The following is an excerpt from The Start-Ups & Emerging Companies Guidebook, a preliminary discussion on best practices and strategies for start-ups and emerging companies to easily leverage.
Even before formation, it is critical to consider how a business will be funded, both initially and in the long term. A business’s initial capital structure can have important implications for the type of financing it is able to pursue in the future, the type of equity that it is able to issue and the investors that it will attract. Companies should be sensitive to securities law considerations, tax impacts and compliance obligations in structuring any financing.
DEBT FINANCING
One means of obtaining funds is debt financing. Debt financing can be obtained from a number of sources, such as private individuals (including friends and family), investment funds that provide venture debt and traditional institutional lenders. Additionally, the U.S. Small Business Administration and other government-funded entities extend certain loans to eligible companies, including qualifying small businesses. A company can also issue convertible debt in which case debt converts to equity in the company upon the occurrence of certain conversion events (such as a qualified equity financing) and the satisfaction of certain conditions.
EQUITY FINANCING
In addition to, or in lieu of, debt financing, a company can obtain funds through an issuance of equity. It is important to consider the type of equity issued and the rights, preferences and obligations comparative to the founding members and other investors. Investors will often seek a preferred equity stake in the issuer, which can provide for a priority or preferred return on their investment, and often comes with certain voting and other rights. A priority return or a preferred return entitles the investor to receive their initial investment back and a predetermined percentage return before any other investors receive any distributions or dividends. Other investors will opt to acquire warrants or options, each of which entitle the holder to acquire an equity interest in the company at a future date and, in the case of options, at a pre-determined price. It is important for startup ventures to be deliberate in issuing equity, as the class and nature of equity issued to initial investors will inevitably impact future equity issuances and the type of investors attracted to the company.
SAFES
Some companies utilize a hybrid and expedited financing method to raise capital called a “simple agreement for future equity”, or a SAFE. The SAFE was created as a way for companies to quickly raise capital. A SAFE does not grant the investor any equity (or debt position) in the company when the investment is completed, but rather gives the investor a right to equity or cash payment in the future upon the occurrence of certain triggering events. Furthermore, SAFEs have largely been standardized and typically have a lower cost for the issuer to produce than other financing documents.
RECORDKEEPING
Regardless of the type of financing a company receives, it is important for any company to maintain accurate and updated records. This includes maintaining up-to-date capitalization tables and related records regarding investor contributions, ownership percentages, and convertible instruments. Maintaining an accurate capital table allows management to reference the ownership of the company in connection with required consent thresholds for certain actions, and to calculate potential distributions in connection with any liquidity events. By keeping accurate minutes of meetings (whether the meetings are of shareholders, members, the board, or the managers) management is able to clearly reference past actions and is able to provide evidence that corporate formalities were properly followed.
FUNDRAISING CONSIDERATIONS
Investor Rights
Investors will often request certain rights in exchange for their investment. Depending upon the type and size of the investment and the stage of development of the company, these could include consent rights over major actions, such as the issuance of additional equity in the company, the incurrence of indebtedness or the sale, disposition or dissolution of the company.
Equity investors may also request certain rights relating to the transfer of equity in the company, including rights of first refusal, tag-along and drag-along rights. A tag-along right gives the minority equity holders in the business the right to sell their equity alongside equity holder(s) selling a specific stake of equity, on the same terms and conditions as offered to the selling equity holders(s). A drag-along right gives the equity holder(s) selling a specified stake of equity the ability to force the non-selling minority owners of the business to sell their interests to a third-party purchaser on the same terms and conditions offered to the majority equity holder(s).
In connection with debt financings, lenders will often require certain limitations on management’s decision-making, including with respect to certain major decisions impacting their investment. Debt is also typically associated with restrictive covenants, meaning that the company has to comply with certain requirements set by the lender. These covenants can be financial (for example, a certain debt to equity ratio must be maintained) or impact operational decisions (for example, purchases above a certain dollar threshold must be approved by the lender). Lenders will also include a default provision with respect to change of control events: a transfer of all or substantially all of the assets of the company or a change in the majority of the voting interests of a company. Lenders also expect to receive certain remedies upon the company defaulting on the terms of the debt, including acceleration of the debt becoming due or forfeiture of the pledge of equity to the lender.
Securities Law
Any time a company sells securities (including equity, debt (excluding traditional commercial loans) or convertible instruments such as SAFEs), the company must comply with the applicable state and federal securities laws. Generally speaking, unless a securities offering is exempt from being a registered offering, securities must be sold pursuant to a registration statement. There are a number of exemptions from registration that a company can pursue, primarily based on the fact that the offering is not a “public offering” and it is limited to sophisticated investors, including a Section 4(a)(2) offering or a Regulation D offering and certain intrastate offerings. Even in connection with exempt offerings, companies must be aware of filing requirements, such as Federal Form D filings and applicable State blue sky filings.
As detailed above, capitalizing a company is a multifaceted process requiring a detailed understanding of investor/lender considerations, tax implications, securities laws and related matters.
