An In-House Counsel’s Guide to Startup Venture-Backed Financing

Most startups rely on capital-raising efforts in order to survive and grow over the long-term. Fundraising can be both challenging and exhilarating. Startups are often unprofitable due to an early focus on rapidly growing their business operations, building upon positive momentum, and capturing market share.

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The guidance of a skilled in-house counsel can make the difference for successfully raising capital. The appropriate type of financing instrument depends on the company’s stage of development in the startup lifecycle.

Phases of a Startup’s Lifecycle

The lifecycle of a typical startup can be broken into four distinct phases:

  • Idea/Concept Stage: This initial phase involves creating a rough prototype or basic version of an initial idea to share with close circle of trusted friends and advisors.
  • Building: This next phase is dedicated to raising additional capital, hiring more employees, and building the basic prototype of the product or service into something that could be released to the public.
  • Scaling: The focus shifts in the scaling phase to expanding customer reach and capturing additional market share.
  • Maturity: Once the company approaches maturity, it turns its concentration to attaining profitability. However, many venture-backed startups are still unprofitable by the time they are sold or go public via an initial public offering (IPO).

While each startup faces unique circumstances, the successive financing rounds are typically labeled Series Seed, Series A, Series B, Series C, Series D, and so on.

Series A Financing Round and Beyond

The Series A round generally involves raising capital from venture capital and other institutional investors. Examples of institutional investors that invest in promising startups include:

  • Venture capital funds
  • The in-house venture capital arm of a large corporation
  • Growth equity funds
  • Hedge funds
  • Mutual funds
  • Sovereign wealth funds
  • Venture debt lenders

In Series A financings, the amount raised is typically in the range of $3 to $7 million. In Series B financing rounds, the amount raised is typically in the range of $7 to $15 million. The amounts of capital raised generally increase with each subsequent financing round. Once a company reaches its Series E round, it is usually raising over $100 million.


Convertible Preferred Stock Features in Venture-Backed Financing Rounds

The Series A round and subsequent rounds of capital raised from sophisticated institutional investors typically involve the issuance of convertible preferred stock. The commonly negotiated terms of this convertible preferred stock include:

  • Conversion: When the conditions are triggered for conversion, the shares of preferred stock typically convert into shares of common stock on a 1:1 basis. This conversion ratio is subject to adjustment if certain dilutive events occur.
  • Board Seats: The leading venture capital investor(s) will be able to negotiate for one or more seats on the company’s board of directors. This enables the investor’s designated individual(s) to exert influence over major company decisions.
  • Protective Provisions: Since investors often acquire minority stakes in the startup, protective provisions give investors the ability to influence certain actions of the company. For example, veto rights covering critical company decisions such as paying dividends and amending the company’s organizational documents may be granted to Series A round investors.
  • Liquidation preference: In the event of a sale or liquidation of the company, this provision entitles preferred stockholders the right to some of the proceeds from the sale or liquidation before proceeds are distributed to common stockholders. The amount of proceeds is known as the liquidation preference.
  • Right of First Refusal (ROFR): When a large common stockholder (such as the founders) decides to sell their shares to a third party, the ROFR provides preferred stockholders the right to purchase before other third parties.
  • Co-Sale Rights: Also known as tag-along rights, this provision allows the preferred stockholders to sell some of their preferred shares alongside a large selling common stockholder on similar terms and in proportionate amounts.
  • Drag-Along Rights: If the majority of the common stockholders (usually the founders) and a majority of the preferred stockholders want to sell the company, drag-along rights compel smaller stockholders to agree also to sell their shares.

Main Transaction Documents in a Venture-Backed Financing Round

There are five main transaction documents that are involved in a Series A financing round, along with many ancillary documents. These documents are also typical of Series B rounds, Series C rounds, and other subsequent financing rounds.

  • Preferred Stock Purchase Agreement
  • Amended and Restated Certificate of Incorporation
  • Investors’ Rights Agreement
  • Right of First Refusal and Co-Sale Agreement
  • Voting Agreement

Venture Debt

Sometimes startups are eligible to receive asset-based loans. There are certain banks and venture lenders, such as Silicon Valley Bank and Western Technology Investment, that specialize in lending to startups.

Most venture debt is structured as asset-based loans. This means that the amount of money the startup is able to borrow depends on the health of their balance sheet and overall risk profile. A common condition for startups receiving venture debt is that they have to provide equity warrants to the lender. The value of the equity warrants is structured to be equal to an agreed percentage of the principal balance of the debt.

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