By Keith Strahan
Generally speaking, startup seed funding is a form of securities offering where an investor or investment group invests money into a business in exchange for an equity stake or a convertible note. Seed funding is typically the earliest funding that you can get to start your business, aside from founders’ personal contributions and loans/investments from family members and friends. Because seed capital is used in the pre-revenue stage of development, investors view these transactions as high-risk investments and won’t be handing them out to every startup that walks through the door.
Seed funding is especially difficult because entrepreneurs and investors come to the negotiating table with completely different priorities and objectives. Entrepreneurs in the seed-stage are looking for money to finance product development and preliminary operations without giving away too large of a piece of their equity pie. Investors, on the other hand, are looking to limit their financial contribution while acquiring an amount of equity that makes the endeavor worth-while. Investors are only willing to extend a helping hand to startups that have incredibly promising ideas and teams – a problem that is all-too-similar to the “entry level job” requiring 2-3 years of experience.
Despite all of the hype surrounding funding from angel investors and venture capitalists, data gathered by Fundable shows that only 0.91% of startups are funded by angel investors and only 0.05% are funded by VCs. Needless to say, if you end up in the exciting position where seed funding is coming your way, you need to set yourself up for success. A crucial aspect of this preparation is legal in nature and requires savvy entrepreneurs to double-check their legal work and link up with an experienced attorney to do so.
To save you a bit of time (and money!), here are five legal steps to take before your first seed round:
1) Be a duly-formed corporation.
So you’ve filed your formation documents with the Secretary of State, paid your formation fees, and have received a Certificate of Formation confirming that your corporation has been properly formed under the laws of your state. Congratulations! But if you’re looking to get some investments with only this piece of paper to your name, you’re going to be S.O.L. Before jumping into the investor feeding-pool, you need to make sure you at least have the following additional items: (i) Employer Identification Number; (ii) Strong corporate bylaws that cover you all the way from pre-revenue to dissolution; (iii) Appointed Board of Directors (“BOD”); and (iv) BOD and shareholder minutes and resolutions. Seed round investors will look at the nuts and bolts of your corporation to ensure that you have spent the time necessary to gather all of the requisite pieces of a duly-formed business in your state. serial lumion 8
2) Finalize an agreement with your co-founders.
The “divorce rate” for business partnerships is around 80% and as accomplished consultant James Krefft warns, the Cost of Poor Partnering (COPP) can be staggering. “The direct cost of a failed business partnership can run as high as 80 percent of the investment in forming the partnership. Perhaps more importantly, based on research conducted by Partnership Continuum, Inc., the indirect costs and the opportunity costs associated with a failed business partnership can amount to as much as five times the investment.” So what do you and your cofounders need to do to protect yourselves against potentially disastrous business-divorce costs? Here’s where cofounder agreements come in. Think of a cofounder agreement as a pre-nup for your business – it addresses critical issues regarding how the business will be run, how disputes will be managed, and how you’ll get paid. Here some of are the key terms you need to address in a written and signed cofounder agreement:
– Who gets what percentage of the company? How do you determine how much equity is appropriate given the value-add of each founder?
– Is the percentage ownership subject to vesting based on continued participation in the business?
– What assets or cash into the business does each founder contribute or invest?
– What are the performance expectations of the founders? What are your roles and responsibilities?
– What happens if one founder isn’t living up to expectations under the founder agreement? How is it resolved?
– If one founder leaves, does the company or the other founder have the right to buy back that founder’s shares (right of first refusal)? At what price?
– How much time commitment to the business is expected of each founder?
– What salaries (if any) are the founders entitled to? How will compensation shift as the company grows?
– How are key decisions and day-to-day decisions of the business to be made? (majority vote, unanimous vote, or certain decisions left solely up to the CEO?)
– Under what circumstances can a founder be removed as an employee of the business?
– How will a sale of the business be decided?
– What is the overall mission and vision for the business?
3) Check your responsibilities to existing shareholders.
If your business has existing shareholders, you need to review what responsibilities you have to them before considering taking on seed funding in exchange for either equity or a convertible note. Do you owe them any certain notices or disclosures? Have they agreed to be diluted if need be? Founders and officers owe certain fiduciary duties to shareholders and breaching these duties is almost certain to land you in a pot of boiling litigation water. A popular startup blogger, José Ancer, describes these duties perfectly. He states, “At the most fundamental level, to say that founders have fiduciary duties to their stockholders means that they cannot, without seriously risking a lawsuit, unfairly enrich themselves at the expense of other people on their cap table. They can certainly get rich by making everyone on the cap table rich; by growing the pie. But they can’t, without some kind of very credible case that it is necessary for the well-being of the entire business, improve their part of the pie at the expense of the rest of it.”
4) Review securities laws that pertain to your fundraising.
According to Section 5 of the Securities Act of 1933, as amended (the “Securities Act”), any non-exempt offer or sale of securities must be registered with the Securities and Exchange Commission (“SEC”). Technically speaking, a convertible note or stock of a company are considered “securities,” so a startup company is generally required to follow Section 5 registration requirements before issuing them. Registration is a complex and expensive process, so many startups instead rely on available exemptions. Three of the most common exemptions are:
– 4(a)(2) – The first common exemption is under Section 4(a)(2) of the Securities Act, otherwise known as the “private placement exemption.” Companies utilizing the private placement exemption must offer securities in an offering that does not involve a “public offering.” While the SEC has not formally defined what constitutes a “public offering” it has offered several factors that are considered in the analysis such as number of investors, investor suitability, intent of the investment, and whether or not the offering is in the form of a general solicitation.
– 506(b) – The second common exemption is under Rule 506(b) of Regulation D. Rule 506(b) of Regulation D provides a strict set of criteria that provides a safe harbor that exempts securities from the registered offering requirements of Section 5. Similar to 4(a)(2), Rule 506(b) has its own set of restrictions and considerations, such as types of investors and whether or not the company has been subject to certain types of legal or regulatory actions, that should be carefully discussed with your attorney.
– Regulation Crowdfunding – Regulation Crowdfunding permits individuals to invest in registration-free, securities-based crowdfunding transactions subject to certain investment limits. The rules also limit the amount of money an issuer can raise using the crowdfunding exemption, impose disclosure requirements on issuers for certain information about their business and securities offering, and create a regulatory framework for the broker-dealers and funding portals that facilitate the crowdfunding transactions.
5) Consider intellectual property protection.
Any novel intellectual property created by your businesses should be adequately protected by a patent or trademark. To see my previous article about the proper time to trademark your business name, click here. In most cases, having a completed or pending patent or trademark is a huge asset to your business and will be looked favorably upon by seed round investors; however having the funding for these protections prior to a seed round presents a “chicken and egg” problem for many entrepreneurs. Here is a link to the USPTO’s Patent Pro Bono Program, which provides free legal assistance to under-resourced startups interested in securing patent protection. If you live in or around Houston, two great resources are the South Texas College of Law Houston Intellectual Property Clinics (one for trademarks and one for patents), which offer low-cost IP services to qualifying business owners. STCL is one of only 18 law schools in the country to offer this type of clinic. Finally, many law firms such as Strahan Law Firm, PLLC in Houston offer affordable, flat-rate trademark filings and same-day filing for most marks.
Another component of intellectual property protection that is often overlooked at the startup stage is a confidentiality/non-disclosure agreement. When approaching a seed round, you will likely be sharing intimate details about your business with third-parties and it is important to mitigate any risk that the information will be shared without your consent. While investors typically refuse to sign NDA’s, people such as programmers, marketers, and web designers who perform work for you and your organization should be required to sign one. (Note: This is not to be confused with a non-compete agreement.)
Starting and growing a business is equally as stressful as it is rewarding, and receiving seed funding is undoubtedly a game-changing experience. Discuss your priorities and concerns with experienced legal counsel and never be afraid to ask for help.