How Do I Take Investments From Investors?

A recent LawTrades user asked- What is the legal process of taking investment from an investor for a startup?

As soon as you have identified the product or service you want to market and have developed your idea for turning it into a business, you should consider incorporating as soon as possible.

Below is the general process we help startups with:

Legal Structuring

Obtaining legal counsel to help you with deciding which corporate structure will best fit your needs, where to incorporate, and how to structure ownership is crucial to building the right foundation that will help you attract investors and save you money in the long run.

For example, high growth companies might want to incorporate in Delaware, whereas incorporating in the state where you’ll be headquartered or principally doing business might be the better choice for others. Also, it may more advisable in some instances to incorporate as an LLC, whereas for others a C-corp will be the better alternative.

Incorporation Benefits

Incorporating your company offers the following benefits:

  • Protects owners from personal liability (e.g., if a creditor or customer sues the company)
  • Reduces risk exposure (making the company more attractive to investors)
  • Allows for the free transfer of ownership through the purchase and sale of stock (subject to restrictions)
  • Endows your company with the opportunity to expand valuable assets (e.g., owning patents, trademarks and other intellectual property)
  • Creates credibility and longevity
  • Offers tax advantages depending on the type of entity

Attracting Investors

Once you’ve put your legal ducks in order, you’ll want to start pitching to investors. The essential ingredients of your pitch include: (1) your elevator pitch, (2) the problem or need you’ve identified, (3) how your product/service is going to solve the problem or meet the need, (4) your revenue model and marketing strategy, and (5) your core competencies and competitive advantage.

You can find a great investor pitch deck template here that was created for crowd-funder, but can be easily adapted to accommodate your specific needs and wants.

Coming to Terms

If you’re fortunate enough to attract an investor’s interest, the next step will be to create a term sheet. A term sheet isn’t a contract guaranteeing you funding. Instead, it’s essentially a sheet that briefly sketches the contours of fundamental terms such as investors’ rights and stock purchase (including liquidated preference), the voting agreement, and the right of first refusal. It also invariably includes provisions that limit marketing the company to other potential investors (i.e., exclusive ‘dating’), and confidentiality clauses. A good primer on term sheets is available here.

Funding Vehicles

Many startups begin their first round of funding with family and friends (F&F), move on to angel investors (high net worth individuals), then to VCs for the Series A round.

When you’re starting a new company, there’s usually no way to value it since it doesn’t have a track record: it has few or no customers, no revenues and no assets. This makes assigning equity pretty near impossible. Until a company is able to gain financial traction where it can issue equity shares (usually at the Series A round), it will typically incur debt.

There are different types of debt instruments. When you’re in the F&F round, the most common debt instrument is a simple note (i.e., a loan), entitling the person who loaned you the money to be repaid at some specific time according to some agreed-to interest rate.

When you’re dealing with angel investors or VCs, you’ll likely be using some form of a convertible debt note. What this means is that the money the investor loans you is considered debt until you obtain the next round of financing, when you can first obtain a valuation for your company. This is the first point at which shares can actually be issued since now you have a way to divide ownership interest.

Convertible debt differs from a regular loan in that the debt automatically changes into a percentage of equity ownership (shares) once valuation is possible at the Series A stage. The person who holds the convertible debt then becomes a shareholder. Angels and VCs often receive preferred stock when the debt converts to stock. What this means is that in the event the company is sold or declares bankruptcy, they would be repaid before common stockholders and most others.

You can learn more about how to divide equity among investors in this piece.

Have more questions? Feel free to visit LawTrades.