup or small business launches a plan to bring its unique value offering to its consumer base. To get there takes not only talent, dedication, and a bit of luck, but it also takes capital.
Timing is immensely important for any business, and each hour that ticks by is an hour a competitor can get ahead. Therefore, it is imperative the team is able to focus entirely on the venture, rather than squeezing in time before or after another job. To do so, however, founders and their team typically must make at least some money, even if it’s below what they could command on the open market. Unless the founders are already wealthy, this requires an infusion of outside capital.
Without prior successful exits, and without landing the startup in a prestigious incubator, most new business ventures do not have investors beating down their door to invest right away. Therefore, often founders look to their friends and family to help with initial financing so they can build the company to a level that will attract outside investors.
Even if a founder is “just” raising investment money from friends and family, there are still a number of legal matters that must be considered and followed to ensure that the company is protected and compliant:
(1) Investor Status
To sell a security (equity in the company) pursuant to a private placement, a company must take reasonable steps to ensure that the investors are “suitable” according to SEC standards, and their status allows the company to meet a specific exemption from public registration. Do not be fooled – a convertible note, SAFE, KISS, or other convertible instrument is considered a “security” by federal and state standards.
Investor participation in a private placement is usually limited to people that are considered “accredited investors,” but can extend out to those who are “sophisticated and wealthy” by the SEC or people with a close personal connection to a founder under California Corporations Code 25102(f).
In short, startups should use an investor suitability form and the advice of an experienced attorney who can help the founders vet each prospective investor. With these tools, the company can ensure that it does not take money from an investor who cannot afford to lose it, and inadvertently violate federal and state private placement rules.
(2) The Pitch
Far too often we notice the focus at the outset of a friends and family round is on the instrument the startup plans to use (such as a convertible note), which typically is putting the cart before the horse. Before things like interest rates, valuations, and discounts are discussed, the investor needs to be excited about investing and convinced that they want to spend their money on the company.
To effectively draw in investors and convince them of the viability of the company, create an engaging pitch deck (often in PowerPoint or a PDF, or a paper version depending on the audience), which outlines the business plan, including: (i) the problem being addressed, (ii) the company’s mission statement and proposed solution to the problem, (iii) competitive analysis, (iv) the business model, (v) the founding team, (vi) amount the startup is looking to raise, and (vii) pro forma financials. A good pitch deck will help sell a prospective investor on why the risk could result in a nice downstream payday.
(3) SAFE Versus a Convertible Note
As an early stage startup without a proven track record, the company must balance an attractive offer versus an offer that is startup friendly. The Y Combinator SAFE has definitely come into vogue as of late. However, it’s a much more startup-friendly instrument than its cousin, the convertible note, and as a result, for many sophisticated investors it will be a non-starter unless the startup is very “hot,” such as already being accepted into Y Combinator. Thus, a convertible note is often a wise starting point.
Unlike a SAFE, a convertible note has a maturity date and allows the investor to earn interest on their investment until the note converts into equity during a fixed price round (such as a Series A). Promising a maturity date and paying minimal interest can be small concessions for a startup and potentially speed up the seed round. Otherwise, the longer it takes to close on the seed capital, the less likely the startup will find a chance to spread its wings. While a startup needs to be strategic and not give away too much, in some cases immediate advantages can be seen to make the investment opportunity attractive to a prospective investor.
(4) Cost Versus Amount Raised
Cash is a scarce resource when a startup is formed, and that means founders must be extra cautious about how each dollar is spent. Therefore, when raising outside capital care must be given to factors such as (i) the likelihood of a lengthy negotiation process against a fast close, (ii) advisor fees, including legal, marketing, and accounting, and (iii) the total founder time commitment to closing investors versus focusing on what they are good at – developing their product or service offering. Using experienced professionals to guide the process, make introductions, and influence strategy can go a long way towards lowering the overall costs and time, even if it can seem daunting to shell out the cash to hire experienced help before the investment money is received.
When raising capital there are a myriad of considerations that extend beyond those provided above. Wise founders surround themselves with an experienced attorney, CPA, and a board of advisors. We recommend founders consider the topics above, but this list is not exhaustive, and so we strongly encourage any founder to enlist the assistance of the necessary professionals to help make informed decisions.
Disclaimer: This post discusses general legal issues and developments, is intended to serve as informational only, and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.