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As you prepare to raise seed funding for your startup, you must understand the key funding structures, terms and legal issues that will likely arise at the term sheet stage and during the negotiations for the final startup funding documents.
With proper knowledge and the guidance of an experienced startup attorney, you will be prepared to make informed decisions that will advance your startup in the short term and the long term.
Part 2: Key Structures, Terms and Legal Issues for Startup Seed Funding
Part 2 of this guide discusses essential deal structuring alternatives, terms and legal issues that you should consider with your startup business funding.
This guide is broken into three parts to provide a comprehensive playbook for startups navigating the seed fundraising process:
Part 1: How to Prepare for Startup Funding
Part 2: Key Structures, Terms and Legal Issues for Startup Seed Funding
Part 3: Common Mistakes Founders Make When Raising Startup Seed Funding
TL;DR: When raising seed funding for your startup, understanding key structures, terms and legal issues can make or break your round. Common funding structures include SAFEs, convertible debt, priced-equity, and founder loans. SAFEs and convertible notes are often preferred for their simplicity and flexibility, allowing startups to delay valuation discussions until later funding rounds. Key deal terms to consider include pre- and post-money valuation, equity ownership and dilution. Important legal issues involve securities law compliance, investor rights, board composition, voting rights and governance.
Working with an experienced startup attorney is essential to navigating these complexities effectively.
Consult with a startup attorney today!
The Best Deal Structure for Startup Seed Funding
There are various types of funding for startups, and our clients often ask, “which type of funding is best for my startup?”
As with many things in business (and life), it depends on many factors:
- At what stage is your business?
- Has your startup raised seed funding previously and are there any related restrictions or approvals?
- How much startup funding will you need?
- What are your plans regarding future funding rounds?
If your startup is an early-stage company that is seeking seed funding for the first time, then you likely should consider one of the following four seed funding structures:
1. Simple Agreements for Future Equity (SAFEs)
SAFES are an excellent option for startup funding at the seed stage. As their name indicates, SAFEs are relatively simple and straightforward and have a limited number of key terms that require negotiation, which lowers transaction costs. The key terms typically are the conversion discount and/or valuation cap, which determine how the SAFEs will convert into the shares of capital stock of the next priced-equity round of funding (i.e., Series Seed Preferred Stock, Series A Preferred Stock, Series B Preferred Stock, etc.).
Importantly, SAFEs are not debt, meaning they don’t accrue interest or have a maturity date. Also, especially at the startup seed funding stage, a SAFE startup financing allows the company to raise money from investors quickly and efficiently, so that your startup can receive and deploy the funding received.
2. Convertible Debt
Like SAFEs, convertible notes offer a relatively straightforward and flexible approach that allows the parties to delay valuation, with similar conversion mechanics (i.e., usually at a discount and/or with a valuation cap).
However, relative to SAFES, convertible debt deals typically require more negotiation and documentation and, therefore, more time and expense.
Convertible debt leans in favor of investors given the interest accrual, maturity date and the investors’ status as debt holders prior to conversion. We often see startups pursue convertible note financings at the request of the investors or in situations where convertible debt is otherwise necessary to attract investors.
3. Priced-Equity
Given the early stage of your startup at seed funding, the valuation of your startup becomes a critical deal issue. If you do not negotiate a sufficiently high pre-money valuation, then you and your other stockholders may experience excessive ownership dilution as your startup issues shares to the new investors.
Assuming you can negotiate an acceptable pre-money valuation (and thereby limit the extent of your ownership dilution), consider using Common Stock or Series Seed Preferred Stock, depending on the amount of money to be raised and what the investors require.
4. Founder Loans
Founders can contribute startup capital to help with formation and initial operating costs, which can be structured as a loan. When the initial amount of capital to be raised is relatively low (e.g., less than $250,000), some startup founders provide seed funding using a simple loan structure.
These founder loans can also include conversion features, including piggybacking on the conversion terms of any later SAFEs or convertible debt.
Why Use Convertible Securities Versus Priced-Equity?
The optimal deal structure for startup seed funding balances the needs of both startup founders and investors, providing sufficient capital to drive growth while minimizing unnecessary dilution and maintaining future fundraising flexibility. Here’s a detailed look at why using a convertible security (such as a SAFE or convertible notes) may strike the best balance:
- Delay Valuation: SAFEs and convertible notes allow your startup to postpone valuation negotiations and resulting equity ownership dilution (which can be significant as an early-stage startup) until a more substantial priced-equity financing round. This is often the essential reason for using SAFEs or convertible debt.
- Simplicity and Speed: It often is easier and quicker to negotiate a SAFE or convertible debt financing as compared to priced-equity rounds. There typically are less deal points and financing documents to negotiate, document and finalize.
- Scenario Analysis to Determine Dilution Impact: Use convertible instruments wisely. Because SAFEs and convertible notes convert into equity in the next priced-equity financing round, which has its own dilutive impact, it is important to work with experienced startup legal counsel who can help you model different financing scenarios so that you have a clear idea of the potential equity ownership dilution that may result from the priced-equity financing that triggers the conversion.
In addition to the discount and valuation cap (if applicable), it is important to define clear terms for the conversion trigger, including the conditions under which the convertible notes or SAFEs will convert into equity, such as reaching a specific new money funding threshold for the future priced-equity round of startup funding.
Key Deal Terms
As you move through the startup business funding process, below are certain key deal terms that you will need to know depending on the types of startup funding that you pursue:
- Pre-Money Valuation: This is the valuation of your startup before the new investment is added, which is an essential component of any priced-equity or startup series funding round. It determines how much equity an investor receives in exchange for their investment.
- Post-Money Valuation: This is the company’s valuation after adding the new investment to the pre-money valuation.
- Equity: Reflects an ownership interest in the company. Equity is typically issued in the form of shares of capital stock, and the ownership percentage is often calculated on a fully diluted basis, which considers the full potential of convertible interests such as stock option pools. In many cases, founders own common stock and investors own preferred stock.
- Preferred Stock: A class of capital stock with preferential rights and privileges over common stock. Importantly, preferred stockholders often enjoy a liquidation preference over common stockholders upon the company’s sale or other liquidation event. Seed funding sometimes involves issuing Series Seed Preferred Stock.
- Common Stock: The basic form of equity ownership in a company. Founders and employees usually hold common stock.
- Equity Incentive Pool: A pool of shares of common stock (often 10% to 20% of the fully-diluted equity capitalization) reserved for future stock, restricted stock or stock option grants to employees, advisors and other stakeholders as part of an equity compensation plan. Establish an adequate equity incentive pool before the seed round to bring on important hires and avoid significant dilution later.
- Cap Table (Equity Capitalization Table): A document or spreadsheet detailing the Company’s capitalization and ownership among its stockholders.
- Dilution: The reduction in ownership percentage caused by the issuance of new shares of capital stock. Dilution is often inevitable. Whether or not it is “good dilution” or “bad dilution” depends on valuation.
Key Legal Issues
Although there is no substitute for an experienced startup attorney, it is important to understand some of the key legal issues that may come up as you structure, negotiate, document, approve and close your startup funding transaction.
- Securities Law Compliance: Startups must comply with the federal and state securities laws when issuing equity or convertible instruments. This compliance typically involves qualifying for exemptions from registration under the Securities Act of 1933, as amended, and the various state “blue sky” laws. This usually requires startups to submit federal or state filings depending on the offering type and where the investors reside.
- Founders’ Agreements: Legal documents outlining the roles, responsibilities, IP assignment and equity ownership of each founder. These agreements can and should include vesting schedules for founders’ equity to ensure long-term commitment.
- Investors’ Rights Agreement: An agreement that outlines the rights of investors, such as voting rights, information rights and rights to future equity issuances. Often startups give significant seed investors the right to participate in future financings to maintain their respective equity ownership percentages.
- Board Composition: Determining who will sit on the startup’s board of directors and if and how many seats investors will receive. This composition impacts control and decision-making within the company. Ensure a balanced board structure that allows for future investor representation without losing founder control and expect your board size and board composition to change as your startup grows. Remember, your startup’s board of directors should be an odd number to avoid voting deadlock.
- Voting Rights: Different classes of stock can have different voting rights. Preferred stock often has certain protective provisions (i.e., “veto rights”) that require investor approval for significant company actions.
- Anti-Dilution Provisions: Clauses that protect investors from equity ownership dilution in future financing rounds. Most often, you should expect to see weighted average anti-dilution provisions; in dire or special circumstances, preferred stock investors may try to negotiate for full-ratchet anti-dilution provisions. Avoid full-ratchet provisions and negotiate for weighted average anti-dilution provisions [RJ1] to protect early investors while being fair to future investors.
- Liquidation Preferences: Terms that determine the order and amounts that investors receive before the holders of common stock in the event of a liquidation event, such as a sale or dissolution of the company. Set reasonable liquidation preferences that protect early investors but do not overly burden future startup funding rounds. A 1x non-participating preference is standard and can be beneficial to both founders and early investors.
- Vesting Schedules: Timelines over which founders and employees earn their equity. Implement standard vesting schedules (e.g., four-year vesting with a one-year vesting cliff and monthly vesting thereafter) to align the interests of employees, consultants and other advisors with the long-term interests of the company. Vesting schedules can also include performance or milestone-based vesting.
Many investors, especially for large startup financings, will require that key founders and executives impose vesting conditions retroactively or reset their vesting as a condition to investment. Therefore, it is important to establish vesting early to attract investors to your startup and demonstrate your commitment to the startup’s long term growth.
- Intellectual Property (IP) Assignment: Ensuring that your startup owns all IP created by founders, employees, consultants and advisors. Your startup should require IP assignment agreements (or similar provisions embedded in other agreements) that ensure all relevant IP is transferred to the company. Investors and acquirers will insist on having these documents as a condition to the deal, which means that these documents are essential to establishing your startup as a suitable financing or acquisition candidate.
- Due Diligence: The process by which investors review a startup’s business, legal, commercial and financial documents before finalizing the proposed investment. Advance work to ensure your “corporate house” is in order is essential for a smooth due diligence process. In diligence (and in life), first impressions matter.
- Term Sheets: A summary that outlines the basic terms and conditions of the proposed investment. While most term sheets are non-binding, the term sheet is where most deals are won (or lost) and serves as the starting point for negotiating the final investment agreements.
- Confidentiality and Non-Disclosure Agreements (NDAs): Legal agreements to protect sensitive information shared between the startup and investors during the fundraising process.
Conclusion:
Securing seed funding for your startup involves navigating a complex landscape of deal structures, key terms and legal issues. Whether you opt for SAFEs, convertible debt, priced-equity or founder loans, understanding the implications of each option will help to balance investor interests with the long-term growth of your business. Ensuring compliance with securities laws, establishing robust founder agreements and preparing for due diligence are essential steps in this process as well. By working closely with an experienced startup attorney, you’ll be empowered to make informed decisions that position your startup for success, both now and in future funding rounds.
Clients also ask us:
How are startups funded?
There are several main sources of startup seed funding, including commercial loans, venture capital, angel investors, friends and family, self-funding, or non-dilutive funding (such as grants). To attract funding, it’s critical that your startup has a solid business plan and demonstrates to investors its potential for growth and eventual exit.
What type of funding is best for startups?
The best funding structure for your startup will depend on the stage of your company, its needs and goals. Early-stage startups often use seed funding structures such as SAFEs, convertible debt or Series Seed Preferred Stock, before seeking larger investments from venture capital investors.
How do I raise seed funding?
Raising money for your startup requires a lot of preparation and diligence, including by developing a compelling business plan, understanding your funding options and key terms and pounding the pavement to meet investors interested in your idea. Founders meet investors by networking, building relationships and participating in startup pitch events and accelerators.
How much money do I ask for in my seed funding round?
Ask for enough capital in your seed funding round to fuel your startup to your next major milestone. This may be a product development, market validation or clinical milestone. It’s important to consider how the amount you raise will affect equity dilution. While it’s nice to have more money than less, you’ll want to minimize dilution. Balance securing enough funds from investors to fuel growth without giving away too much of your company early on.
