There is a lot of information available about startup financing and working with investors. On my blog, there are a number of articles about the topic in general, including the different kinds of financing. This piece is intended to give you some insights into the process, and why there’s a preferred way to do things.
It starts with choosing investors wisely. When choosing investors, the most important things are (1) are they accredited investors, and (2) do they have a good track record and reputation with founders. The least important things are whether they are interested in investing. What is an accredited investor, and why is this important? An accredited investor is NOT someone who has gone through some licensing or certification process. Put simply, an accredited investor is a rich person, someone who can afford to lose his entire investment. Federal law has a number of requirements, but the two basic ones are that the investor either has annual income of at least $200,000 in each of the past two years (or $300,000 with his or her spouse), and has a reasonable expectation of earning at that level in the current year, OR has an individual net worth (or joint net worth with spouse) of at least $1 million, not including the value of his or her primary residence. The reason we prefer that you deal only with accredited investors is that securities regulations make it much easier to do a private financing with these investors, and with much easier disclosure requirements. This will save you time and legal fees.
You also need to investigate your investors, to find out what their track record and reputation is. Are they supportive? Easy to work with? Do they have expertise that can help you build your business? Do they have a history of clashing with founders, belittling them and forcing them out? Is there a tawdry history of sexual harassment? Unsavory associations that could hurt your brand? Better to find out before they end up on your cap table and board of directors. There are plenty of investors out there, and you should be getting references, talking to founders of other startups these investors have invested in, and doing your homework. They are investigating you, after all.
In addition, be strategic in how you search for investors. Too many founders default to local, but if your city doesn’t have a diverse, large, and vibrant investor community, you are likely to have trouble finding investors, and getting market-standard terms. You should be looking for investors who have a history or policy of investing in your type of company. A consumer software investor is unlikely to invest in a medical technology or hardware startup.
Don’t skip the term sheet. For large and complex financing deals, taking the time to negotiate the term sheet pays dividends as the financing moves to a closing. The term sheet is your opportunity to hash out the key terms of the financing, such as how much money will be raised, what is the pre-money valuation, what financing vehicle will be used (convertible note, SAFE, preferred stock), liquidation preferences, and anti-dilution protection. Generally, terms sheets are designed to be non-binding, except for a few provisions such as confidentiality, but still play a key role in constraining the parties from re-negotiating substantive terms as the definitive investment agreements are being negotiated and the due diligence is underway. Putting the time into negotiating these terms in detail, upfront can prevent confusion and disagreements from cropping up later. This is also your opportunity to fully understand what the terms are, and how they impact you and the company. An experienced venture capital investor does dozens of these deals, while this may be your first.
Due Diligence. This is a getting-to-know-you process. Your investor will be reviewing documentation regarding your corporate organization and governance, key contracts, intellectual property ownership, litigation, employment practices, and financial situation (including payment of Delaware franchise taxes). The purpose is to verify that what looks like a good investment actually is, and to identify any potential problems or issues. You should be prepared for this before signing the term sheet, by having all this information about your company assembled and properly organized. If you’ve done a sloppy job of corporate governance, with unsigned board/shareholder resolutions or no resolutions at all, you should be working to fix those problems right away. At best, corporate cleanup will delay closing your financing. At worst, the investor will pull out, and you’ll be back to Square 1.
Negotiating the definitive contracts. While due diligence is underway, your lawyer will be negotiating and drafting the definitive contracts, based on the term sheet. It’s one thing to say “broad-based weighted average anti-dilution protection” in the term sheet, but these documents will add a necessary level of detail. While there are templates out there for a variety of different kinds of contracts, these templates are just starting points. There are provisions in them that won’t fit your term sheet, or that are just plain badly written with typos. In convertible note or SAFE financings, there may only be one document – the convertible note or SAFE – and the term sheet may be pretty simple, because in these types of financings there are typically only a few variables. For a preferred stock financing, whether it’s a Series Seed or a Series A, there will be multiple investment agreements, with a great deal of complexity and detail.
Closing. This is the end of the financing process – when the agreements get signed and the money gets wired into your company bank account. Depending on the complexity of the deal, the closing could happen quickly or it could take 30 days or more. For SAFE and convertible note deals with experienced, sophisticated investors, the closing can happen quite fast. Series A financings will take more time, particularly if you need to convert your LLC to a Delaware corporation.