How to raise capital in startups
Is your company starting to consider if it’s time to raise capital? If so, congratulations – this is a significant step in a startup’s lifecycle, and it can be an incredibly positive milestone for your business.
Securing investment in your company is a tricky process, and it’s something that should be carefully considered. You want to ensure that you’re inviting the right investors into your company. A poorly chosen investor combined with ill-fitting documentation can have long-lasting consequences for your company. There are many things to think about during this stage, so we’re going to take a closer look at how to retain control of your business with well-drafted terms, clear term sheets, subscription deeds, and shareholder agreements as you enter into a capital raise.
When should a startup raise capital?
There’s no easy answer to this question. If your company is ready to scale or expand, or if exponential growth is clearly visible on the horizon, it might be time to raise capital. Having these details ironed out and investors lined up may enable your company to grow without having to worry, “how do I get funded for a start-up?” When deciding if it’s time to raise capital, there are two schools of thought:
- Bootstrap for as long as possible:
If your company has the capacity to continue on without external funding, this can be beneficial down the track. As your business will be more developed, you may be able to raise money at a higher valuation, thus giving up less equity and control.
- Secure funding early:
If your company chooses to raise capital early and quickly, your business will have an increased capacity to scale and grow earlier and quicker. This can give a business the boost it needs for success, and keep you ahead of the competition.
Making this choice will depend on the circumstances and requirements of your business, and how quickly the business needs to grow in order to achieve momentum for success.
What sort of business plan is required for raising capital?
It’s tempting to look to other wildly successful startups and think, “what business plan did you use to get seed funding?” There’s no perfect formula for this. Your company should have a clear plan forward and the ability to answer critical questions likely to come from potential investors. If you’re ready to raise capital, ensure that you have prepared a solid pitch deck, budget forecasting, use case scenarios, and a robust dataroom with all legal and business records.
What are the funding options?
If you’re ready to raise capital, there are five general ways this is done: a friends and family round; accelerator programs; crowd-funding; angel investors; and venture capital firms.
Consider the friends and family round as your first stop in the early days – consider reaching out to potential investors in your close networks. Depending on your contacts, this may be sufficient as a first funding step.
To grow your business, knowledge, connections, and investor relations, accelerator programs are a really good option that can also provide solid business learnings alongside financial support.
If you need the capital but not the hands-on business training, an angel investor or two can provide the boost required in early-to-mid development stages.
Crowd-funding can also be a great option if you have a product with mass consumer appeal and the likelihood of a viral hit.
Of course, venture capital firms are the backbone of the startup industry and they often represent the most appealing (at least financially) method of raising capital. However, please remember that many of these firms usually insist on seeing a solid proof of concept alongside a working business which is bringing in a viable revenue stream. Accordingly, we think that venture capital firms are more suited towards later rounds or more developed businesses.
Founders should be aware that there are legal formalities in a funding process, and legal advice is always recommended.
Once I’ve found an investor, what’s next?
It’s probably best to start by working out what the key commercial terms of the investment will be, and write them in a term sheet (also known as a heads of agreement or a letter of intent). A term sheet is an important negotiating tool in any hefty equity raise. Think of this as a document which clarifies what the main commercial terms will be – investment amount, amount and type of equity to be received by the investor, timing of the investment, any major conditions that tie in like a director seat or special rights.
Having a well-written and clearly thought-out term sheet will help streamline costly and lengthy commercial negotiations. By providing a term sheet, you’re able to set out some general principles and guidelines before the lawyers on either side get into the details. Your lawyer and your potential investor’s lawyer will need to spend a great deal of time on the complex and comprehensive terms of the shareholders’ agreement and subscription deed, among other documents. A good term sheet will lock down the important commercial terms while the lawyers argue over the more esoteric clauses.
What are the pros and cons of using term sheets?
There are many pitfalls a company must avoid when raising capital, and choosing the wrong arrangement can be devastating for your company. Loss of control, poorly defined payment milestones, investor fall-outs, disputes around rights and excessive warranties can create disputes down the line, inhibit a company’s growth and its chance of raising again in the future.
Using a professionally written and negotiated term sheet can ensure this process is as smooth as possible. Here’s the good and the bad:
The good:
- Term sheets are an easy way to lock down the important issues before the lawyers get stuck into the more complex and less commercial important issues.
- Term sheets are (in comparison to the final document) cheaper and quicker to produce and sign, which means that you can get started and get some sort of basic agreement quickly and without incurring too much cost.
- Term sheets serve as a good starting point for lawyers to work off, and they are a good opportunity for both parties to understanding each other’s expectations and where they differ in opinion
- Term sheets aren’t typically binding. This means that your term sheet is an offering of good faith on the part of both parties and can help move the negotiation along with the psychological surety that both parties are interested and committed to making the deal work. It also means that you’re not locked into something too risky, too soon. Note: it is also possible to include binding obligations in a term sheet if deemed appropriate.
The bad:
- As the term sheet is usually not legally binding, it could sometimes be argued that it is an unnecessary extra step without any legal enforceability. In other words, you may spend time (and legal fees) negotiating and signing a term sheet only for the investor to drop out, without anything you can do about it
What else do I need to consider?
When negotiating an investment deal, put a priority on minimising the risk of misunderstanding above all else. Prolonged negotiations can quickly add up and interrupt your business’s growth plans at the same time.
An experienced lawyer can reduce time wasted on pointless negotiations by expertly identifying opportunities for your company. In addition, you should be aware of avoiding unfair terms concerning:
- Warranties;
- Company control; and
- Payment milestones.
In addition, if the deal were to collapse due to an intractable negotiation process, your company could find itself liable for all costs related to the legal and admin fees of the investor – if you agreed to pay those.
Summary
Every capital raise is different, but vital steps can ensure a successful process for startups and their investors. By engaging a legal professional to draft and negotiate on your behalf, your company can minimise loss of control, liability risk, and warranties.
UX Law are experts in the capital-raising process. We can provide you with strategic legal guidance from start to finish. We have the expertise to provide crucial legal advice and draft the key documents which will ensure you are protected now and in the future, including term sheets, subscription agreements and shareholder agreements.