Entrepreneurs like you dream big. Whether you want to enhance the way businesses connect with their clients or increase the efficiency of ordering products online, entrepreneurs set out to change their communities and sometimes even the world with their big ideas. But running out of cash can squash these dreams before you even start – learning about financing a startup business is just as important as effectively running one.
In fact, about 38% of startups fail due to a lack of funding or failure to raise new capital—the number one cause of startup failure. Financing a startup business may seem straightforward, but it’s a convoluted process, not a do-it-yourself project. Businesses must follow federal and state securities laws and SEC guidelines when raising funds, which are often complex and confusing. Not following these guidelines can put you at risk of losing funding along with the business you’ve worked so hard to build.
That’s why it’s essential to enlist the guidance of a startup financing lawyer like Paul Spitz, founder of Kinetic Law, who helps entrepreneurs seal the deals they need to move forward. Paul Spitz has years of experience helping business owners raise the capital they need to leverage and scale their businesses. Therefore, working with an experienced startup financing lawyer will give you the support you need so you can focus your efforts on creating a scalable, viable enterprise.
Before Talking to Investors
The idea of financing a startup business with investors’ money may initially seem exhilarating. But unfortunately, excitement doesn’t change how risky a deal with an investor can be without the proper knowledge, guidance, or support. Because risks are hidden under the surface, business owners must do their due diligence before diving in. So, before seeking financing from investors, here are some key factors worth familiarizing yourself with to ensure the success of your fundraising endeavors.
Researching securities law. For starters, business financing efforts must comply with federal, state, and SEC laws and guidelines. Failure to comply with these laws can lead to civil and criminal penalties, and could kill your business. Because of the complexities of these laws, it’s wise to have a knowledgeable startup financing attorney by your side. This way, you can ensure you adhere to all financing guidelines and avoid future adverse consequences.
Choosing the appropriate investment vehicle/option. While there are plenty of methods to raise capital, it’s crucial to select the most appropriate option for your situation. Not selecting a suitable investment vehicle could cost you control of your company and a lot of money in legal fees. Here are several common investment options entrepreneurs use when fundraising.
- Convertible notes are excellent for business owners raising less than $1 million. They become equity through a future triggering event (typically an equity financing) and the legal fees to close a round are relatively low. Plus, you can postpone equity valuation, giving your business time to grow. The drawback is convertible notes are debt, with a maturity date by which you must either repay the invested amount plus interest, or negotiate an extension with your investors.
- Simple Agreement for Future Equity (also known as SAFEs) also typically finance endeavors under $1 million. They don’t have an interest rate, but they convert to equity through a future triggering event. Plus, they are affordable. There are several versions of SAFEs, and you should work with an attorney to choose which one is best for your company, rather than just downloading something from the internet. Post-money SAFEs can cause excessive dilution, a possible problem for founders. In other words, the founders risk losing control over their company if there is too much equity dilution. Fortunately, Kinetic law has a SAFE version that avoids this complication.
- Preferred stock can be a suitable investment vehicle for founders raising over $1 million. Preferred stock gives investors more rights than common stock. As such, it is attractive to investors but can incur expensive dividend payments. On top of that, it’s often highly complex and detailed. Because of the time and expertise required to formalize the deal, legal fees are typically much higher than for convertible notes and SAFEs.
Selecting suitable accredited investors. Lastly, talking to the right investors is vital. Ideally, you should work only with “accredited investors” – investors that have a net worth or annual income above a specified level. Because accredited investors have a special status under SEC regulations, you don’t have to jump through hoops to land the deal. For example, if you work with non-accredited investors, you must put additional disclosures in the financing agreement, which is time-consuming and can rack up your legal bill.
Negotiating a Term Sheet
A term sheet is a non-binding document that summarizes the terms and conditions of the deal between you and the investors. It irons out the agreement’s details before placing those terms into a legally binding contract.
Not understanding the provisions of the term sheet can result in a founder agreeing to terms that are unfair, or inappropriate for the size of the deal. By having an experienced, knowledgeable startup term sheet attorney on your side, you can ensure you get the most out of the agreement and don’t give away too much.
For example, let’s say the investors added a term suggesting your company pay up to $60,000 in legal fees to the investors’ attorney to complete the transaction. If this term sheet is your first rodeo, you might not know if this is excessively high (it is!). Partnering with a knowledgeable startup lawyer ensures you know what’s fair and what isn’t.
Additionally, many founders assume that because investors and business owners have the same objective when negotiating a term sheet, using the investor’s lawyer will be fine. However, investors are pros when it comes to making deals. They look at term sheets monthly and have seasoned attorneys who know their way around deal negotiations when financing a startup business.
In addition, the investor’s attorney has an inherent conflict of interest, and cannot truly represent both the startup and the investor (no matter what they tell you). These dynamic puts startup founders at a disadvantage right off the bat if they choose to use the investor’s attorney, or even an attorney recommended by the investor. Therefore, having an experienced startup attorney on your side of the table will ensure terms are favorable, and the deal benefits all parties.
A knowledgeable startup lawyer like Paul Spitz can help you determine favorable terms and avoid the financing pitfalls of the entrepreneurs before you. This way, you can focus on growing your business and achieving your dreams.
Drafting and Negotiating the Investment Documents
After the term sheet has been signed, your startup lawyer will begin drafting and formulating the legally binding contracts. While the term sheet provides a blueprint of the terms and conditions of the final agreement, the investment documents will go more in-depth and provide the detailed terms of the arrangement.
The type of transaction will determine the amount of paperwork involved. For example, convertible notes and SAFE financings usually only need one relatively short document – the convertible note or SAFE itself. On the other hand, preferred stock financings require numerous, complex investment agreements.
But, no matter which investment vehicle you use, the terms and conditions can make one’s head spin, even for an experienced founder. A practiced startup lawyer like Paul Spitz understands these complexities and can easily explain them to founders who may be encountering them for the first time. Startup attorneys can break down legalese into understandable language, so there are no surprises down the road.
After pouring everything into growing your company, the last thing you want is a financing endeavor gone wrong. Fortunately, having an experienced attorney in startup financing will give you peace of mind and the confidence necessary to bring your business vision to life.
Closing the Financing Transaction
Closing the deal is an exciting moment: it’s another step toward success and a way to move your business forward.
As the final phase in securing financing for a startup, closing is a crucial time to have a startup attorney guide you. Legal due diligence, including perusing contracts and confirming the accuracy of the information in each document, is vital to closing the deal. A startup lawyer can spot inconsistencies, correct errors, and ensure you get your money quickly.
If you’re like most entrepreneurs launching a business, you’ve probably worked without a paycheck for what seems like forever. But now, you can finally say, “Show me the money.” Your patience and perseverance have paid off. So, it’s full steam ahead, putting your plan into action and showing investors what a successful enterprise looks like.
Financing a Startup Business? Let Us Help Get the Deal Done
Entrepreneurs shouldn’t shy away from seeking investor funding. Those dollars are the lifeblood of many a startup and can fuel your efforts. However, negotiating favorable investments might be outside your wheelhouse, especially since you’re focused on the particulars of your industry. This dynamic is why an experienced startup attorney can make a world of difference. They can help you acquire the necessary capital with the most favorable terms so you can put your energy into your zone of genius.
At Kinetic Law, we have years of experience counseling entrepreneurs. We can help with business formation and structure, debt and equity financing, drafting, reviewing, and negotiating essential documents and contracts, and general counsel services.
Kinetic Law is based in Cincinnati but can help clients throughout Ohio and California via our virtual platform. So, whether you operate your business in Cleveland or Silicon Valley, Kinetic Law can serve your needs and give you the knowledge and confidence you need to grow your business.
Ready to start raising capital? Contact us today for more information.