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Posted in: Articles | Strategy | Investors | Fundraising | Equity | Starting Up | Finance

Dec 19, 2014

Navigating the Stages of Startup Equity Financing

By Timothy Jones

By Mat Goldstein and Tim Jones*

Startups conventionally raise financing in stages or "rounds" of outside investment. In each round, investors and firms supply the startup with new capital in exchange for certain returns. This post focuses on raising financing in exchange for a percentage of the company's equity (versus other forms of financing, such as debt). Each stage of financing requires both strategic and legal considerations. In particular, this post will focus on the legal issues that may arise at the common stages of equity financing.

Early Financing from Non-Traditional Investors

The earliest round of outside financing is typically referred to as the "friends and family round." This round, as the name implies, focuses on smaller-scale financing from personal acquaintances, often those who are inexperienced or unsophisticated investors.

While founders might expect the process of raising money from friends and family to be simpler than entering into financing agreements with major or institutional investors, the pitfalls at this stage should not be underestimated. Among other concerns, valuation issues and securities compliance can be as tricky in a "friends and family" round as they can be in a larger round of financing. Managing investor expectations is also critical at this stage. For example, if your aunt invests heavily in your startup, does she have clear and realistic expectations about profit potential, input on the business, or future dilution of her shares, and does the shareholder agreement reflect those expectations appropriately?

Clear legal advice, term sheets and share purchase agreements can clarify this process. The earlier this infrastructure is built, the better equipped a startup will be to pursue future, larger-scale investments. Weak pre-existing agreements may jeopardize future venture capital investment.

Founders may also engage in other forms of non-equity financing, such as crowdfunding, in this stage.

Seed Financing from Traditional Investors ("Seed Round" or "Angel Round")

Although friends and family investments would be technically considered seed financing since they are used to build a startup's foundation for future growth, a typical "seed round" or "angel round" may involve more experienced investors as well. "Seed rounds" in Canada are typically referred to as rounds that raise between $50,000 and $1,000,000. This capital is generally used for pre-market product development. Current industry trends for seed rounds involve larger target amounts being used more aggressively, although this move is sometimes criticized.

An early seed round is often called an "angel round" in order to differentiate it from previous efforts, as angel investors tend to enter the picture for the first time at this stage. However, as venture capital firms are beginning to enter early rounds of investments more frequently, some commentators suggest that naming this stage an "angel round" might deter non-angels (e.g. friends and family, venture capital firms, or even acquirers) from showing interest.

Key issues at this early stage include valuation, capital structure, governance and liquidity. Professional advice on these matters will ensure a solid foundation for these large-scale growth investments.

In Canada, the Scientific Research and Experimental Development ("SR&ED", often pronounced "shred") tax credit program provides cash refunds and/or tax credits for research and technological development. Often, this tax credit or other government funding sources can be factored into a startup's seed financing strategy. However, startups should be careful to ensure that their corporate and labour structure is organized in a manner that preserves their eligibility.

Some startups require smaller-scale rounds of seed financing before larger venture capital rounds of investment are sought. These subsequent seed rounds are commonly referred to as "bridge rounds," as they "bridge the gap" between seed and Series A.

Venture Capital Rounds (Series A, B, C, etc.)

"Series A financing" refers to a startup's first round of major investment (in Canada generally $1 million and above) and typically targets established venture capital firms as well as more prolific angel investors. Occasionally, the equity provided to investors at this stage may reach 50% of the company's ownership structure.

"Series A" typically refers to preferred shares that are issued to established investors and funds. The issuance of preferred stock has serious repercussions for existing shareholders. Therefore, if a startup is hoping to access venture capital funding in the future, shareholder agreements at earlier rounds should be negotiated and structured with an eye to these concerns.

"Series B" is a second venture capital round and typically finances growth in the scale of the company's business model, team or consumer base.

Subsequent rounds of equity financing (titled "Series C," "Series D" and so on) may be used for dramatic acceleration of the business into international markets, to make acquisitions and for other capital-intensive purposes.

Long before a startup considers accessing venture capital, their capitalization structure and fundraising goals should be clearly plotted. Capitalization tables can be helpful tools.

Each institutional investor involved in this process may have a preferred legal arrangement for financing. Some may request major corporate reorganization. Sophisticated legal advice will ensure that a startup's business affairs and legal agreements are ordered in a way that is attractive to outside investment. It will also ensure that those agreements, when secured, do not destabilize other aspects of the corporation, its share capital and its governance.

*Tim Jones was a summer student at Aird & Berlis LLP.


 

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