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Five steps to take before raising capital for startup

As a corporate transactional attorney with an active emerging growth practice, entrepreneurs occasionally contact me for help once they have embarked on the process of raising money from outside investors for their startup.

I am always eager to help if I can, but I find myself consistently spending more time than anyone would like to address certain matters that invariably slow down the process or, if left unaddressed, risk spooking potential investors.

Here are five actions an entrepreneur can take to speed up the process and address matters that always seem to arise when bringing on an investor:

1) Create a capitalization table

The issue: “Capitalization” really means “ownership” and encompasses all of the stock (if you are a corporation) or units/percentage interest (if you are a limited-liability company, or LLC) held by the company’s owners.

What you can do: Create a spreadsheet listing all owners and their ownership. This ensures owners understand their ownership — whether in terms of stock/units and/or overall percentage of the company, as well as the extent to which their ownership percentage may shrink (aka “dilution”) if more ownership interests are issued. (This also allows for a comparison of the dilution resulting from competing investment offers.)

2) Document company ownership

The issue: A surprising number of startups “issue” stock or units without ever taking the steps necessary to properly document such issuance. Prudent investors examine this documentation as part of their due diligence on the company. Poor documentation often leads to a potential investor wondering what else was mishandled by the company.

Similarly, a company will occasionally attempt to issue ownership, in the form of options, to advisers or employees without having first adopted an option plan. Or they may use language of “options” despite the fact that they are an LLC rather than a corporation. “Options” are difficult to replicate in an LLC context, and even an approximation of an option can have complex and possibly unintended tax and other consequences for the recipient and the LLC.

What you can do: Create a folder that contains your newly created capitalization table (see item No. 1) along with all supporting documentation evidencing ownership (for an LLC, that may just be the operating agreement). Now your lawyer can review what exists more efficiently and focus on what must be corrected or added. Most investors want to see all of this information, too.

3) Document IP ownership

The issue: Prudent potential investors also confirm a company’s ownership of its intellectual property (IP). This means that every person who has ever touched (or might have touched) this IP should have signed an Invention Assignment Agreement that transfers that person’s ownership interest in such IP to the company.

What you can do: Create a folder that contains a spreadsheet that lists every current and former employee and independent contractor of the company along with each person’s signed agreement. Now your lawyer can review what exists more efficiently and focus on what must be corrected, added or explained. (In some instances, failure to get such an agreement may not be a big deal.)

4) Understand “flavors” of startup capital

The issue: Entrepreneurs must understand two typical investment approaches used by early-stage investors — convertible debt and equity. A detailed discussion of these is beyond this article’s scope, but an entrepreneur should understand the basic components of each choice — both as to economics and governance.

For example, convertible debt terms may include interest, a conversion discount, a conversion “cap” and certain “home run” protection if the company is acquired before conversion occurs. An equity investment is typically in the form of preferred stock (or, in some instances, preferred “interest” or “units” for an LLC). Such preferred ownership may have the name of “Series Seed” or “Series A” for which there are fairly typical terms, with variations that are company-favorable or investor-favorable (and, depending on the facts, are invariably negotiated).

What you can do: Do some self-study, since good overviews exist online (just contact me — I can steer you to some). I often discuss with my clients these various choices, the impact of certain considerations (convertible debt may avoid fixing a price on the company now, though the conversion cap can essentially have a similar effect), and the trends of the current investor marketplace. I also cover some newer approaches to these concepts, such as SAFEs (or Simple Agreements for Equity).

5) Determine how to comply with securities laws

The issue: A surprising number of entrepreneurs pay little to no attention to the fact that anytime they contemplate issuing debt or equity in their company, they are subject to federal and state securities laws (and, to the extent investors are in more than one state, securities laws of each state, which may differ, apply). Criminal and civil penalties can loom for those who fail to comply with applicable securities laws. Perhaps of equal importance, future investors and potential buyers of a company may become very concerned (and possibly scared off) if flagrant violations of securities laws exist.

What you can do: Though you can do-it-yourself (DIY) for much of items Nos. 1-4 above, I don’t have a DIY suggestion here. Retention of an attorney experienced with securities laws and structuring private placements is a must. That attorney can help the company understand various topics necessary to ensure compliance with available exemptions from applicable securities laws, including who may (or may not) be an accredited investor, whether the company has a “bad boy” limitation on its ability to use a particular exemption, what limitations may exist if actions occur that can be construed as a general solicitation (such as a Twitter message that the company is seeking investors), and filings that may be required with federal and state regulatory authorities.

Raising capital for a startup can be a stressful process, but by taking the steps outlined above, you can address some commonly overlooked items and avoid creating unnecessary distractions for yourself and your investors.

Gian Brown is of counsel with Holland & Hart LLP in Las Vegas. He has nearly 20 years of experience counseling clients on a wide range of business and transactional matters across a diversity of industries and throughout the entire business lifecycle. Reach him at GABrown@hollandandHart.com or at 702-222-2513

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