Are you raising capital for your business? Here are some of the key legal considerations we will discuss with you:
What kind of funding are you seeking and what are the differences?
We will discuss with you the most appropriate types of funding for your business and for the stage of development of your company. Here are some of the most typical methods of financing:
- friends-and-family financing
- angel investment
- seed funding
- bridge financing
- venture capital financing
- private placements
- public offerings
- bank lines of credit
Do you understand the difference between equity and debt financing? What about hybrid forms, such as convertible notes? How much of your company does an investor receive? How do pre-money valuation and post-money valuation work and why are these numbers important?
What does “pre-money valuation” mean and how does this number work?
Pre-money valuation is the total valuation of your company before the investor provides any funding. Negotiation of this amount determines how much ownership of the company is received by the investor. The higher the valuation, the less the investor receives for a given investment amount. If the pre-money valuation is $1,000,000 and the investor invests $100,000, the investor receives $100,000 ÷ ($1,000,000 + $100,000) = 9.09% of the company. If the pre-money valuation is $100,000 and the investor invests $100,000, the investor receives $100,000 ÷ ($100,000 + $100,000) = 50.00% of the company. Post-money valuation is simply the pre-money valuation plus the amount received by the company in the financing – it’s also the denominator in the calculation of what percentage of the company’s equity is issued to the investor.
You can also start with the percentage you want the investor to receive for a given amount of capital and determine the pre-money valuation required. For example, if you want your investor to receive 10% after investing $100,000, the post-money valuation equals $100,000 ÷ 10.00% = $1,000,000. Pre-money valuation is $1,000,000 – $100,000 = $900,000.
What does “fully-diluted” valuation or capitalization mean?
You’ll hear investors speak of “fully-diluted” pre-money valuation or capitalization, which relates to the price per share the investors will pay. Fully-diluted means that shares reserved for issuance pursuant to a company’s stock option plan, in addition to all other shares actually issued or committed, are included in the calculation of the price per share paid by the investor. So, if the company has issued 100,000 shares to founders and has reserved another 15,000 shares for stock options, the number of fully-diluted shares is 100,000 + 15,000 = 115,000 shares before the financing. The investor’s price per share is the pre-money valuation divided by the fully-diluted pre-money share total. For example, if the pre-money valuation is $1,000,000 and the number of fully-diluted shares is 115,000, the price per share for the investor is $1,000,000 ÷ 115,000 shares = $8.70 per share (rounded). For a $100,000 investment, the investor receives $100,000 ÷ $8.70 per share = 11,494 shares. If the option shares were not included in the calculation, the investor’s price would be $1,000,000 ÷ 100,000 shares = $10.00 per share, and for a $100,000 investment the investor would receive $100,000 ÷ $10.00 per share = 10,000 shares. Investors prefer to include the options in the calculation so as to avoid future dilution of the investor’s stake when options are exercised for shares.
What is preferred stock and when is it used?
Obtaining equity capital from professional investors usually requires the creation of preferred stock which carries various preferences and protections in favor of investors. Preferred stock is usually issued in separate series, such as Series A, Series B, Series C, and so forth, for financings completed at different times based on different (hopefully increasing) valuations of your company. For each round of funding, investors will typically present a term sheet to the company containing a summary of key features of the financing. After the term sheet is finalized, much lengthier agreements will be drafted by legal counsel to fully document all aspects of the financing. In most cases, preferred stock is convertible into common stock at the option of the holder and automatically converts into common stock upon an initial public offering or IPO.
What are convertible notes and when are they used?
Convertible notes are promissory notes issued in exchange for funds loaned to your company. A principal advantage of using a convertible note is that funding can be achieved more quickly and with less documentation than a typical equity financing. It is usually not necessary to establish a valuation for the company when issuing convertible notes – valuation is generally deferred until the next equity financing, such as a venture capital financing. Convertible notes can convert into equity of the company (preferred stock or common stock), usually upon a subsequent financing event. How does conversion work? Most often, the outstanding principal of the note converts into equity at the same price per share paid by investors in the next equity financing. Sometimes a discount is applied to the conversion price in order to reward an investor for providing liquidity before all of the terms of the equity financing, including valuation of the company, are established. Are convertible notes ever payable in cash? The notes may be payable in cash on a specific date if a conversion trigger has not occurred. Convertible notes are commonly used for seed financing or bridge financing transactions.
What is a bridge financing?
A bridge financing is usually a quick cash infusion to allow a company to keep running while a venture capital or other financing is arranged. Existing investors and new investors may be able to participate in a bridge financing. Bridge financings are often completed using convertible notes as described above.
What laws and regulations apply when raising capital for your business?
Raising funds for a business venture is subject to strict regulation under state and federal securities laws, including the U.S. Securities Act of 1933, the U.S. Securities Exchange Act of 1934, the California Corporate Securities Law of 1968 and other state securities laws. It is critical that you confer with counsel before beginning any fundraising efforts.
What restrictions apply to advertising or publicity regarding your fundraising?
Advertising for investors is prohibited in almost all cases, including interviews or articles in which you mention that you’re raising funds. This prohibition on general solicitation extends to communication through websites, blogs, seminars, newspapers, magazines, trade publications, radio, television and other forms of wide distribution. If you seek investor leads through these or similar channels, you will generally be prohibited or restricted from completing the financing as planned and you may be subject to penalties from state and federal securities authorities. What means of communication are permitted when raising capital? We will discuss with you what channels of communication are appropriate when fundraising for your company.
What kinds of information do I provide to prospective investors?
The financing process is subject to specific disclosure requirements relative to your business. Failing to disclose material information (or providing false or misleading information) concerning your business can subject you and your company to cease-and-desist orders, civil penalties and criminal prosecution for securities fraud under the U.S. Securities Act of 1933, the U.S. Securities Exchange Act of 1934, the California Corporate Securities Law of 1968 and other state securities laws. We help companies prepare offering materials intended to satisfy these requirements.
Can you pay a finder to help raise funds for your company?
In most situations when you’re seeking investors and capital, you may only pay commissions or success fees to someone who is a broker-dealer registered with the Financial Industry Regulatory Authority or FINRA. Payments to an unlicensed “finder” are generally prohibited for both the company and the finder. Note that payments in connection with a financing, including commissions, must be disclosed in the transaction notice filed with the U.S. Securities and Exchange Commission (including license information regarding any recipient of commissions or other sales compensation).
Are there particular requirements for who can invest in your business?
In general, it is advisable to approach and obtain funding only from “accredited investors” who meet specific financial suitability requirements under Regulation D of the U.S. Securities Act of 1933. Accredited investors include:
- directors, executive officers and general partners of the company issuing securities;
- persons whose net worth, or joint net worth with spouse, exceeds $1,000,000 (excluding the value of the person’s primary residence);
- persons who had an individual income over $200,000 in each of the two most recent years or joint income with spouse over $300,000 in each of those years and a reasonable expectation of the same income in the current year;
- most entities with over $5,000,000 in assets; and
- entities in which all of the equity owners are accredited investors.
Limiting your offering to accredited investors reduces compliance costs during the offering and avoids unnecessary complications in connection with future transactions.
What filings must be made with government agencies?
The issuance of securities by a company based in California always requires a filing with the Securities Regulation Division of the California Department of Corporations and may also require a filing with the U.S. Securities and Exchange Commission. Are you issuing securities in states other than California? If you are issuing securities to investors or employees in other states, filings may be required in those states as well. We can assist you with the preparation and filing of these required securities law notices