Funding Fundamentals: Legal Aspects of Capital Raising

Raising capital is a necessary step for most private companies, but navigating the legal and strategic nuances of different funding options is where careful consideration becomes crucial.  All capital raising methods – whether you plan to bootstrap, raise from friends and family, take on a loan, or equity finance – come with differing implications that you should be aware of to avoid common pitfalls.

This will be the first of a 5-part series on Funding Fundamentals for private companies, brought to you by Slingshot, where we will provide an overview of different ways to raise funds for your business. The goal is not only to secure funding to grow your company, but to secure the right type of funding that will position you for long-term success.

Below, we introduce five avenues for raising capital.

1. Bootstrapping

This form of self-funding is desirable for businesses in the early startup stages as it allows for full control and retention of ownership. However, bootstrapping is not a sustainable financing method, as it provides limited runway and slower growth.

Without pressure and requirements from external investors, founders often neglect to formalize internal operations and relationships. This can lead to disputes over equity ownership, decision making authority, and what happens if a founder leaves and how a founder leaves.

Ensure you have proper documentation of shareholder loans, that you implement a shareholder agreement if there is more than one founder and consider founder agreements with vesting terms in order to prevent dead equity.

2. Debt Financing

Borrowing money through loans, lines of credit, government programs, and convertible notes (see item 4 below for details on convertible notes) brings money quickly in the door, but also builds potential significant liability for companies (and founders personally where guarantees are involved!).

It is critical to understand the terms of any debt financing you receive, especially any security or guarantee requirements. If not carefully considered, borrowing money could result in you being personally liable for your company’s debt. It could also restrict your company’s ability to borrow in the future or receive future investments.

Loan agreements should always be thoroughly reviewed to consider:

• the repayment schedule and applicable interest;
• what actions, or inactions, can create an event of default whereby the loan becomes immediately due and payable;
• what covenants (promises) are being made by the company, and what restrictions these might create for the company (for example, required approvals before taking on more debt);
• whether a personal guarantee is required;
• what assets, if any, are being offered as collateral to secure the loan; and
• whether securities laws apply to the debt financing in question.

3. Equity Financing

Offering shares in your company to investors can be an attractive way to raise capital – especially when those investors bring not only funding, but strategic insight and other valuable support. Unlike debt financing, equity does not typically require fixed repayments, which provides your company with more financial flexibility and runway for growth. This form of financing may be ideal for companies aiming for rapid scalability.

The obvious challenge with equity financing is the dilution of ownership and potential shifts in control of the business. The key question is whether the capital and support gained are worth the trade-off for your specific business at its current stage.

There are various legal considerations when bringing on an investor, including negotiating the terms of key documents such as subscription agreements and a shareholder agreement. Depending on negotiating power and how much the investor is willing to fund the company, there will be certain expectations regarding investor rights. For example, investors may want a board seat, certain anti-dilutive rights or veto rights in a shareholder agreement to ensure they maintain a level of control over business operations and any future equity issued. Securities law will also need to be complied with, as private companies must rely on certain exemptions to be able to issue securities and avoid reporting requirements and penalties for non-compliance.  

4. Alternative Funding Models: SAFEs and Convertible Notes

Valuing an emerging company, especially in the early stages, can be difficult. Because of this, equity financing may feel complicated to navigate. This is where funding methods such as a simple agreement for future equity (“SAFE”) and convertible notes can be a strategic alternative, as they are much quicker and simpler than traditional equity rounds. The ability to secure funding quickly so that you can get back to building your business provides convenience, but the hybrid nature of SAFEs and convertible notes come with unique legal considerations.

A SAFE is designed as an equity instrument (meaning there is often no interest or maturity date) that allows for a company to receive funds immediately. In return, investors have the right to receive equity in the company at a future date upon some triggering event. Convertible notes, on the other hand, are debt instruments whereby the amount loaned to a company, often with interest, can be converted into equity upon certain conversion events (and at such point of conversion, the debt owed does not need to be repaid).

Both SAFEs and convertible notes have conversion mechanics that are critical to understand prior to executing agreements which include:

• Conversion Price (Valuation Caps and/or Discounts)
  • These terms determine how the investment converts into shares once triggered and could have dilutive impact on your ownership stake in the company. A valuation cap sets a maximum company valuation for conversion (to protect investors in the case of the company exploding in value), while a discount allows investors to buy shares at a reduced price.
• Conversion Events
  • These terms outline events, actions, or inactions that could trigger equity being issued under either a SAFE or a convertible note (for example, upon a sale of the company or a future funding round). You should be aware of any restrictive covenants, such as being prohibited from or requiring approval for incurring additional debt, selling assets, and distributing dividends.

There may also be ancillary documents to a convertible note related to securing the amount loaned that you would need to be mindful of – similar to with debt financing. Securities law compliance is also paramount for both SAFEs and convertible notes.

5. Grant Funding

While a highly attractive method of funding due to its non-dilutive nature, often with no repayment obligations, receiving grant money should not be considered entirely free of risk.

For example, some grants may include terms requiring the recipient to license rights to intellectual property, share in ownership of the intellectual property, or possibly assign intellectual property rights in some form. Intellectual property is an integral asset of your company that should not be given away without careful consideration. Understanding and negotiating these terms ensure you retain control and commercial rights over your ideas and products.

No matter which funding method you choose, engaging with a lawyer in advance will ensure proper documentation, regulatory compliance, and confidence that a review of relevant agreement and terms had been completed with a view to the best interests of your company. Book a chat with our Slingshot Team to discuss how we can be of assistance when it comes to raising capital for your business.