If you are like many entrepreneurs, starting a business isn’t just about founding a company that is successful – it is about founding a company you can sell. This often requires a level of funding that most startup founders simply don’t have available. Fortunately, from major corporations like Google (or Alphabet) to venture capital firms and even individual investors, these days there are numerous potential sources of startup and operating capital available to dedicated entrepreneurs.
Of course, securing outside investment isn’t as easy as it sounds. Sure, there are options available, but (a) how do you find them, and (b) how do you convince them that your business is the right business in which to invest? Both of these are complicated questions that have a plethora of business, financial, and legal implications.
On the legal side, setting up your company for outside investment starts with…setting up your company. From your choice of legal entity (corporation or limited liability company (LLC)) to the way you structure ownership shares and control rights, the choices you make in the earliest stages of your company’s beginnings could have significant implications for its attractiveness to outside investors down the line. This article discusses some of the key considerations involved in structuring a new company for outside investment.
Six Key Considerations When Forming a Company that Will Raise Venture Capital
1. Corporation or LLC?
While LLCs are often the preferred legal entity for entrepreneurs without plans for securing outside investment, they are not necessarily the best option for companies that will seek to raise venture capital. In fact, in most cases, the corporate structure will be a better option.
Specifically, we’re talking about a C-corporation. In the US, there are two types of corporations: C-corporations and S-corporations. The biggest difference between the two is that C-corporations are subject to corporate income tax, while S-corporations are pass-through entities similar to partnerships and LLCs. However, the S-corporation is generally considered the “simpler” of the two corporate forms; and, while this offers benefits under certain circumstances, the options that are available with C-corporations are largely what make them the most attractive to outside investors.
2. Classes of Stock
When forming a corporation with the goal of attracting outside investment, the way you structure the company’s ownership interests (or potential ownership interests) is critical.
Corporations can have different “classes” of stock, and each class can have different rights and preferences with regard to:
- Conversion rights (the ability to exchange one class of stock for another)
- Redemption rights (the right to “cash out” on an investment)
- Voting rights
- Participation in company profits (dividend payments)
- Transferability of shares
While some companies have numerous different classes of shares, in most cases startups don’t need to go crazy with structuring multiple classes. The industry in which the company will operate, the types of outside investors being targeted, and certain other relevant factors will help guide the decision regarding which classes (and how many) should be established in the corporation’s governing documents.
3. Rounds of Investment
If you succeed in securing an initial capital investment, sooner or later, you will likely be looking for more. It is common for startups to have multiple “rounds” of investment and for investors in different rounds to be offered different investment opportunities. For example, maybe your first round of investors consists of friends and family. You want to make sure they have the opportunity to cash out at the appropriate time, but you don’t want to give them rights that could limit what you have to offer to angel investors, venture capitalists, or even early-stage employees. In other words, while founders need to offer enough to attract early-stage and mid-stage investors, they cannot make the mistake of letting one round of outside investment preclude another.
4. Securities Law Implications
In the US, passive investments in corporations, LLCs, and other business entities will typically qualify as “securities” under both federal and state law. Securities are heavily regulated, and issuing unregistered securities (without an appropriate exemption) can have serious consequences – including both civil and criminal liability.
Fortunately, there are a number of exemptions available, and these exemptions protect most smaller startups from the onerous (and expensive) burdens of securities law compliance. But, this does not mean that startups seeking outside investment can avoid the issue. Founders still need to understand what they can (and can’t) do when it comes to offering shares, and what is necessary in order to secure and maintain exempt status.
5. Paperwork, Paperwork, Paperwork
All of this means that there is a certain amount of paperwork involved in setting up a company for outside investment – generally more than what is required for a founder-funded entity. But, documentation is a necessary part of the process, and remember that your company’s governing documents will protect you, the founder, as well.
Even taking into consideration everything we’ve discussed above, the process of forming a company that is attractive to outside investors isn’t that complicated, and an experienced corporate attorney will be able to walk you through your options and help you make informed decisions that can then be used to prepare the paperwork you will need when courting potential investors. The key documents for startups seeking outside investment commonly include:
- Articles of Incorporation
- Shareholder Agreement
- Corporate Minutes
- Stock Certificates
- Subscription Letters (for Passive Investors)
6. Exit Strategy
While some founders dream of remaining involved with their companies long-term, others approach outside investment as an opportunity to extricate themselves and move on to a new venture. Whatever your goals may be, you will want to make sure that your company’s documents provide you with an adequate exit strategy, should the need or desire to leave arise. Here, too, you have a number of options, and the key is to provide yourself with the necessary flexibility without raising the eyebrows of potential investors.
Someone Wants to Invest, Now What? Evaluating Outside Investment Offers
While equity investors will ultimately be issued shares in the company, the process of securing outside investment starts with negotiating an agreement that outlines the terms of the investment. For founders, this requires a delicate balance: On the one hand, you want to show respect and make sure you secure the infusion of capital; on the other, you need to avoid accepting terms that simply aren’t right for your company and don’t align with your long-term vision.
When evaluating potential investments and negotiating with outside investors, a few of the numerous issues founders need to consider include:
- Anti-Dilution Rights – Investors will often seek to protect their ownership percentages with “anti-dilution” rights. Protecting an investor’s share of the company can often come at the expense of yours.
- Covenants – You can think of these as the “terms” of the investment: What will the investors be able to tell you to do (and not to do) when it comes to running your business?
- Liquidation Preferences – If the company sells, how much do the investors get before you’re left with the remainder (if any)?
Set Up Your Company for Outside Investment with Jiah Kim & Associates
Jiah Kim & Associates is an international law firm that represents entrepreneurs and startup companies in corporate matters and contract negotiations. To discuss setting up your company for outside investment, call the firm at (646) 389-5065 or schedule an appointment online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.