Thinking About Venture Capital Financing for Your Company… Start with this…
Depending on where you’re sitting, you may have heard conflicting market rumblings suggesting that the ongoing economic (Venture Capital) scene is making it difficult for start¬ups seeking to raise capital. Some new companies have not seen or felt much of an impact from a tightening market, but, they may have noticed diminishing valuations, re-cutting of “deals”, and at times, deferred closings.
If you’re like us at Morris + D’Angelo, we believe that there are plenty of deals to be done. In essence, the market is resilient and more is always available. There are a lot of finance opportunities waiting to be deployed with investors who are also becoming more selective with their investments.
The world of Financial Technology (FinTech) is changing rapidly; there are constantly new innovations, and Venture Capital Firms are always focused at looking for ways to make investments with hockey-stick future payoffs. There is a rapid movement towards democratizing access to investment resources. This market shift is creating opportunities that were previously only available to wealthy families and heritage banks.
Now, perhaps more than ever, startups looking to fundraise should take the time to position themselves for successful Venture Capital financing. It’s important for founders to understand that preparing for Venture Capital financing starts with a better understanding of how positioning yourself and your company is impactful. In this article, I outline a few of the critical steps that you, as a company founder, should keep in mind to position your company for Venture Capital (VC) Financing.
Decision of Entity and Purview
Choosing the correct Business Entity and Jurisdiction is a significant first step. In spite of the fact that there are many types of business structures, we have found and know that most financial backers like, and more often than not require the startup to be a C Corporation.
C Corporations are different from Partnerships, Limited Liability Companies, and S Corporations, especially in how they are taxed. C Corporations are taxed as separate entities from the shareholders. By contrast, Partnerships, Limited Liability Companies, and S Corporations are considered Pass-Through Entities where the taxable income flows through the entity and is picked up on the owner’s tax returns. Many investors, especially VC funds, cannot invest in Pass-Through Entities because of their limited part-tax-exempt status or the type of funds they manage.
Once the entity type has been chosen (C Corporation or other), the next challenge is to choose the correct jurisdiction. Typically, Delaware has been the choice for forming corporations (and limited liability companies) since the early 1990s. Over a million companies have chosen Delaware as their home state, and over 60% of Fortune 500 companies were formed in Delaware. Maybe yes, and maybe no; Delaware is a good choice, but there are other options.
Founder and First Employee Agreements
This has to do more with proper documentation than anything else. Investors want to know that the company they invest in owns the technology of the company. Business deals can get off track if the company is remiss in getting this basic documentation set up, just to find out during a financial backer’s persistence that the organization’s center innovation is really possessed by a previous pioneer or representative who never assigned their rights over to the company. This starts with ensuring that the founders, employees, and consultants sign proprietary information and invention assignment agreements (PIIAAs) to ensure that they are subject to confidentiality obligations and that any intellectual property they develop relating to the business is assigned to the company.
Another significant step is guaranteeing that stock issued to founders is subject to a repurchase right in favor of the company so that if the founder’s relationship with the company ends, the company can repurchase any shares subject to the repurchase option, usually at the same price the founder paid for them. Initially, the repurchase right should apply to all of the shares issued to the founder. This same approach should be used with employees and consultants receiving equity.
Having the proper documentation set up with standard vesting terms demonstrates to financial backers that the founders have a long-term vision for the company that helps incentivize those key personnel that are important to the success of the company to stay onboard.
Capitalization Table Management
Investors looking to invest in a company will investigate the Capitalization Table (Cap Table). The Cap Table is a report that details the ownership of the company by listing all the securities in a company, including stock, SAFEs (simple agreements for future equity), convertible notes, options, and warrants. The Cap Table records every individual who holds any securities in the company and how much and is a critical document for keeping track of the company’s ownership.
The exclusion of a current and well-organized Cap Table can create a whole host of issues, from incurring additional legal fees to errors that could impede an investor’s diligence that can delay closing. Some investors now require startups they invest in to use a Cap Table Management Program.
Choosing the Correct Investor
You as a Founder should make sure that you do your homework on prospective investors. Many VC funds may have invested in a specific industry or at a specific stage of the funding cycle. So, it’s best that you investigate the VC’s prior business investments, the typical stage, and size of their investments, as well as the background of the VC fund partners. Before your first meeting, you as a founder should get to know everything you can about the VC Fund so you can be sure it is the right fit for your company.
Although there are many issues that are important in positioning a startup for VC Financing that are beyond the scope of this article, the recommendations that I’ve made occur relatively frequently and can easily be resolved with proper planning and financial advice.
The recurring theme in positioning a startup for VC financing is planning and preparation. Spending the time to prepare well in advance of financing will put your company ahead of the game, and in doing so, will save you time, money, and (maybe) a few sleepless nights.
Navigating Venture Capital Financing for the first time or even if you’ve been around the block a few times can be challenging if you’re not paying attention.
This is a topic at Morris + D’Angelo that we are very adept at as we have many success stories we can share with you.
If you have questions, need clarity, or need help determining how to proceed with Venture Capital Financing, or to help retain or maximize your gains, please contact us at Morris + D’Angelo. This is our Expertise!
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Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
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