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Suppose you are a start-up business owner trading through a private limited company, and you hope to raise money from outside investors, including your friends and family. Naturally, you will want to know what options you have and what the legal implications of outside financing might be. This article will walk you through the three main financing sources during a seed-stage round.
The primary sources of seed financing are:
- friends and family;
- angel investors; and
- accelerators.
The Lifecycle of Company Financing
Like people, companies have different stages in their life. In general, they are the:
- launch phase;
- growth stage;
- maturity stage; and
- decline stage;
Depending on the industry and market you are operating in, the numbers can vary considerably. However, the types of financing available tend to be consistent.
This article discusses the primary sources of financing for businesses in the launch phase (also known as the seed stage, as the money you raise will nourish your burgeoning business).
Seed Stage of Development
You may have already launched the first version of your product during this stage, such as a new piece of software or consulting service. This is known as the alpha version of your product. Or you may need additional funds to properly launch your business, such as hiring employees or leaving your full-time job to focus entirely on your business.
You should note that the government is keen to incentivise investing in start-ups. Many of your investors may benefit from tax relief either through the:
- Enterprise Investment Scheme (EIS); or
- Seed Enterprise Investment Scheme (SEIS).
Sources of Seed-Stage Financing
Friends and Family
As the phrase suggests, one of the most common funding sources for start-ups during a seed-stage round is your friends and family. This can also extend to members of your professional network. In addition to providing you with financing, they can be a valuable source of insight.
Angels
Angels refer to high-net-worth individuals (HNWIs) outside your friends, family, and professional networks. These HNWIs invest their money into your company, usually in exchange for equity.
Accelerators
Accelerators, or start-up accelerators, are platforms or groups of investors that try to source and finance a variety of innovative business ideas, usually through small business competitions. These competitions will be assessed by the directors or partners of the accelerator platform.
If your business is successful in these competitions, you will be given access to financing as well as mentoring and exposure to industry experts. They may also provide you with legal and financial advice.
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Equity Financing
Most seed-stage round investors prefer investing through equity financing rather than debt financing. This is because:
- there are certain tax relief schemes only available to start-up investors providing equity financing (e.g., the EIS or SEIS); and
- equity financing, while riskier, carries more potential benefits for your investors because the value of their investment is directly tied to the success of your business — the more your business grows, the more their investment will grow.
In general, equity financing is where you issue shares in your company to investors in exchange for the money they give your company. Usually, your share of ownership in the company will become diluted because they now own a proportionate amount.
Conditions of Equity Financing
Investors will often want more than just shares in your company. Their investment is considered high-risk, so they will usually seek additional protections.
Different Classes of Shares
There are different ways to raise equity financing. One method is by issuing different classes of shares such as preference shares rather than ordinary shares. By way of explanation, shares are of a different class if their rights (like when their holder is entitled to dividend payments) differ from another class of shares.
While issuing preference shares is typical for later-stage equity fundraising, seed-stage round investors tend to avoid them as the two main tax-relief schemes do not cover them.
Shareholder Voting Rights
As part of equity financing, your investors may want you to issue shares with special voting rights. Effectively, when voting as a shareholder, their shares will have more weight per share than yours. This is a way to protect their rights as a minority shareholder.
You should note that you and your investors are free to negotiate the exact nature of the rights associated with different classes of shares. However, if your investors wish to take advantage of the tax-relief schemes, practically, their options will be restricted.
Appointment to the Board of Directors
Another condition of the equity financing may be that your investors will secure a place on the board of directors. This means they will have a say in the day-to-day operations of the business, such as how the company:
- borrows money;
- raises additional equity financing; and
- makes significant capital expenditures like buying a machine.
Share Transfer Restrictions
Investors may require you to amend your company’s articles of association to:
- prohibit the transfer of your shares to anyone else; or
- specify when they are entitled to transfer or sell their shares.
This is to ensure that their interests and the interests of you and your company align.
Contractual Protections
Investors may require you to sign contracts in your personal capacity giving certain promises and certifying that the information you have given about your company is true. Such agreements are called warranties, disclosures, or limitations. The effect is that you, in your personal capacity, will be liable for any misstatements, misrepresentations, or breaches of the agreements. This protects investors and ensures that you, as the founder, cannot hide behind your company’s limited liability.
Formalities for Equity Financing
Generally, there are certain formalities you will need to follow, such as ensuring you have the right as a director to issue certain shares or when you will need shareholder approval.
Additionally, creating new classes of shares or imposing share transfer restrictions will require you to amend your company’s articles of association. In many cases, you may even adopt an entirely new set of articles.
Key Takeaways
Seed-stage funding is the earliest stage of outside financing. Common sources of funding in a seed-stage round include your friends, family, and business network. Additionally, you may seek out investments from high-net-worth individuals or professional investors (called angel investors). Furthermore, accelerators are a new and innovative way for you to secure funding as a start-up. Finally, equity financing may be subject to certain conditions, which you should be aware of.
If you need help raising capital for your business, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Typically, start-ups seek to raise money from their friends, family, business network, and angel investors.
Most seed-stage round investors will give your company money in exchange for ownership, which is called equity. They will also seek additional protections.
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