Last month I wrote about the four stages of startup capital – (1) the seed round, (2) the angel round, (3) the venture round, and (4) the bridge/pre-ipo stage round. This month we’ll take a look at what startups need to do to prepare themselves for a seed or angel round.
As discussed in the previous blog, when a company is in the seed or angel round, it is likely still figuring out its product or business plan, or, if it has moved beyond that point, it is now in a position where it is either entering into production or into the market. In either event, it is still likely that the company does not have significant revenue. The company is looking for seed or angel investors to fund operations as it moves to scale its business.
So-called “angel” investors are not supernatural helpers sent from above, but rather sophisticated investors looking for a high return on their investment to justify the risk they are taking. Investors will want to know that you’ve done your homework and taken the proper legal steps to prepare your company for growth before they invest. Here are five important questions you’ll want to have answered before you raise your first round of capital:
1. Is Your Business a Duly Formed Corporation?
Simply filing articles of incorporation with your state’s secretary of state does not make your company a duly-formed corporation. Your company must take additional steps, depending on the laws of incorporation for your particular state. These can include appointing a board of directors, adopting corporate bylaws, issuing stock to shareholders, and obtaining an Employer Identification Number (EIN). Without these steps, your company may not be duly incorporated. LLCs, while having less formalities, still often require the adoption of an operating agreement and other items.
2. Do You Have a Finalized, Comprehensive Agreement with Your Cofounders?
It’s a classic story: a couple of friends get together to work on a great idea without having an agreement over ownership, or at least one that’s been finalized in a clear, comprehensive, legally operative document. Then, when money begins to flow in, or even the idea of investment becomes more real, everything changes, and conflicts and misunderstandings arise. Some tension and awkwardness over finalizing an agreement with your cofounders is natural and fine, but the time to work through those issues is before you approach angel investors, not after. Make sure you have either a finalized, duly-executed operating agreement if operating as an LLC, or a stockholders’ agreement if your company has incorporated. These agreements should cover topics such as management rights, what happens if a founder dies or leaves the company early, and restrictions on transferring their stock.
3. Do You Own Your IP?
You might think this is an easy question to answer – of course you own your IP, right? Maybe, maybe not. If, like many startups, you’ve worked with independent contractors who’ve done programming work or similar types of creative work, those workers might have a claim to ownership over the products they’ve created if there was no invention assignment agreement in place. In addition, if you moonlighted for your startup while working at another employer with which you do have an invention assignment agreement, your employer may also have a claim to ownership of your IP. Any potential investor might discover this in due diligence and demand that these issues be addressed, or, worse, may simply pass over your company. It’s better to avoid such questions and concerns at the outset and make sure that these kinds of issues are thought through and dealt with.
4. Are Your Potential Investors Suitable For Your Company?
For many startup founders, the idea of approaching strangers and asking them for money is about as appealing as a root canal. So they look to family members, friends, and colleagues that they do feel comfortable approaching. Although some of those people can be great potential investors, there are two main problems with this: (1) investors who lack experience in your industry often are unable to give the good advice and guidance that experienced ones do (and may, in fact, give bad advice) and (2) you may be violating securities laws if these investors are not sophisticated, accredited investors. Federal and state securities laws place strict limits on the types of investors that can invest in pre-IPO offerings, and generally require that such investors meet income or net worth thresholds. These requirements vary based on the type of securities offering your company is conducting. Even if you use a structure that complies with securities laws to bring in non-accredited investors, such investors frequently create more issues than they are worth (see this post and this post for further discussion of this issue).
5. Are You Familiar with the Common Angel Round Investment Structures?
You don’t need to get a degree in finance to successfully steer your company through an angel round, but it is important to get down the basics of the types of investment structures that you are trying to get your angel investors to enter into. There are various options open to startups for early investment rounds, including: (1) common equity, (2) preferred equity, (3) convertible Equity (including SAFEs and the KISS), (4) Convertible Notes, and (5) Exchangeable Shares.
The success of your startup’s seed or angel rounds can be the difference between profitability and extinction, and there are no doubt many lessons that you will only learn by going through the process for the first time. But if you’ve sufficiently answered the above five questions, you are well on your way towards positioning your company for success.
© 2016 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.