This article originally appeared in the Preferred Returns Newsletter of the Fall 2022 Edition of the American Bar Association’s Business Law Section. It is republished here with permission.
Market rumblings indicate the current economic landscape is creating challenges for startups looking to raise money. By some accounts, early-stage startups have not (yet) seen much of an impact of the tightening market, primarily because they have been shielded by corrections in the late-stage and public markets. They have nonetheless seen a decrease in valuations, re-cutting of deals, and in some cases, delayed closings. According to PitchBook-NV-CA’s Q2 2022 Venture Monitor, “...the pace of venture capital (VC) activity across all stages is likely to slow in H2 2022 as the threshold for closing deals rises, and pricing uncertainty extends to early stages of the investment cycle.”
So, even though plenty of deals are getting done and there is a lot of dry powder waiting to be deployed, investors are becoming more selective with their investments. Now, perhaps more than ever, startups looking to raise money should take the time to position themselves for successful VC financing. It’s important for founders to understand that preparing for VC financing starts with a better understanding of some key legal issues. This article discusses a few of the critical steps founders should keep in mind in order to position their company for VC financing.
Choosing the right business entity and jurisdiction is an important first step. Although there are a number of different entity types (e.g., partnership, limited liability company, and corporation, to name a few), most investors prefer, and usually require, the startup to be a C corporation. C corporations are different from partnerships, limited liability companies, and S corporations in how they are taxed. They are taxed as a separate entity from the shareholders. By contrast, partnerships, limited liability companies, and S corporations are considered flow-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, the next issue is to choose the right jurisdiction. Delaware has been the go-to state 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. The Delaware General Corporate Law is reviewed and updated on a regular basis, and, being an enabling statute, provides flexibility for companies to run their business. Additionally, corporate disputes are heard by the Chancery Court before judges with considerable experience and knowledge in business law. For these reasons, Investors favor Delaware. Setting up as a Delaware C corporation is an important first step in positioning the startup for VC financing.
An essential step for any start-up looking to raise financing from investors is proper documentation. That starts with ensuring that the founders, employees, and consultants sign proprietary information and invention assignment agreements (aka 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. Investors want to know that the company they invest in owns the technology. Deals can get derailed if the company is lax in getting this critical documentation in place, only to find out during an investor’s diligence that the company’s core technology is actually owned by a former founder or employee who never assigned their rights over to the company. The company should take care to ensure, where appropriate, that all employees and consultants sign PIIAAs.
Another important step is ensuring 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. Over time, those restricted shares will vest, meaning the repurchase right as to those shares will lapse. Vesting is typically over a four-year period with a one-year cliff, such that 25% of the shares will vest after 12 months, with the remaining shares vesting in equal monthly amounts over the remaining 36 months until 100% of the shares have vested and are no longer subject to the repurchase option. The vesting start date is often times the date the founder formed the startup, but in some cases could precede the formation date. Investors will look at the vesting terms of the founder’s equity, and if the founder is close to having all their stock vested will require the vesting terms to be reset.
This same approach should be used with employees and consultants receiving equity. The vesting start date is usually tied to the employee’s or consultant’s start date. Options granted to employees and consultants should have a similar vesting condition, although the vesting works a little differently. Because options are a right to purchase stock at a future date at an agreed-upon price (i.e., the exercise or strike price), a repurchase right doesn’t work. Instead of a right to repurchase, options are set up so that only vested options can be exercised and purchased. The options granted to employees will typically vest over the same four-year period with a one-year cliff. The vesting terms for consultants are usually more varied and may be tied to the term of the consulting agreement rather than a four-year period.
Having the proper documentation in place with customary vesting terms shows investors that the founders have a long-term vision for the company and helps incentivize those key personnel that are important to the success of the company to stick around.
Investors looking to invest in a company will take a close look at the capitalization table (cap table). The cap table is a document 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 lists everyone who holds any securities in the company and how much and is a critical document for keeping track of the company’s ownership.
There are a number of pro-grams that provide cap table management solutions to more effectively and efficiently manage the cap table. One of the benefits of using a cap table management program is the program’s ability to grow and scale with the business. Some offer additional features such as the ability to obtain 409A valuations, run compliance audits, or generate various types of reports, including proformas. Not having a current, correct, and well-organized cap table can create a whole host of issues, from incurring additional legal fees to correct errors to extending an investor’s diligence which can delay closing. Some investors now require startups they invest in to use a cap table management program.
It is never too early to set up a data room. Having a systematic and standardized way to save and organize the company’s documents in a secure data room will make the diligence process of financing much smoother and quicker, while also helping to contain legal costs. Founders should use care in selecting a data room that is secure and easy to use. The data room should also be organized with a view toward the investor’s diligence process.
Many investors will send out a diligence request list at the start of the financing round (usually around the time the term sheet is signed — this diligence request list of a good template for the organizational structure of the data room. Having a data room organized in a way that is consistent with a typical diligence request list will help expedite the investor’s diligence review.
Although it may not occur to the founders to interview prospective investors, selecting the right investor for the company is as important as the investor choosing the right company for investment. Founders should make sure they do their homework on prospective investors. Many VC funds will invest in a specific industry or at a specific stage. Read up on the VC’s prior investments, the typical stage and size of their investments, as well as the background of the VC fund partners. Before that first meeting, founders should get to know everything they can about the VC fund so they can be sure it is the right fit for the company.
Although other issues are important in positioning a startup for VC financing that are beyond the scope of this article, the issues discussed above occur relatively frequently and can be easily resolved with proper planning and advice. The recurring theme in positioning a startup for VC financing is preparation. Spending the time to prepare well in advance of financing will put the company ahead of the game, and in doing so, will save time, money, and (maybe) a few sleepless nights. To quote a well-known entrepreneur, Alexander Graham Bell, “Before anything else, preparation is the key to success.”