The Short Startup Fundraising Preparedness Guide
If you're hitting a demo day soon, you'd better be prepared to receive checks. Here's how we suggest approaching that...
Hey Founders et al. We’ve created a long list of legal “startup guides” to help founders navigate the stickier legal speed bumps that plague early stagers. Today, we are publishing our 4th of this series: “The Short Startup Fundraising Preparedness Guide.” We’ve packed these guides with resources and organized them into actionable steps you can take (or earmark for later).
Previous Episodes
Coming Soon
The Short Startup Insurance Guide
The Short Startup Advisor Onboarding Checklist
The Short Startup Terms of Service Setup Guide
The Short Startup Fundraising Preparedness Guide
The Short Startup Trademark Guide
The Short Startup Data Privacy Guide
The Short Startup Data Security Guide
The Short Startup Employment Law Guide
… and more
so without further adeu…
Once you’ve decided to raise capital for your startup, it’s important to plan an organized fundraising process to maximize your chances of success. This guide highlights the legal tasks and issues that you’ll need to consider as part of an early stage (pre-seed or seed) fundraising process when you’re raising money from angel investors and/or venture capital investors. You should review this checklist in its entirety before you begin your fundraising process.
For big-picture context on fundraising, Y Combinator has a Guide to Seed Fundraising, and Techstars has a series of videos on getting ready to fundraise. Many startup advisors recommend the book Venture Deals, which is a well-reviewed source for information on the legal and business considerations associated with raising capital for your startup. For an overview specifically focused on legal topics, refer to this Westlaw article. As a founder, it’s important to understand how raising capital will dilute your ownership (refer to the YC educational video for one possible explanation).
Fundraising in the United States is governed by complex securities laws, stiff penalties could be imposed if you do not comply with applicable laws. This guide outlines key legal issues for you to be aware of and points you toward resources so you can familiarize yourself with these issues. We strongly suggest you consult with an attorney on fundraising. The checklist notes the topics we recommend discussing with your attorney.
Please note, this guide is focused on fundraising for early stage companies. The guide does not address Series A or later, which are referred to as “priced rounds” where there is an agreed-upon valuation of the company and preferred stock is issued at a price tied to that valuation. Carta’s blog has a clear explanation of the types of rounds, and Y Combinator (YC) has an educational video on the topic that is very informative.
Note also, this guide does not address equity crowdfunding, which you may consider (refer to these articles from Cooley LLP and Forbes), and can be conducted through platforms like Republic.
Tasks
1. Deciding on Fundraising Instruments
Decide how you’ll structure your fundraise. Prospective investors may ask you how you’re structuring your raise. You’ll need to figure out what type of instrument you will use to raise funds and attract investors. The most common structures for early-stage fundraising are convertible notes, and Simple Agreements for Future Equity (SAFEs).
Simple Agreement for Future Equity (SAFE). The SAFE is a type of investment vehicle created by the startup accelerator YC that is not subject to interest and does not have a maturity date when debt is due. You can find example SAFE documents and a SAFE user guide on YC’s website.
Convertible Note (generally not standard, unless you have an investor who will not use a SAFE). A convertible note is essentially an agreement for debt (with some interest) that matures or converts to equity in the future when a triggering event occurs, such as further fundraising or sale of the company. Angellist has an article explaining convertible notes, and Kruze Consulting has an article and video explaining convertible notes.
In either case, you’ll likely have a valuation cap that you establish or that may be negotiated with your investors. If you secure a lead investor for your seed round, you may agree with them on a form SAFE or Convertible Note that you’ll use with other investors who join the round. There are many online services that provide sample forms or allow you generate the legal forms involved in pre-see and seed stage fundraising, for example:
Be aware that different investment structures create different obligations and liabilities for you and your company, and result in dilution of your ownership, so you should consult with an attorney to decide how to structure your raise and to ensure you understand the legal and business implications of raising capital at this stage.
2. Complete administrative legal tasks
Draft and sign SIde Letter, Management Rights Letter. You may be asked to sign additional agreements such as a Pro Rata Side Letter (which is part of the YC SAFE package, and gives an investor future rights to purchase preferred shares), or a Management Rights Letter (which gives an investor certain rights to receive updates or consult with management, depending on whether the investor has a Board seat). You can find examples of these documents on YC’s website.
Draft and sign Board Consents. Make sure that your Board Consent is in place before you start signing SAFEs, Convertible Notes, or other fundraising-related documents. Typically Board Consent is required to authorize the company to issue investment documents such as SAFEs and/or Convertible Notes, and for the CEO or other authorized officer of the company to sign those documents.
Closing. Decide whether you’ll be closing on a rolling basis (i.e., sign agreements and receive funds transfers as soon as an investor commits) or in a coordinated closing (i.e., sign agreements and receive funds transfers all at once from all investors, once your round is fully committed). This is a brief article explaining the process for a seed raise.
3. Plan communications for your fundraising process before you contact investors.
You’ll need to be aware of some key legal considerations related to communications around your fundraise. We recommend planning out your communications process and vetting it with legal counsel before you start contacting investors about your fundraise.
Identify whether your fundraise falls into any of the following capital raising exemptions. No sugar-coating here, this step is really best done with a startup lawyer.
Identify accredited investors. It is generally advisable to raise investment from “accredited investors” (unless you’re raising pursuant to one of the exceptions above. You should confirm someone is an accredited investor before you provide specific information about your company for fundraising purposes. Refer to the SEC’s website for details on accredited investors. In brief, an accredited investor:
Is a person who meets one of these criteria:
Has a net worth greater than $1M individually or with their spouse ; or
Has annual income exceeding $200,000 for the past 2 years; or
Has joint annual income with their spouse exceeding $300,000 for the past 2 years.
Is an entity or trust that meets certain criteria. You’ll want to chat with a lawyer if you’re not 100% about one of your investors.
Be aware of limitations on publicly raising money. One of the biggest decisions in your fundraising process is whether you’ll raise capital publicly (for example, demo days or email/social media campaigns, often referred to as “General Solicitation”) or privately (for example, directly contacting potential investors one-by-one). U.S. securities law imposes limitations on both public and private fundraising. You should check with your attorney to make sure your plan for communicating with investors complies with applicable securities laws governing your particular fundraising process.
Create an NDA. FYI - be aware that most professional investors will not sign NDAs during pitches and initial meeting. Cooley has an article explaining why. Still, if you have special IP that you want to discuss in detail, or you are entering extremely detailed talks about strategy or other “secret sauce” types of substance, try to have an NDA signed before these conversations.
4. Prepare for investor due diligence.
Investors will likely conduct some level of due diligence on your company before they close their investment.
Prepare your data room. You’ll need a data room that you can share with investors in response to due diligence inquiries. The data room will contain a mix of legal and business documentation. Many founders organize the data room before they kick off their fundraising process, to ensure they are ready to quickly respond to due diligence requests. The U.S. Chamber of Commerce has an article with links to several example due diligence checklists, including Cooley’s sample VC Due Diligence Checklist.
5. Confirm notice and filing requirements for securities law compliance.
Confirm any federal and state filings required. You may need to make federal and/or state notice filings in connection with your fundraising process. You should consult with legal counsel before you start fundraising to determine which notices, if any, need to be filed; what information needs to be provided in the notice(s); and any timing requirements for filing.
Be aware of CFIUS compliance. The Committee on Foreign Investment in the United States (“CFIUS”) may need to be notified if a U.S. business is considering a transaction with a foreign person (which could be a non-U.S. person, government, or entity). Cooley has an article explaining CFIUS, and it’s advisable to check with your attorney to identify any CFIUS compliance requirements for your fundraising process.
That’s all for now. Thanks for reading, and stay lawyerly.
Brian
PLEASE NOTE: This is not legal advice, and thoughts and commentary are solely my own, and not those of Scale LLP.