Back to: EQUITY FUNDING PROCESS
Overview of Funding Stages
The defining characteristic that distinguishes a startup venture from a lifestyle (or small business) business is the growth-based nature of the venture. Both ventures generally begin with personal, friend, or family financing. A non-growth-based venture must achieve sustainability within the confines of personal funds and debt arrangements secured by personal assets. Growth-based ventures, on the other hand, are susceptible of outside equity funding. To achieve the desired growth, equity funding is indispensable. In some cases the business will generate sufficient revenue to grow without outside funding, but this situation is the exception rather than the rule. Startup founders will thus seek investment capital to use to achieve growth. This financing often comes in stages and covers the working necessary to either achieve sustainability from revenue or arriving at the next round of equity funding.
Personal, Friends and Family Funding
The initial funding for a startup venture comes from the founders, friends or family members. See our Sources of Business Funds section for more on this topic.
Seed Stage Financing
A seed stage of financing is the earliest round of equity financing from someone other than founders, friends, or family. Seed stage financing takes place when the entrepreneur has demonstrated product-market fit (or service/content-market fit). Normally this takes place when a business has a valuation of between $100,000 – 2,000,000. The business valuation will vary greatly between types of business and market. In any event, funding at this stage of development generally comes from angel investors who are interested in early-stage ventures.
Growth-stage financing happens once the business has a proven business model. That is, the business has achieved product-market fit and now has stable revenue and growth metrics. Businesses in this category generally have a valuation of between $1-10 million (depending upon the nature of the business and market). At this stage, the primary investors are venture capital funds.
The process for arranging financing will vary depending on the stage of investment and nature of the business. A common model of steps in a venture capital funding transaction includes:
- Review of the business plan by the potential investor;
- Note: The business plan review step may be initiated by the entrepreneur or investor. Entrepreneurs often reach out early in the business life cycle seeking to garner interest in their business. Likewise, venture capitalists in search of portfolio companies frequently reach out to businesses to learn more about their operations. While this is often the first step in the process of securing equity investment, only a small percentage of business plans peek the interest of investors. Likewise, only a small percentage of VC inquiries to startups result in a funding deal.
- An informational interview with the entrepreneur;
- Note: The next step in the process is generally an informational interview where the investor can learn more about the business. This may be the time when the entrepreneurs delivers a copy of the business plan and delivers a presentation. This presentation will cover the major points in the business plan, but will cover important aspects of primary concern to the investor. See our Business Plans, Model, and Presentation material for more information.
- Preliminary negotiations regarding the potential purchase of business equity;
- Note: This may begin over informal back and forth via email, telephone, and in-person conversation. At this point, the parties are working to understand the business operations and arrive at a valuation for the business.
- Creation of a finalized term sheet that outlines the major provisions of the proposed equity deal;
- Note: The initial term sheet will generally cover the 10-12 major provisions of the equity funding deal. See our Deal Term Sheet Provisions for more information about this step.
- A period for the conduct of due diligence by the equity investor;
- Note: Due diligence is the stage where investors thoroughly investigate all aspects of business finances and operations to identify any inconsistencies in the representations of the entrepreneur and any risks not previously recognized.
- The negotiation of the purchase agreement and collateral documents;
- Note: After due diligence, the parties (or their agents) will sit down and work out the final terms of the financing agreement. They will memorialize the terms in a series of documents that effectuates the agreement. See our Series A Documents for more information.
- Completion of necessary regulatory filings; and,
- Note: The purchase or sale of securities (i.e., shares of stock) by a business entity is subject to state and federal securities laws. The federal securities regime requires either registration of the securities or the applicability of an exemption. Even with an exemption, the federal and state government may require an informational filing from the business. See our Securities Law series for more information.
- Finally, the consummation of the deal and the exchange of equity for capital.
- Note: The closing represents the exchange of capital and the transfer of an ownership interest. The closing of the equity financing may take place at one time, in multiple stages, or there may be a rolling closing.
Any of these steps may be absent or vary considerably in an individual funding deal; however, these steps provide a baseline for understanding the major actions that usually take place.
Overview of Series Funding
Following the seed or startup funds stage of financing, startup ventures seek to raise funds through specific rounds of financing. A financing round will have a target amount of money to raise at a given valuation. Sometimes the early round is structured as debt (rather than equity) situation. The startup will issue convertible notes that are debt instruments that may be later converted into shares issued during the following round of financing. In any event, the initial round of pure equity financing is known as series A financing.
Series A Financing
The series A financing round is a formal process. It requires securing commitment from investors until a target funding amount is achieving. Investors may be individuals, funds (such as venture capitalist), or financial institutions. Generally, the series A investors will be super-angels, angel-groups, or low-level venture capital funds. The funding amount may be exclusive as most investors understand that they will be required to provide follow-on funding to maintain their equity position against dilution in later rounds. Once the amount is achieved, the round closes and the funding transaction begins. The series A financing is generally in the range of $1 – 10 million (depending on the value of the business). At this stage founders may sell anywhere from 10 – 50% of there company ownership. This stage of financing is generally very expensive to the founders, but is critical to meeting the early growth objectives of the business. This is generally the scale-up stage of the business lifecycle. The funds generally supply the necessary working capital until another planned financing round or, in rare cases, the company is self-sustaining with revenue.
Series A Preferred Shares
As part of the series A financing, the investors will demand a preferred class of stock. The preferred stock will generally have conversion rights, participation rights, and a liquidation preference. These characteristics are discussed further in our Business Capital Structure Series. Additionally, the terms of financing and issuance of the series A shares will be subject to the all of the steps characteristic of a venture capital investment. This may include negotiation of a term sheet, due diligence, and staged or incremental closings (see our Equity Funding Process series for more detail). The series A, as the name implies, is in anticipation of future rounds of financing as the company grows. Subsequent rounds are conveniently named series B, C, D, etc.
- Note: There is a recent phenomenon in Series A rounds that allow the investor to convert her shares upon the issuance of a future rounds into the preferred shares issued in that round. This is a protection to the investor that allows her to avail herself of the benefits afforded future investors. It also has protections against losses in a future down round.
There are several standards documents employed in the equity funding transaction. Many of these documents surround the formation of a new business entity (or modification of the existing entity), governance procedure, and the actual purchase and transfer of an ownership interest. Below are brief explanations of the most common documents involved in the Equity Financing Transaction.
- Amended and Restated Certificate of Incorporation – If this is a seed round or series A financing, the company may reorganize in an attempt to clean up the ownership structure. The common trend is to reorganize in Delaware, given the manager-friendly provisions of Delaware law. In any event, the articles of incorporation may be amended to include the provisions desired by investors. In a seed funding round you will likely see an authorization of the common and preferential class of shares issued in the financing. Further, there will be a new board of directors, with the investors represented.
- Stock Purchase Agreement – The stock purchase agreement will contain all of the terms previously negotiated in the term sheet. Later stage financing becomes increasingly demanding and will include increased representations and warranties and closing conditions. Further, the agreement may require legal certifications and a legal opinion regarding company status and compliance.
- Investors’ Rights Agreement – The investor rights agreement will contain the protective provisions prescribed for investors. These may include participation rights, information rights, redemption rights, registration rights, and other investor-specific control provisions. If the shares are capable of conversion into a future round of equity shares, this agreement will outline the conversion rights (as the shares will technically be exchanged with the corporation for the new class of shares).
- Management Rights Letter – The venture capital firm wants to avoid becoming subject to regulation under the Investment Company Act. To avoid this, the VC firm must have certain rights to control or decision making in the business. The management rights letter will establish this authority and qualify the startup as an venture capital operating company.
- Term Sheet – The term sheet is the document memorializing the initial agreement between the parties. It will contain the major terms that are incorporated in all of the other documents. The term sheet may also include elements that do not make it into the final agreements. For example, it is common for term sheets to include a cap or maximum that the startup company will contribute toward the cost of the investor’s legal counsel working on the investment.
- Employment Agreements – As part of the financing arrangement, the company may be reorganized. In such a situation, the founders will receive a large percentage of the company as part of the reorganization. Likewise, the investors receive a large percentage of the shares. If the founders will continue on in the business, a percentage of their ownership may be subject to a vesting schedule. The vesting schedule is used to incentivize the founders to continue to perform (see our Vesting Schedule lecture for more information.).
- Right of First Refusal and Co-Sale Agreement – The investors may desire the inclusion of a right of first refusal and co-sale rights regarding the sale or transfer of shares by any shareholder. Right of first refusal allows the company the first right to purchase shares at the price offered by a third-party purchaser. Co-sale rights allow the holder of shares to participate at a given percentage in any sale or transfer of a shareholder’s interest. These agreements protect the closely-held nature of the business.
- Voting Agreement – Often a condition to investor funding is the execution of a shareholder agreement addressing specific matters. The issues addressed in the shareholder agreement could concern voting for directors, sales or mergers of the corporation, amendment of the articles or bylaws, etc.
- Schedule of Exceptions – The Stock Purchase Agreement contains varies representations and warranties from the entrepreneurs to the investors. The schedule of exceptions allows the entrepreneurs to make extensive disclosures about the company. These disclosure create constructive knowledge for the investors. As such, they cannot later claim that they were not aware of some fact and attempt to back out of the deal or bring a lawsuit against the founders.
- Legal Opinion – The legal opinion is a certification from the company’s attorney stating that all of the corporate governance affairs are in order and that the funding transaction does not run afoul of the corporate governance documents or federal or state law.
- Board Consent – The board will have to initiate and approve the action of selling equity in the corporation. The board will generally take formal action through a unanimous consent in lieu of meeting vote.
- Stockholder Consent – As with other major transactions, the shareholders will have to approve the action of selling equity in the corporation. Like the board consent, all shareholders will approve the action via unanimous consent in lieu of meeting vote.
Officer’s Certificate – The president or other officer will act on behalf of the corporation in negotiating and carrying out the equity funding process. The officer’s certificate attests that the officer has authority to act on behalf of the corporation in this manner.
- Secretary’s Certificate – The secretary must certify the authenticity of corporate records. This includes any board actions as originating through appropriate corporate governance procedure.
Good Standing Certificates – The company will be required to provide a certificate from the state demonstrating that it is in good standing under the state law.
Indemnification Agreements – The officers and directors of the corporation will seek indemnification from liability for the actions taken for the corporation.
- Confidential Information and Invention Assignment Agreement – These documents are relevant when the corporation is reorganizing. In that case, the parties will make certain that all intellectual property ownership interests are transferred to the corporation. Often, the IP constitutes the strategic advantage of the company. Failing to adequately transfer the IP can greatly affect the value of the company. As such, the parties will sign agreement concerning the disclosure of confidential information and the assignment of IP to the business.
- Stock Certificates – Not all companies actually issue physical stock certificates. If they do, however, these certificates must comply with state law and be issued in accordance with internal governance procedure.
Board and Stockholder Approval
The investment process generally requires significant board and shareholder approval. First, in drafting the standard documents, the board of directors will need to initiate an amendment of the articles of incorporation (and potentially the bylaws) to accommodate the issuance of a preferred share of stock with the desired characteristics. The requirements for shareholder vote on the amendment of the articles varies with the state of incorporation. Most startups in a financing deal are organized or reorganized in Delaware.
Delaware generally only requires a majority vote of all outstanding stock and a majority of each class of voting stock in order to amend the articles. There are some limits on the requirement for class vote, depending on whether the amendment adversely affects the powers, preferences, or special rights of the class of shares. Since the issuance of a new class of shares does not necessarily affect existing classes, class approval may not be required. In any event, shareholders generally vote to increase the number of authorized shares as part of the process.
The due diligence process is where investors (mainly through there representatives) do a thorough inspection of the startup venture. The purpose is to verify the information supplied by the entrepreneurs and to identify any points of risk in investing in the firm. The extent of diligence varies depending on the stage of company development. In early-stage companies there is generally very little diligence, while later stage companies go through significant diligence.
A Little More on Due Diligence
The party selling their business venture is expected to confirm a certain thing including financial records, viable planning, legal compliance etc., before entering an agreement, this is known as due diligence. Due diligence can also refer to the seller’s investigation prior to finalizing a deal with a buyer. The seller needs to know whether the buyer has the adequate fund to complete the transaction. He would also like to confirm a certain thing which might affect the seller or purchased entity after the acquisition.
Due diligence is not always a legal obligation, rather it refers to the voluntary investigation carried out by the parties involved in a transaction.
Equity research analyst, fund managers, broker-dealers and investors perform due diligence in investment world, companies making an acquisition and venture capitalists investing in a startup are also expected to perform this investigation before finalizing the agreement. Individual investors are not legally obligated to perform due diligence but are recommended to, on the other hand broker-dealer are obligated by law to perform due diligence of a security before selling it.
In the U.S. the Securities Act of 1933 makes it mandatory for all the security dealers to disclose all the material information regarding security to a prospective buyer. Failing to do so is considered to be a criminal offense under this Act. Although, the Act also makes sure the security dealers and brokers do not face an unfair prosecution for not knowing an information about the security. They are obligated to perform due diligence before selling the equities of a company and disclose the information fully to the prospective investors, but they are not accountable for any information that they didn’t find in due diligence process.
A Due diligence meeting is a standard part of an Initial public offerings. An underwriter needs to make sure that all the pertinent material information regarding the securities are disclosed to the potential investors. The underwriters, issuer and all other concerned individuals including syndicate members and attorneys meet before issuing the final prospective to confirm that the due diligence process prescribed under state and federal securities laws, is properly followed by the issuer and underwriter.
The due diligence process includes multiple steps of investigation in order to get a complete picture before taking the final call. It involves analyzing the total valuation of the company, examining the revenue, profit and margin trends, looking into the competitors, investigating valuation multiples, balance sheet examination, analyzing stock price history, considering stock options and dilution possibilities and inspecting long and short term risks. The due diligence also looks into the management and share ownership of the company and Wallstreet analysts’ consensus for earning growth, revenue and profit estimates of the company for next two-three years.
Areas Reviewed During Due Diligence
The areas of review are:
While the entrepreneur and investor must be aware of the diligence matters, the actual inspection should primarily be conducted by professionals (attorneys, accountants, and technologists). These individuals can do a far superior job in identifying the potential pitfalls or areas of risk. Below will provides some key points of research into each of these ares.
Financial Due Diligence
- Income Statement, Cash Flow Statement, and Balance Sheet – In early-stage firms, these documents can be very rudimentary. In any event the investor will verify ownership of assets and assess accounts receivable.
- Financial Projections – An accountant will compare the revenue and cost projections with the operational requirements. The purpose is to make certain that the cost projections match the necessary operational expenses associated with growth. Often there will be company, market, and economic risks associated with the operations that must be considered. Lastly, it will focus on the expectations for funding demand and the expected sources of capital.
- Capital Structure – What is the ownership structure and what effect does it have on the equity value of the company. This will include any debt instruments and their limitations on the company.
- Tax & Reporting Compliance – Has the company complied with all taxation and regulatory filing requirements. Are the tax filings accurately and appropriately executed.
Operational Due Diligence
- Product/Service Review – Review the market trends and characteristics for the product or service being delivered.
- Customers, Suppliers, Purchasers, Partners – Review for any vulnerabilities in operational relationships.
- Competitive Analysis – Review of the operational characteristics of the firm in comparison to competitors in the market.
- Marketing and Sales Channels – Review of efficiency and vulnerabilities in the marketing and sales process. This may include a comparative analysis of compensation structure for internal and external sales units. This will include an analysis of the method for driving new customers/clients.
- Research and Development – Technically proficient individuals will review the intellectual property and R&D for feasibility and potential in the market.
- Management & Personnel – Review the corporate organization structure and the roles of individuals in the organization. This may include identifying performance of key individuals and the identification of indispensable parties. It will further outline the ownership and compensation structure of these individuals.
Legal Due Diligence
- Corporate Governance Matters – Has the company complied with all corporate governance processes and procedures?
- Litigation – What litigation is pending by or against the company?
- Regulatory Environment & Compliance – What regulatory issues is the company facing. Most commonly, this may include tax, securities, environmental, and employee-labor compliance.
- Intellectual Property – Are the intellectual property rights secured in the company. How strong are the intellectual property rights?
- Insurance – What events are insured or bonded and where are the holes or risks in coverage.
The Stock Purchase Agreement
The stock purchase agreement is the central contract between the parties where the business agrees to exchange as specific number of shares of the business venture for the agreed upon funding. The stock purchase agreement is made up of the following elements:
- Preamble – This provision identifies the parties to the agreement.
- Note: The preamble may be immediately followed by background recitals and a definitions section.
- The Action Section – This section identifies the value being exchanged
- Note: In this case the value being exchange will be a class of preferred shares in exchange for a predetermined amount.
- Example: The purchase agreement will identify the company valuation, total number of shares, and the price paid per share. It will also outline this information in a capitalization table that may be included in the body or appended to the stock purchase agreement.
- The Rights of the Parties – This includes the rights with regard to their ownership interest.
- Note: See the Term Sheet Provisions Material for more information on the extent of shareholder rights that may be included in the agreement.
- Example: The agreement may outline the rights of shareholders to redeem their shares with the corporation upon the occurrence of defined circumstances or events.
- The Representations and Warranties – The representations and warranties state the facts about the business venture that are true and will remain true at the time of closing.
- Note: Basically, all of the material aspects of business operations are capable of inclusion in the representations and warranties. Generally, however, these provisions will focus upon the aspects of the venture uncovered during due diligence that present some level of risk to business continuation or operations.
- Example: The company will represent that it is incorporated, in good standing, authorized to carry on its business, holds all relevant licenses and permits, is qualified to transact business in every relevant jurisdiction, the capitalization structure, pending or threatened litigation, data privacy, and ownership of intellectual property. Investors will generally represent their authority to enter the transaction and its status as an accredited investor.
- The Covenants – This section contains the duties that each party must undertake as part of the agreement.
- Note: In many situations, the funding will be contingent upon the current owners undertaking certain actions.
- Example: The company must file the securities regulation documents required to perfect an exemption from registration.
- The Conditions – These are generally tied to the covenants and outline factual elements that must be true prior to closing.
- Note: These are facts that must be true for the agreement to be enforceable.
- Example: For example, the agreement may be conditioned upon the completion of due diligence; acceptance of regulatory filings by the company; filing of an amended and restated certificate of incorporation; the transaction must qualify for a state-sponsored tax credit for the transaction to be consummated; the entrepreneurs enter into a continued employment agreement with the firm; the company counsel must deliver a legal opinion letter.
- Endgame Provisions – These are the provisions that outline the rights and responsibilities in the event of failure of any representation, warranty, covenant, and condition.
- Note: The endgame provisions will generally allocate the burden of attorneys fees in the event of a successful transaction and otherwise.
As part of the funding process (particularly the due diligence process), investors will require that the attorney for the startup venture deliver a legal opinion concerning certain organization and governance requirements. This opinion letter allows for counsel to make certifications regarding aspects that may or may not be included in the stock purchase agreement. This also allows for an additional level of protection from the counsel’s professional liability insurance.
The counsel legal opinion generally covers the following certifications:
- Incorporation – The company is validly incorporated and in good standing in the state of incorporation.
- Registration – The corporation is registered as a foreign entity in jurisdictions where it is not registered and has authority to carry on business in those jurisdictions.
- Authority – The corporation, through its agents, has the authority to carry out the subject funding transaction, such authority is authorized in the governing documents, and the governance procedures necessary to carry out such transaction has been completed.
- Capital Structure – The representations made regarding the capital structure structure and total capitalization is accurate.
- Issuance of Shares – The shares sold in the transaction have been appropriately issued pursuant to state law and corporate governance procedure.
- Corporate Action – The individuals acting on behalf of the corporation are duly authorized.
- Documentation – The individuals executing the documents on behalf of the company have authority to do so and to effectively bind the company in the subject transaction.
- Governmental Approval – The stated transaction, as completed, does not conflict with state or government laws (or require government approval).
- Federal Registration – The company is exempt from registration under federal and state securities laws.
- Litigation – All matters of litigation either initiated by, contemplated by, initiated against, or threatened against the corporation have been disclosed.
Legal opinions are less common in seed funding transaction involving angel investors. It is universally expected in deals involving venture capitalists. The expectation of the legal opinion letter will vary depending upon the size and nature of the deal.
In seed rounds it is common to have a rolling closing date. This means that investors will join the round and provide funding before all investors necessary to meet the target amount have committed. The startup cannot wait to close the seek round until all investors commit, so it will arrange for multiple closings. All rounds will generally close within 90 days of the 1st round. Investors generally dislike rolling closing, because it increases the risk to early investors. The early investor is committed whether the firm achieve the entire target amount. This can create operational difficulties if the startup does not receive all funding. Likewise, later investors receive an advantage in waiting to see if the seed round will be fully funded and how the firm performs over the extended period. In any event, all investors in the round receive shares under the same terms.
In Series A rounds, there is generally a single venture capital firm involved. As such, the funding round is generally closed and all of the funding takes place at one time. There are, however, situations where series A financing rounds have rolling closings. A series A closing is generally done pursuant to vote of the board of directors. The early investors may require a majority (sometimes super majority) of directors or shareholders approve the timing of future closing and the investors involved.
Legal Fees in a Funding Transaction
Legal counsel plays and important role in funding transaction. The process can be quite complicated and the counsel helps negotiate the deal as well as draft the applicable documents. The startup venture will always have counsel. In a seed round it is not common for investors to have counsel. In a series A round it is very common for the investor to have counsel as well.
The company generally pays for both company and investor counsel (or rather it comes out of the funding provided by investors). The amount the company is responsible for paying is generally capped (negotiated in term sheet) or subject to “reasonable fees”. The cost of a seed financing may be as low as $5,000, while the fees for a complicated late stage financing can be over $100,000. Company counsel is generally more costly than investor counsel, as company counsel drafts documents and facilitates due diligence. The variation in price generally results from the degree of due diligence and negotiation between the parties. As expected, the negotiation is far more extensive and fees much higher when company and investor counsel are involved. The costs also go up when diligence reveal issues in the governance or intellectual property holdings that must be remedied. As discussed in a separate lecture, legal diligence verifies financial (capitalization issues), operations (intellectual property), and regulatory issues. Counsel may not charge or reduce charges if the transaction does not class. If the counsel performs significant diligence, charges are certain. This may require contracting with specialty counsel to conduct the IP or regulatory diligence.