By Robert Londin
What does it take for your startup to get funded, grow and monetize? Many entrepreneurs turn to me for guidance on how best to launch a new venture, obtain funding and, ultimately, realize a liquidity event.
There is a lot of publicly available information and advice for entrepreneurs. However, practical advice for founders and principals (both from a business perspective and from a legal point of view) insofar as realistic expectations and goals are concerned may be difficult to find.
This article briefly highlights and serves the entrepreneur as a roadmap of early stage practical advice. In addition, this article identifies many deal points and considerations from the point of view of the early stage investor in order to provide entrepreneurs with a better understanding of the inner workings of early stage capital markets.
1) First Steps. Before getting too deeply involved in general legal requirements, a few initial determinations for the potential venture should be tackled. Capital sources will analyze basic attributes of the early stage business plan: (1) what is the opportunity or market niche for the venture’s products/services; (2) is the business plan/opportunity protectable (from an intellectual property point of view) or is there a significant barrier to entry for potential competitors; (3) has the entrepreneur succeeded in prior business ventures and how strong/experienced are the founders and management team; (4) what is the revenue model; (5) how much capital is needed and what are the uses of funds; and (6) what is a likely potential exit/liquidity transaction (sale transaction or public offering; or is the venture sustainable as a long term revenue producing business so that holding the investment would be desirable to an initial investor – – note, early stage investors are typically not thrilled with the long term hold model because they are looking to receive a multiple return on their investment in a relatively finite period of time).
Additionally, entrepreneurs will need to demonstrate a commitment to the venture. Business plans rarely get funded with a part-time commitment from an entrepreneur who is looking to draw some sort of remuneration other than sweat equity and appreciation of founder shares.
2) Where the Money is. Commonly, a venture requires startup capital from “friends and family” coupled with a contribution to the venture of all the intellectual property rights (including the business concept) to a newly formed entity. From a legal point of view, this is relatively easy to document depending on the attributes of the investors. In addition, once the venture is up and running, the next round of financing may be sourced from a strategic partner, a more sophisticated investor group specializing in seed capital rounds (as opposed to a true larger venture capital round) or, depending upon the type of issuer, a new breed of investor that provides investment funds in exchange for a share of revenue (coupled with a mandatory repayment of investment and an equity kicker).
Another financing tool is a bridge round where investors will lend funds to a new venture. That debt investment, by its terms, would be convertible into the securities issued by the venture in its next round of equity financing. Again, from a legal point of view, the documentation of the bridge financing is commonplace. The key business considerations include whether there is a cap on the enterprise’s valuation in the conversion of the debt in to the issued equity and whether the bridge investor will be entitled to convert its bridge note to the next round of equity securities at a discount. In seed capital circles, there is a growing debate over the use of bridge notes versus using a true equity round at an agreed valuation. In any case, entrepreneurs raising funds via a bridge note run the risk that, if the next round of equity financing does not close, at some point the bridge note will become payable and potentially wipe out founder equity.
3) Valuation. Another chief concern raised in connection with early stage financings will be how much equity in the venture the founders are willing to give up in exchange for invested capital. This is a negotiation over the “pre-money” valuation of the venture — how much the enterprise is worth BEFORE investor funds are added to its capital structure. Entrepreneurs should negotiate for reasonably supportable “pre-money” valuation with, hopefully, some sort of supporting rationale relating to the industry or type of technology involved. The rule of thumb here is that such valuation may not be finalized until closing even if a term sheet points to another valuation. Many closings occur where valuation is “tweaked” shortly before transfer of funds.
4) Seed/Venture Capital Deal Points and the Value-add Proposition. Investors will protect themselves in the event that agreed upon pre-money valuation turns out to be wrong or unsupportable. Such protection is called “anti-dilution” protection and can take many forms (ranging from averaging valuations in subsequent financing rounds to hard “resets” of valuation based upon subsequent rounds); basically, this is price protection for the astute investor. The chief deal points in this regard are what type of reset is involved, how long is the venture/founder subject to such a reset, and whether the investor has a right to continue its anti-dilution protection if it elects not to participate in subsequent financing rounds. This is commonly referred to as a “pay to play” provision.
Hard money/venture round of financing deal points generally focus on anti-dilution protection, investor rights insofar as controlling management and certain corporate actions as well as the economic terms of the investment and, of course, valuation. I counsel entrepreneurs to look to the value add of investors. Founders and entrepreneurs should assess whether a potential investor can add value to the venture in addition to a check. Investors may serve in an advisory capacity or make introductions to customers and/or for strategic alliances.
5) Basic Legal Considerations/Documentation. With respect to legal considerations and documentation, entrepreneurs should first analyze the potential revenue model for the venture so that appropriate jurisdiction and entity selections can be made. This is largely about tax planning. However, there is an initial conflict with respect to desirable entity selection. In early stages, founders prefer “pass through” entities for tax purposes (subchapter “s” corporations and limited liability companies, for example). However, institutional investors and venture funds down the road will likely insist that the venture be a Delaware “c” corporation for a number of reasons. The transition from the pass-through to a “c” corporation is not unusual. Heartache and legal expense can be saved if the revenue model, likely sources of funds, and potential exit transaction are considered at the outset. The bare minimum legal planning and documentation for a founder/entrepreneur to get started include entity/jurisdiction selection, a certificate of incorporation or organizational instrument, some very basic company housekeeping documentation (chiefly involving the founders’ contribution of the intellectual property rights and business plan to the capital of the new entity), documenting the founders’ equity, and, in many cases, adopting an equity incentive plan for future service providers and drawing a shareholders’ agreement (or operating/LLC agreement) governing the management/control of the venture and certain agreements among the initial owners including with respect to transfers of ownership.
Startups are not flush with cash and documentation can (in certain circumstances) be costly and time consuming. Recognizing this, in many instances I and the Jaspan Schlesinger LLP Transactional Department may discuss alternate fee arrangements and “startup packages” which address many of these documents and concerns. However, before offering an alternate fee arrangement (with packages, fee caps and/or equity participation) the potential viability of the venture and exit transaction will be assessed. Like an investor, before agreeing to any type of alternate fee arrangement, counsel will review the potential market niche, revenue model, the strength of the entrepreneur and management team, and the potential exit.
Like selecting potential investors, entrepreneurs should look to their counsel as potential value add propositions. A subset of transactional attorneys offers practical business advice, connections, and commercial value. Counsel should have a general familiarity with what is commercial, practical and, most importantly, which deal points are “market” for the negotiations during the startup’s countdown and percolation.
Who Wrote This? Robert Londin is an equity partner at Jaspan Schlesinger LLP (Long Island’s leading full service law firm) and a passionate, commercial advocate counseling numerous companies, entrepreneurs and business concerns in connection with the negotiation and documentation of their business and legal objectives. The JSLLP transactional group is well-positioned to lend its acumen given its broad practice and experience with startups and emerging growth companies, finance/securities, venture-capital and financing transactions, executive compensation arrangements, general corporate affairs and counseling, and mergers and acquisitions (exit transactions).
This article originally appeared at https://www.linkedin.com/pulse/5-practical-considerations-entrepreneur-preparing-launch-londin.