Financing New Ventures: 10 Key Considerations to Structure an Equity Raise for a New Company
By Charlie Alovisetti, Navid Brewster
May 10, 2022
Raising money for a company is challenging. It can be even more challenging if you haven’t been through the process before and don’t know what decisions you need to make. In this article, we will lay out ten different considerations you should think about when setting up your financing (for the purpose of this article we assume a privately held company raise through equity—debt and public companies are more complex subjects). The first five points go to the actual terms of the raise and the final five points are more logistical in nature—though equally as important if you want to successfully raise money. Hopefully, thinking through each of these points will help you to realize any issues you may not have considered.
It should go without saying that, in creating this list of common issues, we’ve simplified what can be a complex process and have not described every possible issue or wrinkle. Please consult an attorney before taking on any investor money.
Structuring Investments
Financial and Business Issues
1. Structure of Raise
Put simply, money can be raised via a non-priced round (i.e., using a method such as a convertible note or SAFE that does not require setting a value on the company) or a priced round (where a valuation of company is necessary since you will need to set a price per share). Note that, based on investor demands, you may still need to include a valuation cap in a convertible note or SAFE, which may make such a raise somewhat of a priced round, but this is a wrinkle for discussion in a separate article.
Non-priced rounds have the advantage of being a simpler, quicker, and cheaper means of raising capital since they can be executed through short-form industry-wide standard documents. However, there are drawbacks. It can be difficult to raise large amounts of money via a non-priced round, and it may cause excessive dilution to later-stage investors. Additionally, non-priced rounds are more typical for seed-stage financings looking to raise smaller amounts of capital.
2. Valuation
Once you’ve structured a raise, the most important decision point will be the valuation you place on the company. It can be hard to push for a high valuation for a company without real revenue or profit, which is why many companies try to raise capital via a convertible note or SAFE for seed-stage financings.
The valuation’s impact is very straightforward—the higher the valuation, the less of the company you need to give away to raise capital. Though, this may make the raise more difficult to execute if investors think the valuation is too high. Conversely, a lower valuation requires the company to issue more equity in exchange for less capital from investors. Founders and companies must balance the need to attract investors to their raise, while also considering future financings when determining the appropriate valuation for the company.
3. Waterfall
After valuation, the next most important decision point is how you want to handle the waterfall of repayment in the event of a distribution or sale of the company. Do your investors get their money back first (i.e., a preference)? Do you want to guarantee them some kind of return on their money (i.e., a preferred rate of return)? And once the investors are repaid, do you then share pro rata in the remaining money, or you do only get the better of your preference or your pro rata amount (i.e., is the preferred so-called participating preferred)? These terms can make a tremendous difference in the value received by founders and investors in a future sale of the company.
4. Governance
Governance rights for investors in a capital raise can usually be distilled down to two key questions:
- Do you want to give investors board seats and, if so, will certain decisions require specific board member approval; and
- Should your investors have specific veto rights on actions the company may want to take?
From the founders’ and company’s perspectives, we typically suggest providing limited veto rights that protect the position of the preferred equity, such as a blocking right on any changes to the waterfall or any change that impacts the investors’ priority. It’s not uncommon to provide investors with the right to appoint a board member or manager for the class of investors—without specific blocking rights at the board/management level—to ensure the investors’ interests are represented in the management of the company.
5. Other Deal Terms
Points one through four above are the critical deal points for structuring an investment. However, there are a large number of other deal terms that often need to be considered when structuring the raise, including: anti-dilution, pro-rata rights (sometimes called pre-emptive rights), drag-along, tag along, tax distributions (for an LLC), information rights, registrations rights, and transfer restrictions.
There are a wide range of these provisions, which is a topic for a separate article. Aside from a structuring standpoint, it’s worth considering how you want your raise set up. Should it be viewed as investors as on “market” terms, or are their unique circumstances at play? You should tell your lawyer the general tenor you would like to take about these important non-core provisions.
Logistical and Legal Issues
6. Lead or No Lead
From a structural perspective, one of the most critical questions is whether you will be able to identify a lead investor for your round. There are several major advantages to having a lead:
- It may allow you to hit a minimum threshold of investment dollars to kick off a round (see point seven below);
- You have someone to negotiate with; and
- Other investors may be comforted by the fact that someone sees you as a good enough investment to take the risk of being the lead
However, if you can’t find a lead investor, it is still possible to raise capital—though the challenge we often see is the company and founders’ ability to get enough investors without a lead investor.
7. Minimum Raise, Rolling Closings and Mechanics
A key mechanic question for any company raising capital is whether their raise will have a minimum amount for an initial closing. Essentially, closings can occur in one of two ways: (1) either all the money comes in at once or (2) the money comes in over time (a rolling closing).
In the event of a rolling closing, investors may not want to be the first money in. Their concern, quite naturally, is that if a company raises an amount of money far short of what is needed, that money will simply be wasted. That’s why companies raising money often include a minimum raise in their financing terms—meaning they will not close on any money until they have arranged for at least a certain amount of money.
8. Existing Investors (if applicable)
If you’ve already accepted financing from investors, you have a few additional considerations to think about.
First, do you need your existing investors’ approval to close this new financing? You don’t want to get to the finish line with a new round of money only to have someone holding a veto right balk at the terms.
Second, do any of your investors have pro-rata rights (sometimes called preemptive rights) to invest in the next round? Be sure to work this into your calculations.
Third, think about how the valuations of the two rounds compare. The follow-on round can be an up round (at a higher valuation), a down round (lower valuation), or a flat round (same valuation). Beyond the obvious impact on earlier investors’ attitudes, the price of the new round could potentially impact anti-dilution rights (see #5 above) if those rights were provided in earlier financings.
Finally, if the first round was in the form of a SAFE or convertible note, then before starting your new round, it’s a good idea to look back and consider how this process will impact the economics of the new raise (here’s a good article on the math).
9. Cannabis Regulatory Considerations (if applicable)
Raising money for a licensed cannabis company can present additional challenges (we discussed this complex subject in this article). For instance, many states and local jurisdictions require some level of disclosure of investors depending on the structure of the raise and the amount of equity in the company investors will own. These disclosures can trip up a company and may disqualify some willing investors from participating in the raise.
10. Exemptions from Securities Registration
Last but not least, is the matter of securities laws (both federal and state). All sales of securities in the U.S. must either be registered with the SEC or sold pursuant to a specific exemption from registration. Here’s a high-level summary of exemptions from registration. Most cannabis private financings are structured as 506(b) offerings, with smaller numbers relying on 506(c) or Reg CF. However, lesser-used exemptions sometimes may come into play—especially for smaller raises or those involving unaccredited investors (which is a bad idea, by the way).
Raising money for a company is challenging, especially if you’ve never done it before. (And can be especially difficult due to cannabis regulatory considerations). We hope this article gave you a good idea of the process and brought forth issues you may not have considered.
If you have any questions about financing a new venture, our corporate attorneys are here to help! Please reach out to our Corporate Department.
As mentioned before, in creating this list of common issues we’ve simplified what can be a complex process and did not describe every possible issue or wrinkle. Please consult an attorney before taking on any investor money.