Legal must-haves before raising capital with Becki DeGraw | Wilson Sonsini Startup Legal Basics
26 Aug 2024 (24 days ago)
Wilson Sonsini partner Becki DeGraw joins Jason
- Startups often begin by raising funds through convertible notes and SAFEs.
- Once a startup achieves significant milestones, such as reaching a million or two million in ARR or revenue, they may attract interest from venture capitalists for a priced round.
- During a priced round, when a startup receives investment from venture capitalists, it's common for previous convertible notes to be converted into equity.
Legal preparations for startups and the importance of early legal counsel
- It is important to get legal counsel involved early in the process of starting a company, ideally before a term sheet is signed.
- Legal counsel can help ensure that all necessary legal documents are in place, such as assignments, capitalization tables, vesting schedules, and employment agreements.
- Common mistakes that founders make include not having proper documentation of intellectual property assignments, capitalization table management, and employment agreements.
Common Legal Oversights: Cap table, IP assignments, and employment agreements
- A clean capitalization table is essential for investors as they want to know their exact ownership percentage.
- A poorly maintained capitalization table, such as one missing crucial documentation or with inaccuracies, can significantly delay or even derail a potential investment deal.
- Failing to properly document share issuances and obtain necessary approvals can lead to tax complications and necessitate retroactive adjustments, potentially involving the IRS and causing financial repercussions.
Risks of DIY legal documents and safes
- It is important for founders to educate themselves on the basics of legal matters related to starting a company, such as vesting schedules, share issuance, and capital gains.
- Founders should understand basic legal terms and processes related to fundraising, such as pre-money and post-money valuation and liquidation preferences, to be effective in investor negotiations.
- Founders can benefit from creating their own capitalization table to understand how dilution works and the impact of different financing scenarios.
Cap tables and equity management
- Employee Stock Ownership Plans (ESOPs) should be created before a large investment round to avoid diluting the investor's shares.
- Founders should create a proforma cap table to project their equity ownership after financing rounds, including the conversion of SAFEs, convertible notes, and the addition of an option pool.
- Founders should request their attorneys to run M&A scenarios at different sale prices to understand the impact on their equity and potential payouts, especially in situations like down rounds or early exits.
Impact of mismanagement on legal and financial outcomes
- Mismanagement can lead to founders losing control of their companies and receiving no equity if the company is sold.
- When negotiating a carve-out in a down round or bridge financing, it's crucial to consider the expected sale price and the potential return for common shareholders after deducting expenses like banker fees, legal fees, and overhang.
- In scenarios other than an IPO, understanding the waterfall distribution of funds is crucial, as it dictates how money flows down to different stakeholders based on their agreements and equity structures.
Pro forma cap tables and employee stock option plans (ESOPs)
- Founders should understand the potential outcomes of their decisions and seek advice from board members or other experienced individuals if they feel they are not receiving adequate guidance.
- Founders should view tasks such as financial planning and legal due diligence as essential chores that, while potentially tedious, are crucial for the success of their business.
- Founders should seek out and rely on competent legal and financial advisors to navigate the complexities of fundraising and business management.