Posted by Early Growth
August 28, 2014 | 9-minute read (1636 words)
Among the earliest decisions you have to make when you’re getting your startup off the ground is how to fund it. Whether you intend to go it alone for as long as possible, or line up funding right away, the earlier you decide on a strategy, the better. Our Seed Funding Your Startup webinar with Kristine di Bacco, Associate Attorney at Fenwick & West and Sirk Roh, EGFS’ Chief Operating Officer, was a dive into the ins and outs of early-stage financing and a look at some of the key vehicles.
While bootstrapping for as long as you can might be the right decision for you, and it offers the benefit of no dilution, if you know you’ll ultimately want/need to raise investor funds, don’t rely on your own resources for too long. It can raise questions in investors’ minds as to whether bootstrapping was really your choice, or you simply were not able to convince anyone to invest.
One thing to be religious about from the beginning: keeping your personal finances separate from your startup’s. That includes bank accounts, credit cards, and checks. Not only is this important from an accounting perspective, investors scrutinize it as well, and it’s also hugely important from a liability (personal versus corporate) standpoint.
Family and Friends Round
In addition to your own funds, friends and family rounds are often one of the first sources of funding. And why not? They already know your background and history and have a basic level of trust. It’s fine to tap these sources first, but subject to the following ground rules: be upfront with them about the risks, don’t accept funds from those who can’t afford to lose their investment, and don’t cut corners — always document your agreements.
Incorporating as a Delaware C Corp
Once you get into institutional funding sources (Angels — wealthy individuals, investor groups, more formal funds — and VCs), one thing you need to know is that incorporating as a Delaware C Corp is a non-negotiable for institutional investors. As a point of reference, 99% of Early Growth Financial Services client base is registered as Delaware C Corps.
Why Delaware, you ask? Because the state has the country’s most sophisticated, predictable, and corporate-friendly regulatory regime and case law. The state filing process is also efficient to navigate and user friendly.
Even if you’re physically setting up in California or elsewhere, you should incorporate your startup in Delaware (You must register with California’s Secretary of State in order to be headquartered there while incorporated in Delaware). And do this in the beginning. You can certainly change your status later on, but it is both expensive and time-consuming.
When to Incorporate Your Startup?
Another thing you might be wondering is when is the right time to incorporate?
The answer is simple. Do it as early as possible. You not only don’t want to wait for investor money, you also want to put as much time as you can between getting set up and taking outside investment for several reasons:
#1: fundraising is a full-time job. The last thing you need or have time for is to go through incorporating and trying to get funded at the same time. If you’re not already incorporated you’ll run into delays closing funding.
#2: It means you can issue founders’ stock when your company is not worth much. Since founders have to pay for their stock, doing this in the early days will save you a ton of money since you can issue stock at minimal value (i.e., fractions of a penny).
#3. You’ll start to build relationships with attorneys early on, well before you begin looking for funding. This will be enormously helpful when you get ready to raise.
And while you’re at it, work on becoming part of the startup ecosystem as soon as possible. In addition to attorneys, that includes bankers (choose startup friendly ones), accounting and HR firms, and other professional services providers. In fact, part of your criteria in selecting providers should be how helpful they can be in terms of fundraising needs later down the track.
Funding: Getting Ready
As you start gearing up for funding, first work on the practicalities. Think through how much money you need, and plan to raise enough to get you through 18 months, so you have some runway before needing to raise again. With this milestone funding approach, you’ll raise only what you need (limiting your dilution) and assuming you hit your milestones, set yourself up for big valuation increases going into the next round.
Then put together the main 3 things you need to get funded:
When it comes to funding options, one of the first decisions you’ll make, is whether to go with convertible debt or raise an equity round.
1. Convertible debt is usually for raises of less than $1M. That said, it really depends on what’s right for your situation. If you only need a small amount of money, convertible debt can be good. The debt automatically converts (at a discount, usually 15-20%, to compensate early investors) when you raise equity.
The reason these deals are so popular is that they are relatively quick, and cheap to do from a legal standpoint, in large part because they postpone the valuation discussion until later. In the meantime, you’ll pay interest on the debt, typically at a rate of 4-6%.
What’s gotten controversial in some corners is convertible debt that includes a valuation cap. They tend to be set in the range of $5M-10M, and the rationale for using them is to reduce uncertainty over valuation - a big drawback for early investors (who take the most risk). They’re also designed to let your investors share in the valuation upside when you raise a priced equity round later on.
Negotiation tip: start with a discount offer and let investors raise the issue of a cap.
Another potential issue with converts is what happens in case of a sale of the company prior to maturity. They can be structured to trigger a change of control payment based on a multiple of face value plus interest to compensate investors OR to convert to common stock at a pre-determined valuation cap.
2. Series Seed Preferred Equity is another relatively new financing option, designed to be used when you need to raise more than $2M of funding. The benefit is that they require less documentation than a Series A does. They are governed by 2 main documents: your certificate of incorporation (for the state of Delaware) and your investment agreement (mainly your purchase agreement).
Another benefit of Series Seed agreements is that they are founder friendly. While they offer investors basic protections, they delay negotiating some bigger points that are addressed in Series A. They also come with a narrower set of investor rights. For instance: investors do not have registration rights, they benefit from fewer company covenants, and have no co-sale rights, no preferential dividend rights, and no redemption rights (no forced share buybacks from investors). Their non-participated liquidation preference is only 1x and board seat representation comes with limited protective provisions and voting rights.
Because these are priced equity securities, investors and founders need to agree on valuation. This means the negotiation and documentation process is longer than that for converts, and the legal process more expensive and intensive.
3. Series A is used for larger priced rounds, typically in the range of $2-5M. Compared to convertible debt and Series Seed, these are the most complex, lengthy, and expensive agreements to draw up. Investment agreements are governed by 5 main legal documents: Stock Purchase Agreement, Investor Rights (including price-based anti-dilution provisions) Agreement, Right of First Refusal and Co-Sale Agreement, Voting Agreement, and the Certificate of incorporation. You should expect to give up a significant amount of equity, 20-40%.
If you’re negotiating a priced round, one of the key things to remember is that setting pre-money valuation is more of an art than a science; and it’s always the result of negotiation. Lots of qualitative factors come into play, including: the industry you’re operating in and how much traction you can demonstrate.
Also, be alert to the impact the size of your option pool (the percentage of your equity that you set aside for future hires) has on your retained equity stake. Investors will insist that the pool be calculated based on pre-money valuation, which is dilutive to founders’ equity. There are different approaches to setting the size, but option pools usually range from 10-15% of equity. Negotiation tip: think through your needs and try to agree on as small a pool as you can manage. And check out David’s earlier post on startup equity for more nuts and bolts on capital structure and funding terms.
Some final thoughts: getting funded is a lengthy process: it typically takes 6 months to close a round. It pays, (literally!), to get as strategically well-positioned as possible before you start.
Questions or comments about funding options or strategies? Tell us in the comments section below or contact Early Growth Financial Services for fundraising guidance.
Deborah Adeyanju is Content Strategist & Social Media Manager at Early Growth Financial Services, an outsourced financial services firm that provides small to mid-sized companies with day-to-day accounting, strategic finance, CFO, tax, and valuation services and support. Deborah is a Chartered Financial Analyst (CFA) charterholder with more than a decade of experience as an investment analyst and portfolio manager in New York, London, and Paris.