Legal Issues in Fundraising for New Businesses

15 mins read

Introduction

Starting a new business is an exciting journey, but it also comes with its own set of challenges, particularly when it comes to raising the necessary capital. While some businesses may require millions of dollars to get off the ground, others can get by with much less. Regardless of the size of your start-up capital, it is essential to be aware of the legal issues that arise during the fundraising process. In this blog post, we will discuss the legal considerations for new businesses looking to raise capital and explore when a company needs to start thinking about fundraising.

When Does a Company Need Fundraising?

The need for fundraising varies greatly between businesses. The amount of capital required to start a new venture will depend on a number of factors, including the cost of creating a prototype (if needed), operating capital, inventory, marketing, and salaries for the founders. Additionally, legal costs, particularly in the area of intellectual property (IP), must also be considered.

It is not uncommon for a new business to require seed capital to get off the ground. This initial funding is critical in bringing the business to the next stage of development and is typically used to cover the costs outlined above. The size of the seed capital required will depend on the specific needs of the business, and the founders should carefully consider their budget and projections before starting the fundraising process.

In conclusion, the need for fundraising varies greatly between businesses, but it is an essential part of the start-up process. By being aware of the legal issues that arise during the fundraising process, new businesses can ensure that they are well-prepared to secure the capital they need to grow and succeed.

Fundraising Sources

Once a business has determined that it needs to raise capital, it is important to identify the best sources for obtaining that funding. There are many options available, depending on the size of the capital requirement and the goals of the business. Here are some of the most common sources of funding for new businesses:

Solutions for Smaller Capital Needs: For businesses with smaller capital requirements, there are several options to consider:

  • Friends and Family: One of the simplest and most accessible sources of funding for many businesses is to tap into their personal networks. Friends and family members who believe in the business may be willing to invest, providing seed capital to get the venture off the ground.
  • Project Finance: This type of funding is specifically designed to support new ventures and is often used to finance specific projects or initiatives within the business.
  • Factoring: This is a form of financing in which a business sells its accounts receivable to a third-party, who then collects the payments on those invoices.
  • Invoice Discounting: Similar to factoring, invoice discounting allows a business to receive an advance payment on its outstanding invoices.
  • Crowdfunding: Crowdfunding has become a popular way for new businesses to raise capital, especially for those that have a compelling product or service idea. Crowdfunding platforms such as Kickstarter or Indiegogo allow businesses to pitch their idea to a large community of potential investors, who can then choose to contribute to the campaign.

Solutions for Larger Capital Needs: For businesses that require a larger amount of capital, there are several options that may be suitable:

  • Venture Capital: Venture capital firms invest in early-stage or high-growth companies, providing them with significant amounts of capital in exchange for equity in the business.
  • Angel Investors: Angel investors are individuals who provide seed capital to new businesses in exchange for a stake in the company.
  • Investment Banks/Private Equity: Investment banks and private equity firms can provide large amounts of capital to support the growth and development of new businesses.
  • Initial Public Offering (IPO): An IPO is when a company goes public and issues shares of stock to the general public. This is often seen as a significant milestone for a growing business, and can provide a significant source of capital for the company.

In conclusion, there are many options available for businesses looking to raise capital, and the best solution will depend on the specific needs and goals of the business. By exploring the different funding options and considering the legal implications of each, new businesses can make informed decisions about how to secure the capital they need to grow and succeed.

Debt Financing vs. Equity Sale

When it comes to raising capital, there are two broad categories of financing to consider: debt financing and equity financing.

Debt Financing: Debt financing involves obtaining capital by taking out a loan, typically in the form of a note. This type of financing allows the business to receive a cash infusion without giving up ownership or control. The cost of debt financing is the interest that must be paid on the loan, and the debt must be repaid within a specific time frame.

Equity Financing: Equity financing involves selling a portion of the company’s securities, such as stocks or bonds, for cash. This type of financing allows the business to receive a large sum of money in exchange for a share of ownership. The cost of equity financing is control and capital distributions, as the equity investors become partial owners of the business and are entitled to a share of the profits.

Equity financing may also be used to obtain intellectual property (IP), particularly in cases where the IP is a key asset of the business. In these cases, the equity investor may receive a stake in the company in exchange for financing the development or acquisition of the IP.

Hybrid Models: There are also hybrid models available, such as an equity buyback, in which the company repurchases its own shares of stock. This allows the company to reduce the number of shares outstanding and increase the value of the remaining shares, while also providing a return on investment to the equity investors.

Convertible Notes

Convertible notes, also known as debt/equity swaps, offer a unique form of financing that combines elements of debt and equity financing. This type of financing agreement involves a loan with an option for the investor to convert the loan into equity at a later date.

Advantages of Convertible Notes: Convertible notes are often used by startups and early-stage companies because they provide quick access to capital without requiring a full equity sale. Additionally, convertible notes usually come with a discount on the equity, making them a more attractive option for investors. Partial conversion may also be available, allowing for a more flexible financing structure.

Cautions: However, it’s important to be aware of the unintended consequences that can arise with the use of convertible notes. For example, the conversion of the loan into equity can impact the future valuation of the company. It’s also important to remember that conversion is considered a sale of securities for regulatory purposes, so it is subject to securities laws and regulations. Accrued interest also factors into the conversion rate, so it’s important to consider this in the calculation of the conversion price.

Angel Investors

Angel investors are high net worth individuals who invest their own funds in early-stage, high-risk startups. They are typically the first group of investors to come on board after friends and family, providing seed capital to help the company obtain proof of concept and build its initial product or service.

Investment Approach: Angel investors tend to favor convertible notes and large equity buys, as they provide quick access to capital and the potential for a high return on investment. Despite being individuals, angel investments are usually made through an intermediary entity, such as a venture capital firm or investment fund.

Potential Downsides: It’s important to be aware that angel investment is subject to dilution in later rounds of investment, as the company raises capital from additional investors. This means that the ownership stake held by the angel investors may decrease as the company grows and attracts more investment. Angel investment is also considered the “most expensive” form of capital available, due to the high risk involved in early-stage startups.

Venture Capital

Venture capital (VC) is a type of private equity firm that pools funds from high net worth individuals to invest in high-risk, high-reward startups. VCs typically come in during a company’s “Series A” funding round, which is the initial round of investment for manufacturing and scaling the product or service.

Investment Approach: VCs are generally appropriate for startups with high capital needs that cannot be obtained through other means. They provide access to “venture debt” (i.e., loans) and usually invest larger amounts than angel investors. The exit strategy for VCs is typically an initial public offering (IPO) or acquisition by another company.

Risk vs Reward: VC investment is a high-risk, high-reward model. In exchange for providing capital, VCs typically take an equity stake in the company and play an active role in its management and strategy. This can be beneficial in terms of access to expertise and network, but it also means that the founder(s) of the company will have to give up some control and potentially face dilution in later rounds of investment.

Project Finance

Project finance is a type of debt financing that relies on a project’s revenue generation for payment. It’s popular in industries such as construction and energy, where there are tangible assets that can be used as collateral.

Loan Structure: Project finance is usually structured as a loan to a special purpose entity (SPE), which is created specifically for the project. The loan is typically secured by the project’s tangible assets, such as equipment, and sometimes by a surety bond. In exchange for providing the loan, the lender takes both an equity stake in the SPE and a secured interest in the project’s assets.

Insulating Liability: The use of an SPE helps to insulate the sponsor company from liability and allows lenders to take a more focused approach to the project’s risk. However, it also means that the company will have to give up some control over the project, and the SPE may face restrictions on its activities.

In conclusion, project finance can be a useful source of financing for companies involved in construction and energy projects. It allows companies to secure financing for their projects based on the revenue generated by the project, rather than their own creditworthiness. However, it’s important to carefully consider the terms and conditions of the loan, and to seek the advice of legal and financial professionals before entering into an agreement.

Negative Cash Conversion

Negative cash conversion, also known as vendor financing, is a financing technique in which suppliers retain ownership of their products until they are sold to an end customer. This type of financing is typically used by retail companies during an expansion, such as opening a new location.

Advantages: Negative cash conversion allows a company to conserve its capital and use it for other important initiatives, such as marketing and promotion, that can increase sales. This financing method enables companies to obtain products without incurring the cost of purchase upfront, which can be particularly useful for start-ups or businesses with limited cash reserves.

Limitations: Negative cash conversion is not widely available to brand new businesses as it usually requires a certain size and established customer base. Additionally, suppliers may be hesitant to provide this type of financing due to the inherent risk involved in retaining ownership of the products.

Private Placement

Private placement refers to the sale of securities to a limited number of individuals or institutions, without a public offering. This type of capital raise is subject to different regulations than a public offering, as private placements are exempt from many of the disclosure and reporting requirements of the Securities and Exchange Commission (SEC).

The SEC has created several exemptions to enable private placement, including Rules 504, 505, and 506 of Regulation D. These rules outline the parameters for a private placement, including the number of investors, the type of investor, and the information required to be disclosed to investors.

One of the key considerations in a private placement is the distinction between accredited and non-accredited investors. Accredited investors, as defined by Reg D, have a net worth of at least $1 million or an annual income of $200,000 or more. Non-accredited investors are not subject to the same financial requirements and have more protections under the law.

In addition to federal regulations, private placements are also subject to state requirements. For example, Rule 147, also known as the Intrastate Securities Rule, requires that the company offering the securities must be incorporated in the state in which it is offering the securities and must carry out at least 80% of its operations in its home state. The sale of securities under this rule is also limited to the company’s home state.

It is important for companies to be aware of both federal and state regulations when considering a private placement. Failing to comply with these regulations can result in legal and financial consequences, so it is essential to work with a securities attorney to ensure compliance with all applicable laws.

Private placements can offer a number of benefits to companies, including the ability to raise capital quickly and efficiently, and with fewer regulatory requirements than a public offering. However, it is important to keep in mind that private placements are also subject to certain restrictions, including limitations on the number of investors and the types of investors that may participate.

Furthermore, the lack of disclosure and reporting requirements in private placements can make it more difficult for investors to make informed decisions. As a result, private placements are typically only suitable for experienced investors who are familiar with the risks and opportunities associated with early-stage investing.

In conclusion, private placement can be a useful tool for companies looking to raise capital, but it is important to understand the regulations and restrictions associated with this type of financing. Companies should work with a securities attorney to ensure compliance with all applicable laws and to protect themselves from potential negative legal and financial consequences.

Sweat Equity

Sweat equity is a valuable tool for startups and small businesses looking to raise capital without incurring debt or giving up control. This strategy involves assigning a value to the services of employees or independent contractors, with a portion of that value being paid in cash and the remainder being placed on a ledger for future purchase of securities. This method is a way of raising much-needed human capital, and it places a value on the contributions made by employees and contractors to the company.

In this model, the employee or independent contractor takes a cut in the value of their services in exchange for cash, while the remainder is placed on a ledger for future equity in the company. The sale of securities can be linked to a specific period of time or triggering event, such as an equity sale. It is important to be cautious and not tag the sweat equity to a specific percentage, as this could limit the company’s future options. However, it is advisable to place a ceiling on the percentage, to ensure that the company is protected from any unexpected dilution.

A software developer usually charges $100/hour for their services which are required by XYZ start-up. XYZ start-up pays the developer $50/hour and places $50 on a ledger for each billable hour spent. In this scenario, the software developer is providing their services at a discounted rate in exchange for a portion of their compensation being placed on a ledger for future securities. This allows XYZ start-up to raise much needed human capital without having to pay the full rate upfront, while also incentivizing the software developer to work hard and be committed to the success of the company.

Utilizing sweat equity is a great way to raise capital for startups and small businesses that may not have access to traditional sources of funding. It is also a way of retaining employees and contractors who have a stake in the success of the company. Additionally, this method is flexible and can be tailored to the specific needs of the company, making it a versatile option for businesses looking to raise capital.

However, it is important to consider the legal implications of sweat equity. For example, in some cases, it may be necessary to have a formal agreement in place between the company and the employee or contractor, outlining the terms and conditions of the equity arrangement. Furthermore, it is essential to comply with all applicable laws and regulations, including securities laws, to ensure that the equity arrangement is legally compliant.

In conclusion, sweat equity is a valuable tool for startups and small businesses looking to raise capital while retaining control of their company. This method allows employees and contractors to be compensated for their services while also giving them a stake in the success of the company. Utilizing sweat equity can be a flexible and effective way to raise capital, but it is important to understand the legal implications and to comply with all relevant laws and regulations.

Phantom Equity

Phantom Equity, also known as “shadow equity” or “ghost equity”, is a unique and innovative form of compensation used by start-ups and early-stage companies. This concept provides an alternate or supplementary compensation to an employee or independent contractor in the form of equity ownership in the company, without the actual ownership of shares. This type of equity is used as a metric for valuation during a triggering event, such as acquisition, and the phantom equity holder receives a payout based on a percentage of the purchase price equivalent to their “shares”.

Phantom equity is particularly useful when the founder’s exit strategy is acquisition, as it provides a valuable form of compensation to employees and contractors, who would otherwise be left out of the reward for their hard work and dedication to the company. Phantom equity is an attractive option for start-ups because it provides an alternative way of compensating key employees and contractors, which does not put a strain on the company’s already limited resources.

It is important to note that holders of phantom equity do not have a vote in the company, as they do not have actual ownership of the shares. This lack of voting rights serves to protect the company and its existing shareholders from potential disputes or disagreements. Phantom equity can also be structured in a way that it only becomes valid after a certain period of time has passed, or when a specific triggering event occurs, such as the company being acquired or going public.

At the triggering event, the phantom equity holder will receive a payout based on a percentage of the purchase price equivalent to their “shares”. This payout is determined by the valuation of the company, which is based on various financial metrics, including revenue, earnings, and growth projections. The exact percentage of the purchase price received by the phantom equity holder will depend on the terms of the equity arrangement and the valuation of the company at the time of the triggering event.

In publicly traded companies, phantom “shares” can be pegged to the price of the company’s stock. This form of phantom equity is a way for employees and contractors to participate in the success of the company, without actually owning shares. The value of the phantom “shares” is linked to the company’s stock price, which means that employees and contractors can benefit from the growth of the company, without having to invest their own funds.

In conclusion, phantom equity is a valuable form of compensation for start-ups and early-stage companies, as it provides a way to compensate employees and contractors without putting a strain on the company’s resources. It is a flexible form of equity that can be structured in a way that suits the company’s specific needs, and can be a valuable tool in attracting and retaining key employees and contractors. While holders of phantom equity do not have a vote in the company, they can still benefit from the success of the company and receive a payout when the triggering event occurs.

Valuation Considerations

Valuation of a business is the process of determining its worth, usually in monetary terms. It is a crucial aspect of any business and is used for various purposes such as mergers and acquisitions, equity financing, and tax planning. However, the valuation of new businesses is subjective and challenging, as there is limited financial history and the future is uncertain.

Past rounds of investment can also impact future valuation, as different investors may have different valuations of the company. This can cause conflicts and can potentially lead to a lower valuation in future rounds of investment.

Valuation can be done by third-party valuation experts who can use a combination of methods, including projections based on future growth potential and liquidated value of the company’s assets, including intellectual property. However, projections are rarely reliable at the seed stage, as the future of a new business is uncertain. It is crucial to consider these challenges and issues when determining the valuation of a new business.

Caution on Option Shuffle

The option shuffle is a common practice in venture capital investing that involves creating an option pool of a portion of the company’s shares, typically 20%, to be used to incentivize future employees or directors. This dilutes the pre-money valuation of the company, meaning the valuation is reduced due to the creation of the option pool. As a result, investors may provide less capital as the option pool reduces the percentage of ownership they are acquiring. However, this reduction in valuation may not be reflected in the post-money valuation, which is the valuation of the company after the investment. To mitigate the impact of the option shuffle, companies may choose to use alternative forms of equity compensation such as phantom equity or implement a solid hiring plan to minimize the need for a large option pool.

Pitch Deck

A pitch deck is a visual presentation of a start-up’s business plan and is used to convince investors to provide funding. The goal of the pitch deck is to succinctly and effectively convey the key information investors need to make an informed decision. As such, it is important for the pitch deck to answer several key questions that potential investors are likely to have, including:

  1. What is the inherent problem the start-up wants to solve?
  2. In what way does the start-up solve the problem that’s different from the competition?
  3. What is the nature of the target market?
  4. How much money does the start-up need for the next step and where will it be used?
  5. What is the start-up’s growth strategy over a significant period of time?
  6. How does the investor get out with their capital and a strong ROI? (i.e. what is the exit strategy)

The pitch deck is typically composed of 10-15 slides and is used to supplement the entrepreneur’s verbal pitch. The slides should be visually appealing and easy to understand, but more importantly, they should be informative and concise, providing the key information investors need to make a decision.

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