Running the day to day of a startup is an exciting ordeal that many entrepreneurs live for. However, when it comes to legal and finance requirements, it’s not necessarily an entrepreneurs favorite topic. That is because raising capital for your startup is a lot more complex than it sounds – and it already sounds pretty complex.
However, given the reality of how startups work, the majority of startups will have to be forced to rely on outside financing in their early stages while they expand.
Types of Startup Capital
For most startups, most capital that will be raised will come in the form of either equity or debt that may convert into equity.
Equity capital is an ownership stake in the company the investor is bringing his or her money into. For their investment, they will typically get part ownership of the company (whether it be in the form of membership percentage for a limited liability company (or “LLC” as it is commonly known) or shares of a corporation. With this ownership percentage, the investor will generally be able to share in the profits of the company and may even have the ability to have a say in how the business is run – depending on what type of membership interest or shares are received.
Debt capital is not an ownership stake in the company but rather, a loan the company has to pay off to the person or company that loaned out the money. Many times, if this debt is not paid, it is possible for the debt capital to turn into equity into the company whereby the person or company that loaned the money becomes an interested party in the company, as indicated in the above section.
There are many securities laws that affect who can invest into a startup. These laws are on a federal and state level and will vary depending on a multitude of factors. Typically, the ability to invest traditionally is only available to certain types of sophisticated and wealthy investors.
Crowd Funding and Investing
With the increase of crowdfunding platforms such as Kickstarter, Indiegogo, GoFundMe, etc., many people are able to invest into startups that wouldn’t normally be able to invest into those same startups under various securities laws. However, with these “investments” typically these are not really in the equity or debt category because they typically get some type of reward for their investment that is not ownership or a loan that gets paid back.
Stages of Startup Funding
This is the first stage of funding. In this stage, usually, a startup will be comprised of a founder (co-founder possibly) and a small group of employees, if any.
In the seed round, most equity is raised by small convertible notes or common equity.
This is what I like to call the first “real” fundraising stage. At this stage, the startup is starting to really “enter the market” and may or may not be bringing in any type of revenue.
During this round, a startup will begin to secure funding from “angel” investors. Angel investors are affluent individuals who must have a minimum net worth of one million dollars and a yearly income of at least $200,000 before they can qualify as being considered an angel investor. Angel investors typically use their own money to invest in startups.
The venture round occurs when a startup company is in need of substantial revenue streams to take it to the next level.
During this round, a startup will attempt to secure funding from venture capital firms, usually in exchange for preferred stock. The venture capital firm will usually take an active role in the funded startup company and may require that funding is received in stages or milestones the startup must meet in order to receive the next group of funds. Typically, a venture capital firm will be involved with a company for a period of usually four to six years and will exit upon a merger, acquisition, or initial public offering.
The Pre-IPO stage (sometimes also known as the “Bridge Stage”) occurs when the startup company has been successful and has decided that the best course of action for its continued growth is to take the company public through an initial public offering (or “IPO” for short).
The IPO process is an extensive, lengthy, and expensive process. Thus, funding will still be necessary to allow for the startup to get to the point where they can make an IPO happen. Venture capital firms will usually also still be involved during this stage with the hopes of getting the startup to the finish line.
For a startup company, raising capital is one of the most important considerations that needs to be factored in the overall plan of the company. There are many options for startups to raise capital – each with their own set of rules, legalities, and formalities that need to be taken into account. If you are a startup that is looking to raise capital, it might make sense to consult with a business lawyer sooner rather than later. Feel free to contact us with any questions regarding the startup funding process and for advice on how to proceed.
Julian Cordero is an Attorney, Music Producer, and Entrepreneur. Oh and he blogs too! Julian is licensed to practice law in New York and is the Managing Member of Cordero Law LLC, a New York City based law firm focusing on Business Law, Entertainment Law, and Intellectual Property