More advice on raising money – Legal…

April 12, 2007

I wanted to write a follow-up to a previous post detailing some lessons learned as we continue our capital-raising journey. The topic of the first post was focused on identifying potential investors and how to approach them. This follow-up is focused on the “how” of what documentation is needed to raise money once friends or family say they are willing to invest. The basic advice I had been given and will pass on is to make sure you document everything in writing. This does not mean writing down an IUO on a napkin at your favorite local diner. Don’t laugh, I’ve read many stories (some of them successful) of entrepreneurs documenting investments on a napkin. I wouldn’t recommend it though. For this, you need a lawyer, specifically a lawyer who is familiar with capital markets transactions, which is a fancy term for companies raising money.

A lawyer will be able to provide you with the right kind of documentation so you can raise money one of two ways, selling stock in your company (most common) or borrowing money as a loan from investors. There are even things in between where you can borrow money from investors and offer them the right to convert their loan into stock in your company in the future. This is called a convertible security, and it’s not as complicated as you think. Nonetheless, you need a legal expert who knows this stuff to give you the right document. Most of the wording is going to be the same no matter which lawyer gives you his template. So don’t try drafting these agreements yourself.

If you decide to sell stock in your company by selling shares to investors, the documentation will involve several pieces of documentation. That’s what the lawyer is for. The trick with selling shares in your company is that you need to figure out what each share is worth. This is a frustrating exercise and involves you determining how much you think your company is worth (i.e. $250,000, $1 million, $5 million). If your start-up is in the idea-phase, meaning you don’t have any revenues, this will be difficult. Many people will argue your business is not worth anything, and you will argue that your business is worth as much as the idea is worth (billions and billions). In the end, you will have to negotiate down to something reasonable (I will put up another post that discusses valuation).

If you need to raise money quickly and don’t want to spend the $10k it will probably cost for the legal work associated with raising equity, you’re best bet is a convertible note. As discussed before, this is a much simpler document and outlines how you will be borrowing money from investors and that their investment will convert into shares later on (most of the time it’s within 12 months) when the business is further along and people are more comfortable discussing how much the company is worth when you hopefully have revenues and cash-flow. The convertible note is a complex IOU which says that when the investor gives you the money, you sign the document that says the company promises to convert the loan into shares in your company. The best part of using a convertible is that the legal costs are minimal (doesn’t require any custom work) and you don’t need to set a valuation for the company, meaning you can raise money much more quickly because there’s no negotiations taking place. As far as choosing the right law firm and where to start, check out my other posts on the topic of searching for and hiring a law firm. If you’re curious who we’re using, it’s Perkins Coie out in Menlo Park CA. Shoot me an email and I’d be happy to make the introduction.

JT

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