Founders often run into similar questions and curiosities. Below is a log of frequently asked questions addressed by our lawyers, many of whom have been in your shoes.
- What is a capitalization table?
A capitalization (cap) table is a record of the ownership of a company and will include a list of both the owners and the type of security the owners’ possess. For more on cap tables see What You Need to Know about Capitalization Tables.
- What is a capitalization table used for?
A cap table is useful for determining voting (e.g., who needs to approve a new investment under the charter) and economic rights (e.g., distribution of dividends). Companies can also use a cap table to help make decisions about granting new securities. For example, a company can use a cap table to determine the extent to which the founders will be diluted if a venture capital firm invests $X at a $Y valuation or to determine how much to expand the option pool to provide adequate equity incentives for new hires. For more on cap tables see What You Need to Know about Capitalization Tables.
- What should a capitalization table include?
A cap table should include a summary of current ownership by type of security and class, as well as details listing individual holders, type of security, date of grant, exercise price (if applicable) and vesting period (if applicable). For more on what should be included in a cap table see What You Need to Know about Capitalization Tables.
- What is a business plan?
Investors and potential partners or employees will want to see an outline of the business, the company’s purpose, plans and strategy. Typically, a plan includes:
- Description of the problem to be solved
- Description of the company’s solution and value proposition
- Market analysis, including competition
- Business model
- Organization and leadership
- Description of service or product line
- Marketing and sales strategy
- Financial projections
- Funding request (if applicable)
Each of the above sections should be targeted to both the business and the business plan’s intended audience, and should present information as succinctly as possible. For more on business plans see Expressing Your Great Idea: A Business Plan and Executive Summary.
- Who is an accredited investor?
An accredited investor is defined as anyone meeting any one of the following criteria:
- Earning income exceeding US $200,000 individually or US $300,000 together with their spouse, in each of the prior two years, and reasonably expecting the same for the current year
- Possessing a net worth of more than US $1 million, individually or together with a spouse, excluding the value of the person’s primary residence
- Serving as a director, executive officer or general partner of the issuer of the securities
Entities that hold in excess of US $5 million in assets and are not formed for the specific purpose of acquiring the securities being offered are also considered accredited investors, as are entities with equity owners who are all accredited investors.
In addition, certain banks, insurance companies, and trusts are considered accredited investors under existing regulations. For more on accredited investors see What is an Accredited Investor?
- Why is accredited investor status important?
Under US federal securities laws, a company seeking to sell or offer to sell securities must either register the transaction with the Securities Exchange Commission (SEC) or find an applicable exemption. Given the heavy disclosure burdens and costs of registering securities (think IPO), exempt transactions are the most efficient way to raise money for an early-stage company. Several key federal exemptions available to startups require that the company offer securities only to individuals who are accredited investors. For more on the importance of accredited investor status see What is an Accredited Investor?
- What is due diligence?
Venture capital investors typically complete a due diligence review process before finalizing an investment. Investors perform due diligence to confirm information previously provided by the company’s management and assess the strengths, weaknesses, and risks of the company’s business and plans. The process, which involves reviewing and gathering information and documents about the company and investment opportunity, includes both business diligence and legal diligence. For more on due diligence see How to Perform Due Diligence for a VC Financing.
- What is the due diligence process and what materials are typically reviewed?
The legal diligence process typically commences once the primary terms of the proposed investment have been agreed to in the form of a non-binding term sheet or other similar format. At the due diligence stage, the investor or the investor’s counsel will often deliver a list of requested documents for completing the due diligence process, known as a “due diligence request list.” The documents to be reviewed will vary based on the company’s business and industry. However, the legal diligence process will often include a review of the following materials, among others:
- The company’s corporate records
- The company’s capitalization table
- Agreements relating to the company’s capital stock
- Confidentiality and proprietary information and invention assignment agreements
- Agreements related to employment
- Other material agreements
- Materials and information relating to the company’s intellectual property
For more on the due diligence process see How to Perform Due Diligence for a VC Financing.
- What is the typical board composition after a financing?
After a startup’s first round of venture capital financing, revisions to the board composition generally take place to include a mix of common and preferred stock directors (designated by the founders and investors, respectively), and often an independent director. When the board composition changes, the board adopts a more formal board meeting schedule and process, and running effective board meetings becomes more critical to the startup’s success and the directors’ protection. For more on board composition after first-round financing see How to Run an Effective Board Meeting.
- What factors should entrepreneurs consider when evaluating investor options?
Entrepreneurs should consider several factors when evaluating investor options, including an investor’s:
- Expertise, desired involvement, investment history, co-investors, competitive investments, founder friendliness, personality and expectations.
For more on evaluating investors see How to Find the Right Angel/VC Investor.
- What are the 3 most common seed financing options?
The 3 most common seed financing alternatives are (1) equity financings, (2) convertible debt and (3) convertible equity financings, which are a hybrid of 1 and 2.
For more on these 3 seed financing options see Three Most Common Seed Financing Alternatives – Weighing the Pros and Cons.
- What is involved in an equity financing for a seed raise?
Equity financings tend to be the most complex type of fundraising available to companies for a seed raise. The financing documents for an equity financing can be long and include a number of terms to be negotiated between the parties. Investors and founders engage in determining the value of the company and what the future relationship between the company and the investor will look like. Usually, in return for their investment of capital, investors receive preferred stock in the company, although in some cases equity financings can involve common stock. For more on the pros and cons of equity financings see Three Most Common Seed Financing Alternatives – Weighing the Pros and Cons.
- What is a convertible debt financing?
Unlike equity financings, convertible debt provides a relatively quick, inexpensive and often simple financing structure. When convertible debt is used, the company and investor will structure the financing as a loan to the company with an interest rate and maturity date. At the end of the term, or upon some pre-determined future event (usually a Series A round), the outstanding debt (initial investment and any accrued interest) will be converted into equity. Generally, in order to incentivize investors to make a risky, early investment, the investors will be entitled to some discounted rate or a warrant as a “sweetener.” For more on the pros and cons of convertible debt financings see Three Most Common Seed Financing Alternatives – Weighing the Pros and Cons.
- What is a convertible equity financing?
Convertible equity is similar in structure to convertible debt, but eliminates the features that lead to a classification as debt. Rather than being structured as a loan with interest due and a maturity date, a convertible equity financing would generally accumulate no interest and have no expiration date. An investor would still be able to convert the investment into equity upon the occurrence of some future event, but would not be able demand repayment of a loan. Investors may be willing to accept this method of financing as they are typically not motivated by the minimal interest returns on a debt instrument, but are instead looking for a much higher return on investment. Therefore, the absence of interest or an end date is likely not important to investors. For more on the pros and cons of convertible equity financings see Three Most Common Seed Financing Alternatives – Weighing the Pros and Cons.
- What are Small Business Investment Company (SBIC) loans
In the United States, lenders to emerging growth companies often fund loans from an entity licensed under the Small Business Investment Company (SBIC) program of the US Small Business Association (SBA).
For both lenders and borrowers, SBIC funds are attractive because the funds typically have a lower cost of capital. SBIC loans, however, require that the borrower meet certain criteria to qualify. For information on the key criteria for borrowers to qualify for an SBIC loan see Small Business Investment Company Loans.
- What can a founder do to improve chances of securing a meeting with a VC?
The following four tips can improve a startup’s chances of securing a meeting with a VC: (1) research the VCs of interest, (2) network by attending networking and industry events and utilizing contacts, (3) obtain an introduction to the VC and (4) remain efficient and organized in all communications with VCs. For more tips on how to improve a startups chances of securing a meeting with a VC see 4 Ways Founders Can Improve Chances of Securing a Meeting with a VC.
- What is an accelerator?
At the most basic level, accelerators are organizations that concentrate resources in an effort to accelerate the lifecycle of startups and to provide them with years’ worth of experience in just a few months. Accelerators select, through a rigorous application process, a batch of early-stage tech startups to participate in the accelerators’ programs. The selected startups will then join the accelerator for a period of a few months, during which the accelerator will often provide a small cash investment, mentorship from experienced entrepreneurs, seminars and access to other members of the entrepreneurial community. For more on accelerators see What is an Accelerator and Should a Startup Join One?
- What are the advantages and disadvantages of joining an accelerator?
First-time entrepreneurs in particular benefit from access to a network of mentors and peers. Startups may learn important insights from seminars regarding substantive areas that are outside the founders’ expertise or from founders of other startups in the accelerator. Many people feel that the best accelerators increase the odds of additional funding for participating startups by providing those startups with increased credibility and exposure within the investment community through Demo Day.
By contrast, for some founders, accelerators can turn out to be a distraction, wasting founders’ time and resources. While acceptance into an accelerator’s class of startups may seem exciting, with all but the most prestigious accelerators, partaking in an accelerator program risks signaling to venture capitalists that the startup could not raise funds any other way and therefore must not be a sound investment. Finally, the funding that accelerators do provide is often small monetarily and on terms that are unfriendly to a company.
For more on whether a startup should join an accelerator see What is an Accelerator and Should a Startup Join One?
- What are the SEC’s crowdfunding rules?
Many startup founders are excited about the Securities and Exchange Commission’s (SEC’s) crowdfunding rules (adopted in 2015). The rules can help make new funding sources available to smaller companies that may lack access to traditional sources of capital. However, because the crowdfunding rules also seek to protect investors and minimize fraud, the rules can be difficult to navigate. The crowdfunding rules include certain limitations on who can engage in crowdfunding, how much individuals can invest, and what specific measures issuers and intermediaries must take before and during financings. Furthermore, as issuers and investors utilize the internet and social media to facilitate new investments, issuers and investors may become subject to other complicated US state and federal laws. For more on the SEC’s crowdfunding rules see 5 Key Things to Know about Crowdfunding.
- What are the three “I”s of crowdfunding?
The three “I”s of crowdfunding are issuers, investors and intermediaries. Under the SEC’s crowdfunding rules there are a series of major rules that issuers, investors and intermediaries should keep in mind when considering the benefits and drawbacks of engaging in crowdfunding. For a chart providing a list of some of these major rules see The Three “I”s of Crowdfunding – Issuers, Investors and Intermediaries.
- What factors should entrepreneurs consider when deciding whether to take on foreign investors?
The following are five factors entrepreneurs should keep in mind while considering a foreign investor:
- Governmental Restrictions – The US government maintains a routinely updated list of countries and people with whom the US prohibits US persons from doing business with.
- Securities Laws – As with all issuances of securities by US companies, any transaction with a foreign investor must comply with US federal securities laws.
- Bureau of Economic Analysis – The US Department of Commerce requires US companies to file annual reports of foreign direct investments with the Bureau of Economic Analysis (BEA) if companies exceed certain thresholds.
- Tax Implications – Taking on foreign investors can have important tax consequences for both a company and its investors.
- Practical Considerations – Aside from the above legal and regulatory considerations, companies should consider the practical limitations that a foreign investment relationship might entail, i.e. communication barriers, time zone differences, etc..
For more information on each of these factors see 5 Factors to Consider When Taking on Foreign Investors.
- What are protective provisions and why are they important?
“Protective provisions” provide rights to preferred stockholders to approve certain decisions made by, or with respect to the company. These approval rights are of critical importance to a company and its investors and often involve significant negotiation.
The preferred stock typically votes with the common stock, except if a special class or series vote is required by the protective provisions in a company’s certificate of incorporation or by applicable law. For more on protective provisions including a list of the typical provisions included see What are Protective Provisions and Why are They Important?
- What are the key types of terms included in a preferred stock financing term sheet?
While a term sheet does contain a myriad of terms, generally the most important fall into three categories:
1) Economic Terms: These terms affect a startup’s economics and financials. They can also play a role in allocating proceeds upon a liquidity event, such as a sale or initial public offering.
2) Legal Terms: These terms have a direct impact on the investors’ control and decision-making powers.
3) Investor Financial Protection Terms: These terms refer to terms in the term sheet that help protect investors’ economic expectations against changes brought on by subsequent financial transactions.
For more on the important terms in each of these categories see Term Sheet Terms Defined.
- What qualities are venture capitalists looking for in a startup?
All venture capitalists want to see certain qualities in a startup that signal strong growth potential before they invest. Entrepreneurs who recognize these factors can improve their pitches, differentiate themselves from other contenders, and ultimately improve their likelihood of securing funding. In particular, entrepreneurs should know that venture capitalists prioritize the following characteristics:
1) Talented team
2) Large addressable market
3) Viable business model
4) Competitive differentiation
For more on these qualities see 4 Qualities Venture Capitalists Look for in Startups.
- What are convertible note caps and why are they important?
As the convertible note market developed, some investors argued that the uncapped convertible note misaligns entrepreneur and investor incentives (for more on convertible notes generally see 3 Most Common Seed Financing Alternatives – Weighing the Pros and Cons). Investors argue that the discount typically given to most convertible note investors fails to fully compensate an early investor for such an early-stage risk, especially if the first priced equity round is at an unexpectedly-high valuation (which can happen in a hot market). In this case, the entrepreneur reaps most of the upside from having the time to use the investor’s money to build a more valuable business (resulting in the entrepreneur retaining a higher ownership percentage of the business when the company raises funds at the high valuation). This argument led to including a valuation cap on the conversion price of the note. For more on convertible note caps see What Are Convertible Note Caps and Why Are They Important. Despite the logic of a cap, a cap can have unintended and potentially negative consequences. For further discussion of these issues please see Why a Valuation Cap in a Convertible Note Financing May Not Make Sense.
- What are some reasons why a valuation cap in a convertible note financing may not make sense?
While capped notes are popular, founders should not assume that having a cap is inevitable or that not having one is unusual. Many companies successfully negotiate uncapped convertible notes, and there are reasons why that approach makes sense:
- A cap may have the unintended effect of imposing a “ceiling” on the valuation upon which a new investor might be willing to invest in the first priced equity round.
- The negotiation typically involved with including a cap may decrease the speed of execution typically viewed as an attractive component of convertible note financings.
- A valuation cap ends up being a de facto negotiation of what the investor thinks is the current value of the company, which is a negotiation founders are generally trying to avoid when choosing a convertible note round.
For more on the reasons why a valuation cap may not always make sense see Why a Valuation Cap in a Convertible Note Financing May Not Always Make Sense