INTRODUCTION

Raising money is essential for the growth and success of startups, however, this process can be challenging especially for startup founders who are unfamiliar with the process. One way startups raise money is through venture financing, so startup founders must understand the basic concepts involved in venture financing. Financing is usually done in rounds with each round involving various elements, the rounds are named in somewhat abstract ways, such as ‘Series A’, and ‘Pre-Seed’ these terms and other factors involved in the fundraising process make it appear daunting.

It would be ideal if venture financing was simple and summarized in a single document. Unfortunately, this is not the case, so the purpose of this article is to provide a brief overview of the legal aspects involved in raising venture capital that founders should be aware of.

WHY RAISE MONEY?

Your startup product could be truly revolutionary, possibly the next Uber or Airbnb, but regardless of its potential, you will need a significant amount of capital to grow. While bootstrapping may help the startup grow to a certain extent, you will need more, this is where external investors and fundraising come in. A startup may wish to raise money for a variety of reasons, these reasons may vary from one startup to another.

Without adequate funding, most startups will fail and yet only between 0.05-1% of startups actually raise venture capital. Startups by their nature are meant to grow fast and this means burning capital to sustain their growth. The amount of money required for startups to become profitable is usually well beyond the financial capabilities of the founders and their friends and family. Aside from sustaining the startup and growing the business, sufficient funding also gives a startup a competitive edge; more money often means access to better staff, better marketing strategies and more.

STAGES OF FUNDRAISING

There are different types of investors who finance startups at various stages. These investors may be venture capitalists (VC), micro VCs, angel investors, syndicates, etc. Each phase of the startup’s life has its own unique needs to consider. Before launching the product, funding may be needed to develop your product, hire staff and create a buzz for your product. After launching the product the needs may change to revenue growth, increased operations or branding & marketing.

Fundraising may be divided into three main stages. Early-stage funding (pre-seed and seed) is the first stage, during which the founders are still developing the product and validating demand. Family and friends, angel investors, accelerators or incubators are common sources of finance at this stage.

The growth or later stage is the second stage; at this time, the rounds are usually Series A, Series B, and so on. At this stage, funding is used to help the startup scale, extend markets, and expand sectors. In the third stage, which is usually when an exit happens,  the startup is now accessible to the general public through IPOs (Initial Public Offerings) or the startup is bought by a bigger company.

PRE-FUNDING CONSIDERATIONS FOR FOUNDERS

Convincing someone to invest in your business is difficult on its own, one way you can help is by trying to insulate your startup and your potential investors from risk as much as you can. A good way to do this is through a solid legal foundation which protects the startup from potential risks while also potentially attracting new investors. Some legal considerations and protections are outlined below.

1. CORPORATE STRUCTURE

Choosing the right structure for your startup is essential because it influences your tax responsibilities, fundraising capabilities, and more. While it is possible to restructure your startup later on in its life cycle, it is advisable for founders to adopt the best structure for their startup from the outset. Restructuring a startup later in its life cycle can be complicated and have unanticipated tax effects. Startups may choose from a variety of business structures,  these structures differ depending on location. In Nigeria, for example, there are private limited liability companies, limited partnerships, general partnerships and so on. There are C-Corps, S-Corps, limited liability companies (LLCs), and other types of corporations in the United States (Delaware).

When deciding on a structure for a business, founders must consider factors such as taxation, laws and regulations that apply to each structure, as well as what structure investors prefer. A Delaware C Corp, for example, was recommended in the book Venture Deals because most investors are familiar with it. However, depending on your goals, that structure may not be the best for your startup. The documentation, tax implications, the expense of setting up that structure, liability protection, startup control, and more must all be considered when choosing the right structure. The structure chosen must always take the startup’s unique requirements into account.

2. THE FOUNDERS’ AGREEMENT

Before getting their first term sheet, founders can take a variety of legal steps to ensure their startup is well-positioned for success. Entering into a founders’ agreement early is one of the first ways founders may set themselves up for success. The relationship between the founders is usually good at the outset of a startup’s life. This solid relationship, however, may not always remain the same as the startup grows; the relationship may shift for a variety of reasons. Because the future is unknown and founders cannot predict how their relationship will develop, they can safeguard their startup’s success by preventing a founder’s exit from negatively impacting growth. Experienced investors also expect founders to anticipate this issue and protect themselves from one another, the best way to do this is through a founders agreement.

3. INTELLECTUAL PROPERTY

Intellectual property (IP) is another factor founders ought to consider when raising funds, especially where the founders have developed a unique product or technology. This is because proper IP protection and documentation can potentially give a company a competitive advantage as well as a regular source of revenue (royalties). IP protection also adds to the value of a startup. IP issues can kill a startup before it even gets off the ground, therefore founders must be cautious in documenting clear IP rights from the start. The best ways to legally protect IP include patents and trademarks for brand protection, as well as IP agreements and confidentiality agreements to safeguard trade secrets, are the best ways to protect IP. When picking a company name is it equally important to pick one that is free from trademark issues or domain name problems.

A proprietary information and inventions agreement (PIIA) between a founder and his employer, for example, could result in a big IP problem. Although the PIIA may not be a whole agreement but rather a clause in an employment contract, the effect is the same. If the founder begins working on the business while still employed by the employer, the founder’s IP may become the employer’s property, which will have major consequences for the startup. Founders can safeguard their intellectual property via patents and trademarks. However, these instruments are not always appropriate. A patent, for example, gives the holder a 20-year monopoly on the use and sale of their invention; however, startups without new inventions may not benefit from this. Trademarks may have a broader application since they protect the distinctive name, symbol, or phrase that identifies the startup as the product’s owner. Whatever path a founder takes, it’s critical to balance the financial investment required against the possible upside.

4. EMPLOYMENT CONTRACTS

Employees are at the heart of a startup’s growth. Without the help of workers, founders cannot successfully grow their startup to unicorn status. The strength of the team is a crucial aspect even before investors contribute money to a firm. However, problems with employment or employees may be detrimental to a startup. Employment contracts are an important tool for guarding against potential employment troubles. A severance clause should be included in the employment contract so that if an employee is fired to prevent litigation after an employee is fired. Founders may also choose to make their employees “at-will” employees, allowing them to terminate their employment at any time and for any reason without penalty.

Offer letters or employee agreements must be carefully drafted. It should include a confidentiality and invention assignment provision or confirmation that the employee will sign a separate confidentiality and invention assignment agreement. A good confidentiality and invention assignment agreement will cover the disclosure of confidential company information, the startup’s ownership of inventions, ideas and work products of the employees and protect the IP of the startup. The employment agreement will also include a non-compete and any stock options that may be granted to the employee and on what terms. There should also be a company policy or employee handbook which outlines expected behaviour from employees.

5. PRIVACY POLICY & TERMS OF USE

A terms of service agreement outlines the terms and conditions for visitors to your website. The terms of service should specify how the site can be used and any restrictions that may be applied. It should also include disclaimers and limitations on site owners’ liability.

A privacy policy outlines what will be done with data acquired from visitors and how that data will be shared with third parties. The privacy policy must be compliant with the Nigerian Data Protection Regulation (NDPR) and the General Data Protection Regulation (GDPR). This means, among other things, that it must cover the information collected by the website, how that information is obtained, how that information may be shared with third parties, and the steps taken by the startup to safeguard the security of the information collected. Privacy policies should be tailored to the startup.

6. PERMITS & LICENSES

It is essential for founders to determine which permits and licenses are required for their startup. Startups in the financial sector, for example, may need permits from the Securities and Exchange Commission (SEC) or the Central Bank of Nigeria (CBN). Industry-specific permits may be required if the startup’s business is in a regulated sector. Beyond ensuring they have the necessary licenses, founders must also ensure that the investors are accredited or legally excluded from accreditation before collecting funds from them.

7. SHAREHOLDERS’ AGREEMENT

Shareholder agreements are important for managing the startup’s relationship with its investors. Shareholder agreements are separate documents that can exist alongside a company’s memorandum and articles of association. It usually outlines each shareholder’s rights, responsibilities, liabilities, and obligations, as well as how the startup should run. Important clauses such as drag-along provisions or tag-along rights should be included in the shareholders’ agreement. Anti-dilution provisions should also be included. The addition and withdrawal of investors and founders should be covered by a good shareholders’ agreement.

CONCLUSION

The factors mentioned above are crucial to consider when fundraising, but they are not the only ones. In addition to the items listed above, founders must ensure that all agreements to which the startup is a party are properly documented and recorded.  There are also other ways to fund a startup outside venture capital, and the factors that founders consider will differ based on the option they select. However, regardless of the funding source chosen by the founders, it is critical to build a sound legal foundation; and the best way to do so is to hire an experienced lawyer.

REFERENCES

1. Afolabi Elebiju, Chuks Okoriekwe, ‘Getting tech startups investment ready: commercial and legal considerations for founders’, (2020), <https://arbiterz.com/getting-tech-start-ups-investment-ready-commercial-and-legal-considerations-for-founders/>
2. Aderonke Alex-Adedipe, Adedolapo Arisoyin, ‘Stages In Startup Financing, Legal Considerations’, (2022)
3. Brad Feld, Jason Mendelson, Venture Deals: Be Smarter than your Lawyer and Venture Capitalist, (2nd Edn, Wiley 2012)
4. Daniel Behar, ‘4 Legal Issues Startups need to consider before fundraising’, (2021), The Times of Israel, <https://blogs.timesofisrael.com/4-legal-issues-startups-need-to-consider-before-fundraising/>
5. Geoff Ralston, ‘A guide to Seed Fundraising’, YCombinator, <https://www.ycombinator.com/library/4A-a-guide-to-seed-fundraising>
6. Industry Investment Bank, ‘The legal aspects of fundraising startups you should know’, <https://industry4ib.com/blog/the-legal-aspects-of-fundraising-startups-you-should-know/>
7. Julian Everly Shervington Wright, ‘A guide to raising money for startups’, (2021) <https://www.forbes.com/sites/forbesbusinesscouncil/2021/10/26/a-guide-to-raising-money-for-startups/?sh=49941771ec3f>