This article originally appeared in the Preferred Returns Newsletter of the Fall 2022 edition of the American Bar Association’s Business Law Section. It is republished here with permission.
The market rumblings indicate that the current economic landscape is creating challenges for startups looking to raise funds. By some accounts, early-stage startups haven’t (yet) felt much impact from the market tightening, mostly because they’ve been shielded by corrections in the early-stage and public markets. Still, they saw falling valuations, shrinking deals and, in some cases, delayed closings. According to PitchBook-NV-CA’s Second Quarter 2022 Venture Monitor, “…the pace of venture capital (VC) activity at all stages is expected to slow in the second half of 2022 as the threshold for closing deals increases and price uncertainty extends to the early stages of the investment cycle.
So even though there are a lot of deals going on and there is a lot of dry powder waiting to be rolled out, investors are becoming more selective in their investments. Now, perhaps more than ever, startups looking to raise capital should take the time to position themselves for successful VC funding. It’s important for founders to understand that preparing for venture capital funding starts with a better understanding of some key legal issues. This article discusses some of the essential steps founders need to keep in mind in order to position their company for venture capital funding.
Choice of entity and jurisdiction
Choosing the right business entity and the right jurisdiction is an important first step. Although there are a number of different types of entities (for example, partnership, limited liability company and corporation, to name a few), most investors prefer, and generally require, that the startup is a C corporation. C corporations are different from partnerships, LLCs, and S corporations in the way they are taxed. They are taxed as a separate entity from shareholders. In contrast, partnerships, LLCs, and S corporations are considered flow-through entities where taxable income flows through the entity and is reported on the owner’s tax returns. Many investors, especially venture capital funds, cannot invest in FTEs due to their limited partial tax-exempt status or the type of funds they manage.
Once the type of entity is chosen, the next problem is to choose the right jurisdiction. Delaware has been the go-to state for setting up corporations (and LLCs) since the early 1990s. More than one million businesses have chosen Delaware as their home state and more than 60% Fortune 500 companies have been created in Delaware. The Delaware General Corporations Act is reviewed and updated regularly and, being an enabling statute, provides companies with the flexibility to manage their business. Additionally, corporate disputes are heard in the Chancery Court before judges with considerable experience and knowledge of business law. For these reasons, investors favor Delaware. Forming as a Delaware C corporation is an important first step in positioning the startup for venture capital funding.
Founders and First Employees Agreements
An essential step for any startup looking to raise funds from investors is proper documentation. This starts with ensuring that founders, employees and consultants sign Proprietary Information and Invention Assignment Agreements (aka PIIAA) to ensure they are bound by confidentiality obligations and that any proprietary intellectual property they develop in relation to the business is attributed to the business. Investors want to know that the company they are investing in owns the technology. Deals can be derailed if the company is lax in putting this essential documentation in place, only to discover during an investor’s due diligence that the company’s core technology is in fact owned by a former founder or employee. who never ceded his rights to the company. The company must take care to ensure, where applicable, that all employees and consultants sign the PIIAA.
Another important step is to ensure that the shares issued to the founders are subject to a right of redemption in favor of the company, so that if the founder’s relationship with the company ends, the company can redeem all shares subject to to the buyout option, usually at the same price the founder paid for them. Initially, the redemption right should apply to all shares issued to the founder. Over time, these restricted shares will vest, which means that the right to redeem these shares will lapse. Vesting is typically over a four-year period with a one-year limit, such that 25% of the shares will vest after 12 months, with the remaining shares vesting in equal monthly amounts over the remaining 36 months until until 100% of the shares are acquired. acquired and are no longer subject to the buyback option. The acquisition start date is often multiplied by the date the founder formed the startup, but in some cases it may precede the formation date. Investors will review the founder’s equity vesting terms, and if the founder is about to have all of their shares vested, the vesting terms will need to be reset.
This same approach should be used with employees and consultants receiving equity. The vesting start date is usually tied to the employee or consultant start date. Options granted to employees and consultants should have a similar vesting condition, although vesting works a little differently. Since options are a right to buy shares at a future date at an agreed price (i.e. strike or strike price), a call right does not work. Instead of a call right, options are put in place so that only vested options can be exercised and purchased. Options granted to employees will generally vest over the same four-year period with a one-year cap. The conditions for acquiring consultants are generally more varied and can be linked to the length of the consultancy agreement rather than a four-year period.
Having the proper documentation in place with the usual vesting conditions shows investors that the founders have a long-term vision for the company and helps entice key personnel who are important to the company’s success to stay.
Management of the table of ceilings
Investors wishing to invest in a company will look at the cap table. Capitalization table is a document that details the ownership of the company by listing all the securities of a company, including shares, SAFEs (simple agreements for future shares), convertible notes, options and warrants. subscription. The caps table lists everyone who holds securities in the company and their amount. This is an essential document for tracking company ownership.
There are a number of programs that provide cap table management solutions to manage the cap table more efficiently and effectively. One of the benefits of using a cap table management program is the program’s ability to grow and evolve with the business. Some offer additional features such as the ability to obtain 409A assessments, perform compliance audits, or generate various types of reports, including forms. Not having an up-to-date, correct, and well-organized cap table can create a host of problems, ranging from additional legal fees to correct errors to an investor’s extension of due diligence that can delay closing. Some investors now require the startups they invest in to use a cap table management program.
Configuring a data room
It’s never too early to set up a data room. Having a systematic and standardized way to save and organize company documents in a secure data room will make the funding due diligence process much smoother and faster, while helping to contain costs. legal. Founders should carefully choose a secure and easy-to-use data room. The data room should also be organized in preparation for the investor due diligence process.
Many investors will send out a list of due diligence requests early in the funding cycle (usually at the time of term sheet signing – this due diligence list is a good template for the organizational structure of the data room. Have a data room organized in a manner consistent with a typical due diligence checklist will help expedite the due diligence review of the investor.
Choose the right investor
Although it may not occur to founders to interview potential investors, selecting the right investor for the company is as important as the investor choosing the right company for the investment. Founders should make sure they do their homework on potential investors. Many venture capital funds will invest in a specific industry or at a specific stage. Learn about venture capitalists’ past investments, the typical stage and size of their investments, and the backgrounds of venture capital fund partners. Before that first meeting, the founders should learn everything they can about the venture capital fund to make sure it’s a perfect fit for the business.
While other issues are important in positioning a startup for venture capital funding that are beyond the scope of this article, the issues discussed above occur relatively frequently and can be easily resolved with proper planning and procedures. appropriate advice. The recurring theme in positioning a startup for VC funding is readiness. Spending the time to prepare well in advance of funding will give the business a head start and in doing so, save time, money and (perhaps) a few sleepless nights. To quote a well-known entrepreneur, Alexander Graham Bell, “Above all else, preparation is the key to success.”