Blog by Attorney H. Robert Fischer III
How Do I Fund My Startup? A Legal Perspective.
So, you took the first step and organized your startup business entity. Now what? Well, now you probably need money. As we all know, without enough funding, a successful business might just remain a pipe dream.
At this stage, you might be running into trouble bootstrapping or you might be ready to begin hiring employees, purchasing equipment, obtaining patents or otherwise. Whatever the case, you will need to choose between securing a business loan or attracting investors to get to the next level.
The first round of investment is known as seed funding. Seed funding can be through bank loans, friends and family, or angel investors.
Bank Loans:
Business loans are attractive because it is simple transactional relationship with a lender, unlike investor relationships. On top of that, you will not need to give up equity in your company. The disadvantages? Well, banks know the risks involved when lending to a business without a proven track record and dealing with owners with less than stellar credit scores.
Because many startups fall short on obtaining business loans, particularly those with good rates, investment funding may be your best (or your only) option.
Family and Friends Investors:
Friends and family are the most common source of early investment. Often, these investments are structured as gifts, loans or equity investment. If structured properly, the family and friend seed funding can be the launchpad that a startup needs to become an established and profitable business.
The tendency is to approach these transactions very informally. Even though you are doing business with your close friends or family whom you trust, handshake deals can be devastating to both your fledgling startup and to your longstanding personal relationships.
Legal Documents
Promissory Note: A loan can be an ideal and simple funding solution. To avoid legal issues down the road, you will want to make sure everything is set out in a promissory note so everyone knows what to expect in terms of repayment.
Investment Agreement: Because the friend or family member may be obtaining an ownership stake in the company, you will want to make sure that you have a solid investment agreement that sets out the terms of the relationship and an agreement outlining the rights and duties of the new owner with respect to the company.
Resolution/Consent: The Board of Directors, members, or owners, will need to approve the investment in writing.
Compliance
Registration: The Securities Exchange Commission (“SEC”) regulates family and friend investors the same way it does with any other type of investors. In short, the SEC requires that any security offering is registered with the commission, which can be very expensive. If the SEC finds a violation of their regulations, they can enforce strict penalties. The costs of registration are often a non-starter for new companies.
Angel Investors:
An angel investor is a SEC accredited, high-net-worth individual who provides funding to startups in exchange for equity in your company.
Angel investors usually have very deep pockets. Also, angel investors can bring their own expertise and network to help your company be successful.
The problem is that angel investors are difficult to find. They can be picky about the investments that they participate in; they will want to do extensive due diligence.
If you are fortunate enough to track down one that is willing to do business with you, you need to make sure that your relationship is framed with solid legal documents. When you take on an angel investor, you may be giving up control of your business. You need to be sure you are only giving up what you need to. You need to have a way out if things go south. At the same time, you need to make sure that you are in compliance with the state and federal securities laws.
Legal Documents
Investment Agreement: What type of ownership interest will they acquire? What happens if additional shares are issued at a later date? What are the remedies if performance goals aren’t met? What about an exit plan? These questions, and others, need to be clearly stated in an investment agreement.
Governing Documents: Your governing documents, such as your Bylaws or Operating Agreement, need to comport with the angel investors’ interests and control in the company.
Resolution/Consent: The Board of Directors, members, or owners will need to approve the investment in writing.
Compliance
Registration: In much the same way as with family and friend equity investments, the SEC requires securities offerings to angel investors to comply with a litany of regulations to be recognized. Again, compliance with these regulations should not be taken lightly, as they can result in heavy sanctions.
If you are excited to elevate your business to the next level with an influx of funding, do not rush through the process. You should have the situation reviewed by an experienced corporate attorney. Walters & Galloway, PLLC has extensive experience representing entrepreneurs through every stage of business. Our attorneys would be happy to discuss your situation with you and help you get to your goals as quickly as possible while avoiding legal pitfalls.
