The basics of Startup Funding

So you’ve got a great business idea, and a team ready to bring it to market (or at least a plan to begin getting it there), but the one thing you don’t have, like a lot of new companies is the capital to begin.  This post will walk through the traditional process for a startup to seek and receive funding.

Unless you can self-fund from your own pocket until you can monetize your company – which can take a long time depending on what your business is planning on doing – you are going to have to look for outside funding.  The first place is always to see if any family or friends want to get in on the action – although if they won’t be working towards your company’s goal and merely providing capital as a passive investment, they better be “accredited investors” (which means they have a net worth of over $1M excluding personal residence, or they’ve made over $200k the last couple years [or over $300k combined with their spouse]).  Otherwise you may run afoul of the securities laws.

After family and friends, the next place to look is for any local business plan competitions or pitch contests, etc.  There are many local economic development organizations that offer grants and awards, which are usually no-strings attached cash.

If you’ve made it through those avenues and have either not received any funds or enough funds, then you are going to have to look to institutional investors.  In the case of brand new startups, they are going to be looking for the niche of venture capitalists known as “seed” or “angel” investors.  They usually prefer to be the first investors in the company and invest similar amounts in each of the companies they do invest in.  Usually the early stage companies are pre-revenue, so arriving at a valuation tends to be very difficult.  To keep things simpler, angel investors may invest a certain sum into each company and use the same valuation.  For example they may invest $150,000 to $250,000 into each company and giving each company a pre-money valuation of $1M, so they’d receive from 15% to 25% equity in the company, respectively.

Another way startups can initially seek funding from institutional or other investors is through a private placement, which can be done at almost any stage of a company’s life.  This type of offering is done by preparing a private placement memorandum and then soliciting, privately, investors to subscribe to the offering.  Its usually set so that the company seeks a minimum and maximum amount of funds, and usually from only accredited investors, although sometimes up to 35 non-accredited investors can participate.  If the company is only selling to accredited investors, however, they will be able to take advantage of one of the new provisions of the recently passed JOBS Act, which will allow for public advertisement of the offering, think twitter, facebook, etc.

Traditionally, venture capitalists on the east coast tended to use private placement memorandums and subscription agreements to get investors into their company.  While historically on the West Coast, most notably in Silicon Valley, they began to use term sheets and then stock purchase agreements to sell investors equity.  This is now known as the Silicon Valley investment model that is used nation wide as well as in other countries (albeit modified to fit into each nation’s laws).  Today, you will see both private placements and Silicon Valley type-investments all over the place.  In the high tech community, the Silicon Valley model has become the norm.

This model, as discussed above, allows the company to sell to investors a certain amount of shares in the company using a stock purchase agreement.  The terms the investors receive have become pretty standard, although each deal usually has its own tweaks.  The investors will usually receive preferred stock that has certain rights, including income/liquidation preferences, the ability to convert to common shares, voting rights, registration rights, anti-dilutive rights, etc.  There are usually a number of rounds of investment needed by the company to keep if funded.  Each of these rounds is usually designated by either a name or letter designation, as in a Seed Round, followed by a Series A Round, and a Series B Round, etc…

The standard set of documents used in one of these financings is as follows:

  1. Stock Purchase Agreement – this is the agreement where the company and investor(s) each make various representations about the IP in the company, the investors’ status as accredited investors, etc.  Also it sets the stage for the entire deal – setting out how many shares will be sold for what price, when, where and detailing the other documents to be used.
  2. Investor Rights Agreement – this agreement gives the investor(s) rights with respect to registration, information (annual financial statements), as well as others.
  3. Voting Agreement – this agreement dictates how each investor or each group of investor in a series can vote on various corporate items, such as election of directors.
  4. Right of First Refusal and Co-Sale Agreement – this agreement gives the investor(s) a right of first refusal if any of the founders desire to sell their shares to a third party, as well as, if the investor decides not to exercise its right of first refusal, the right to sell the investors shares to the third party as well – similar to a tag along right.
  5. Indemnification Agreement – this agreement lays out ad nauseam how the company will indemnify the investor in any litigation.
  6. There are also others that are not always used, but that can be important in certain situations.

There is a movement toward standardizing the forms used in these types of investments, through the use of various sets of form documents.  None have won out as of yet, but having an industry standard would be helpful.  Each of the set of forms out there have their own benefits over some of the others.  Here are a few:

Series Seed Documents.

National Venture Capital Association Model Documents.  

TechStars Model Seed Funding Documents.

Y Combinator Series AA Equity Financing Documents.

Lastly, there is the upcoming crowdfunding method which may bring about another viable way for early stage startup companies to get the funds they need to see their business plans come to life.  Everyone is still holding their breath until the SEC comes out with its regulations.