STARTUP FINANCING: Sources and Rounds. Part I.
Updated: Jun 28, 2020
As a startup founder, you have a compelling task to raise money and multiple sources to choose from, including family and friends, angel investors or venture capitalists (VCs). Those sources are usually associated with different funding rounds, and require legal agreements, due diligence and compliance with securities laws. To choose a specific source and round, you need to decide on the amount of funding you are raising and amount of rights you are willing to give out to investors, as well as the complexity of compliance with securities laws and legal due diligence you are willing to undertake. Please note that each funding round, even friends & family, is a securities offering that has to be either registered with the Securities Exchange Commission or fall under one of the exemptions from registration.
Below we compared three funding sources (friends & family, angels, and VCs) in conjunction with three funding rounds (see Comparison Chart of Funding Rounds) and the legal considerations associated with each of them, including using different registration exemptions (see Comparison Chart of Registration Exemptions).
Funding Sources and Funding Rounds
1. Friends & Family:
Friends & Family Round: when you reach out to your personal network for smaller investments in your startup, generally under $500,000. Although legal requirements are minimal here, you still need to comply with securities laws by filing a Form D or making a securities offering under Section 4(a)(2). Additionally, you need a common stock purchase agreement (together with an investor questionnaire and risk factors) or a convertible note agreement (together with a convertible promissory note).
Advantages of Friends & Family Round:
· Relatively cheap and quick process to get funded; and
· Maintaining control over the startup.
Disadvantages of Friends & Family Round:
· Unlikely to bring expertise and other strategic value to the startup;
· Unable to invest significant amount of money; and
· Risk of harming personal relationships.
2. Angel Investors or VCs:
An angel investor is either a high-net-worth individual or a full-time investor in early-stage companies (sometimes called “super-angel”). A VC is an investment fund that manages the money of investors who seek private equity stakes in startup and small- to medium-sized enterprises with strong growth potential. Both angel investors and VCs can participate in Seed and Series rounds.
A Seed Round; Series Seed Round: when you have proven revenue potential, understand your market, and look for investments in the amount of more than $500,000-$1M but under $5M approximately. Seed rounds are generally under $2M. A series seed is a “bridge” round of financing larger than an average seed round but not quite on par with a “Series A” (from $3M up to $5M). You would need to file a Form D, and draft a preferred stock purchase agreement, or a convertible note agreement. A Simple Agreement for Future Equity (SAFE) is an option as well, and even more beneficial for a company than a convertible note. Convertible notes provide more protection to investors than SAFEs. In these rounds, we suggest conducting at least minimum Legal Due Diligence (“Legal DD”), which includes review of incorporation documents and a capitalization table.
Series Rounds (A, B, C, etc.): when you raise more than $5M in size to expand a successful business with a revenue stream. The average Series A funding round is about $5-10M and Series B is about $10-15M. You would need a preferred stock purchase agreement in addition to extensive Legal DD and Form D. In these rounds, we conduct extensive Legal DD to discover any previous legal challenges, to ensure the business has been established properly, and that none of the employees have been involved in any illegality. To make the Legal DD process easier, we recommend populating the data room with all the documents before you start fundraising.
Advantages of Rounds with Angel Investors:
· Relatively quick; and
· Maintaining control rights (many angel investors do not insist on board representation or significant approval rights).
Disadvantages of Rounds with Angel Investors:
· Unlikely to bring expertise, talent and connections as much as VCs do; and
· Usually unable to invest as much money as VCs.
Advantages of Rounds with VCs:
· Receiving sufficient funds, expertise, talent and connections needed for startup’s growth.
Disadvantages of Rounds with VCs:
· Takes longer to get funded due to business and legal negotiations;
· Possible dilution to the founders, because VCs usually negotiate the equity price; and
· Giving up control rights (board representation, veto power, right to remove CEO, etc.).
 General solicitation is allowed under three circumstances: (i) the offering is registered in the state where the investor lives; (ii) the company has registered the offering in another state and provides all investors with the disclosure documents relevant to that registration; and (iii) all purchasers are accredited investors (exclusively according to a state exemption that permits general solicitation and advertising).
 Although not defined by Section 4(a)(2), sophisticated investors would include: (i) qualified institutional buyers (QIBs), including any bank, savings, and loan association or other institution that in the aggregate own and invest on a discretionary basis at least $100 million in securities of issuers not affiliated with the QIB and that have an audited net worth of at least $25 million; and (ii) accredited investors, including institutional accredited investors, registered broker-dealers, and key employees of the issuer.
 In the context of a natural person, an accredited investor includes anyone who (i) has income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or (ii) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). Entities such as banks, partnerships, corporations, nonprofits and trusts may also be accredited investors.
 For example, the most recent balance sheet, income statements, statements of stockholders’ equity, and similar audited financial statements for the preceding two years, as well as a description of the issuer’s business and the securities in the offering.
This article is not legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Kristina Subbotina, Esq. Ms. Subbotina is a New York-based attorney specializing in advising individual and corporate clients on aspects of corporate law.