Law Offices of Ronald D. Jackson

Business Law

Tips for Raising Money for Start-ups and Emerging Businesses

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Disclaimer: This is not legal advice.

Entrepreneurs can waste a lot of time chasing dollars from sources that are not going to invest or who will extract too high a price. You need a fundraising strategy, one that is based on your getting appropriate financing at the right time. To reach your goals, pay attention to these seven legal and business tips when financing a start-up company.

Tip #1 Organize in a business form that attracts investment

The business form you choose, whether to operate as a corporation, partnership, limited liability company (LLC) or something else, will affect your funding options. If you need to raise money, you need a business form that supports that goal. Different investors have different preferences and expectations about business forms. If your investors require "pass-through" tax benefits then a partnership, S corporation, or LLC may be a good choice. For a variety of reasons, venture capitalists traditionally invest in incorporated businesses, ie. traditional C corporations. As your business grows, the business form may change to satisfy the needs of new investors. Whether a company stays in a particular business entity or transitions from it is often dependent on financing strategies. For example, staying in an unincorporated or "pass-through" business entity for as long as possible may be a good strategy. It might attract initial investment dollars. However, converting to a regular C corporation may be necessary later to obtain venture capital funding. Always consider your business form before looking for investment dollars. See my article, "Choosing a Business Entity," for a more thorough discussion about business entities.

Tip #2 Put together a complete management team

People invest in people, not business plans. A solid, well-balanced management team is essential to your efforts to successfully raise money. Serious investors expect that a complete team leads the venture. You may know a lot about the technical aspects of the proposed new product or service. However, to build a viable business, you'll need a balanced and sophisticated management team. Among other things,the business will probably need people who know about marketing and selling products or services, manufacturing, managing people, and accounting. Even if some team members are already on board, you should identify areas where the team needs shoring up. Plug any holes or have a realistic plan for doing so before seeking other people's money.

You may need to successfully recruit the talent the venture needs. The company’s ability to offer attractive financial incentives, like stock options and other deals may be key. The new venture will not get the management talent it needs without offering appropriate financial rewards to prospective employees. Likewise, your need and approach to protecting intellectual property will likely affect your competitive advantage in the recruitment process. In particular, insistence on restrictive employment agreements, like noncompetition clauses, can hurt recruitment efforts. This is especially true when negotiating with sophisticated employees who have options in areas like California where noncompetition agreements are generally unenforceable. Finally, solicitation of people whom others employ should be done very carefully. Dealing with restrictive agreements that prospects may have with current or previous employers can delay or even frustrate your recruitment efforts. These restrictive agreements come in many varieties. Prospects may be subject to nondisclosure, noncompetition, invention, nonsolicitation or other restrictive arrangements. If you breach or induce anyone else to break any of these arrangements, you could face what you definitely don't want: an expensive and time-consuming lawsuit from a vengeful former or existing employer. Overall, consider what talent the venture needs, prepare a legally defensible recruitment and negotiating strategy, and go get it.

Tip #3 Evaluate your options for early stage financing

Self, family and friends financing. Consider this as your leading option. Nobody believes in you more than yourself, and your family and friends. This core of support may be your most flexible, patient, and available option for financing your growth business.

Investment "angel" financing. This is a possibility if you have an innovative product or service, and can get an "angel." Many investment angels are the product of sustained economic booms. They are often willing to invest their cash earnings in promising start-up ventures. Increasingly, investment angels are forming groups that meet regularly to entertain proposals from start-up companies. Angel capital may offer considerable advantages: local money, perhaps more "patient" money, and perhaps most importantly, a supportive partner for your management team.

Venture capital financing. This is a long shot for the very early stage company, because venture capitalist don’t usually invest at the initial phase of a start-up company. VCs seek significant investment returns. They usually prefer to wait to see if your management team is seasoned and the market large enough (and lucrative enough) to justify their money and time.

Corporate Financing. If you have a product or service that can help a larger, established company become more competitive, then this might be an option. Partnering with an industry behemoth can offer big advantages. It can mean lots of investment money and access to technical know-how that is unavailable anywhere else. However, partnerships between leaders and startups can also be like those of unequally yoked couples. Despite the benefits, the costs can be heavy, especially for the small, start-up company.

Government Financing. Emerging growth businesses are important to states. The Oregon Department of Economic Development offers programs to support emerging businesses. Similarly, the Portland Development Commission (PDC) provides several programs to help early stage companies in the Portland area. Government funding will have "public benefit" requirements. Government funding may be available, and should be on your list for consideration.

Bank financing. Bank financing is probably not a viable option for a growth-oriented start-up compnay, because entrepreneurial businesses are different from the garden-variety small business. The two business types have different risk and financing dynamics. While traditional bank financing is often available to small businesses, it not typically available to start-up, entrepreneurial growth companies. Also, banks prefer to lend money against real assets and to businesses with track records. Collateral is a major requirement for traditional bank financing. In short, your business may be too new or too "risky" to attract the interest of a traditional banker.

Tip #4 Anticipate the impact of deals you make with initial investors

To get initial investments, your business may need to make some financial deals. You need to watch the terms of these initial investments, and anticipate their impact on future fund raising. Assume that a family member wants his or her contribution to be a loan and not equity. You need to understand that the terms of that initial deal, whether debt or equity will be important. Initial equity arrangements can cause stock dilution problems when new equity investors come in. Or, a friend-investor may want to have some control of the business in exchange for investment. Depending on how it's done, this situation might also affect subsequent investment interest. Similarly, at first, you will probably have to use incentives other than salary to attract talented employees. Sophisticated employees will want an equity position in exchange for the risks of signing on. How you price the employee stock options will affect your relations with future investors. It can affect the price that you can expect from subsequent investors. The employees expecting liquidity at some reasonable point in the future will influence your exit strategies. The tensions this situation can create are significant. Also, if initial investors get rights of first refusal, this could limit your options in the future?

You will memorialize the deals with initial investors in your organizational paper trial. You will reflect these transactions in provisions of the business's operating documents, bylaws, stock agreements, loan documents, and the like. Future investors will look closely at this paper trail before investing in your business. Make sure these documents do not contain any problem terms or clauses that may scare off future investors. At stake is your flexibility to finance the growth of your business.

Tip #5 Protect your intellectual property

Intellectual property includes copyrights, trademarks, patents and trade secrets. Copyrights protect "original works of authorship" such as screenplays, computer programs, photographs and other "literary works." Trademarks protect the names, words, slogans, and symbols that you use to identify your business’s products or services. Patents protect new, useful, and "nonobvious" inventions and processes. Finally, trade secrets protect valuable information that is not generally known and that you have kept secret.

Depending on the nature of your business, "intellectual property" may be your business’s sustaining blood. Potential investors will be very interested in knowing how you have protected these assets. As such, you need to protect them, but in practical ways that do not hinder marketability. An attorney can prescribe measures that will protect such property. The difficulty with devising protection measures is knowing when something goes too far and risks your business’s ability to form strategic partnerships and make deals.

Your approach to protecting intellectual property should be practical with an eye on your business’ needs and interests of potential investors. Always consider the business’s need for a given protection measure. Patent applications can take years and cost thousands: will advances in the field make the invention obsolete before the government issues a patent? Noncompetition agreements can hurt your recruitment efforts: is it essential that the business extract these commitments? Can a nondisclosure agreement yield the same result but allow you to begin a new employment relationship on more amicable terms? Insisting on stringent licensing terms can result in stymied deals and aborted business partnerships. Always ask: Are these licensing terms truly necessary? Does it matter if you consider that the "real" intellectual property resides in the minds of your technical and creative team? Are the efforts manageable to protect trade secrets, or are the administrative costs of carrying out the protections too burdensome? You should consider these issues before deciding how to protect your intellectual property. Potential investors want to know that you have taken steps to protect intellectual property. They will be very interested and probably turned-off if former employees are competing directly with the business, or if your licensing agreements are too loose. However, your goal is to protect the property without rendering it useless. It requires a legal and business strategy and common sense.

Tip #6 Comply with securities laws

If you plan to finance any part of your business with other people's money, you may be involved in the offer and sale of securities. Generally, the sale of interests in stocks, bonds, limited partnerships, and limited liability companies (LLCs) are "securities." However, many other agreements where you pay another person part of your profits or make interest payments fall under the definition too.

Both federal and state laws apply to securities transactions. Federal law applies to any security sold in "interstate commerce." Courts have defined "interstate commerce" very broadly to cover transactions involving the US mails and even intrastate telephone calls. Although federal law is becoming more preeminent in this area, state "blue sky laws" and registration requirements still apply. Generally, the federal securities laws require you to either register a security with the government or have an exemption from registration under the law. Additionally, anti-fraud provisions apply to any securities transaction. That means that even if you have a registration exemption, you still must comply with the anti-fraud provisions. You must disclose any information that a prudent investor would find "material" in making a decision to invest.

Because the registration process can be expensive and time-consuming, start-ups and small companies usually look for an exemption. An exemption from registration may be available depending on the situation. Generally, availability of a registration exemption depends on several features of the transaction. The type of sale is important, whether it is an intrastate or interstate transaction. Also, some exemptions depend on whether the sale is of a certain size (not more than $5 million). The number and type of investors involved is important (i.e., "accredited," "nonaccredited" or employee investors). The amount of sales activity over a certain period (i.e., within a year) is also used to figure out if an exemption is available. Additionally, the laws restrict the manner and nature of any advertising or solicitation that may be done concerning a securities transaction.

Entrepreneurs should always get legal advice about federal and state securities laws before offering, selling or issuing any securities. Failure to comply with these laws can result in serious consequences, including both civil and criminal penalties. Besides those problems, a company history that includes blunders in this area may scare away future investors.

Tip #7 Be Persistent

Be persistent in looking for investment dollars. Marketable ideas and solid management teams attract investment interests. For a start-up, however, you will need to find initial investors who are patient. They should not be overly concerned with liquidity, or the ability to sell the company’s securities. Without the advantages of public trading, the company’s initial investors will not have access to a readily available aftermarket. Whether the initial investors are family and friends, employees, larger companies, or others, your objective is the same: to persistently seek out and find other people who are willing to put their money into your adventure.

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