Key Legal Issues With Equity Financing a Startup 

Equity financing involves external investors providing funds for your startup in exchange for a stake in your company. Capital raising rounds tend to be competitive, and receiving an offer from a potential investor can be exciting. However, it is crucial to take a step back and carefully review your company’s position and the terms of the investment agreement before accepting any funds. This article will discuss several legal issues involved with equity financing a new business. 

1. Equity Dilution 

Equity dilution is one of the primary legal issues of equity financing. It refers to reducing existing shareholders’ ownership in a company when issuing new shares. Dilution typically happens when a company raises additional capital by selling new shares to investors, such as venture capitalists or angel investors. 

Dilution is a common occurrence in equity financing rounds. If you seek further investment in exchange for equity, your portion of ownership will decrease further. It is your choice whether to dilute your stake in your company. Still, you should consider the long-term implications of your decision, including potential loss of control and voting power. 

2. Due Diligence 

Potential investors will conduct due diligence on your company to ensure it will be a sound investment. By carefully choosing which companies to invest in, investors safeguard their assets from risk. You should prepare for them to conduct due diligence by gathering the necessary documents and information, including legal and accounting records. 

3. Non-Disclosure Agreements 

During funding rounds, you will share large quantities of information with potential investors. You will explain what makes your startup’s products and services unique. Additionally, you will disclose potentially sensitive information about your company’s financial situation. 

It can be a great idea to ask those you share this information with to sign non-disclosure agreements. These agreements will prohibit them from disclosing certain pieces of sensitive information about your company. Furthermore, it will create a route for you to seek legal redress if they do.

4. Intellectual Property Issues

Investors will want to know that your company owns its intellectual property. A common mistake founders make is not ensuring the company owns its intellectual property. It should not be in the hands of founders or other parties, such as the person who created a design for your brand. 

Potential investors will want to know that you have registered the intellectual property in your company’s name. It carries value, and there is a risk of legal dispute if others own the rights. You should register your business’s intellectual property rights in your company’s name or seek to ensure it owns the rights before raising capital. 

5. Investment Terms 

Before agreeing to any form of investment, carefully read and review the terms of the investment agreement. It is a great idea to seek legal advice about any investment agreement. A lawyer can also help you devise a non-disclosure agreement and understand the implications of equity investment. 

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6. Exit Implications 

Angel investors and venture capitalists actively seek an exit from their investments. This allows them to generate a return, which they then reinvest in other opportunities, building and diversifying their portfolios.

This expectation of exit can have several impacts on your company, including the following:

• pressure for growth;
• focus on valuation; and
• potential for conflict.

Investors’ exit expectations can drive growth in a startup. However, they can also increase pressure on you and your team to scale the business rapidly. Investors might expect you to expand into new markets, develop innovative products, and quickly achieve milestones. Differences in timelines and expectations between you and your investors can sometimes lead to conflicts of interest. 

Before agreeing to equity investment, ensure your goals align with those of potential investors. Angels and venture capitalists tend to have slightly different exit expectations. Therefore, you must be clear about your goals and inquire about their exit strategy prior to agreeing to their investment. Once you have secured investment, clear communication with your investors is crucial throughout your relationship. 

Key Takeaways

Equity financing presents opportunities and challenges for startups seeking external investment. You should consider several legal issues before entering into investment agreements. In doing so, you can protect your company’s interests and ensure its long-term success. Potential legal issues include the following: 

• equity dilution; 
• preparing for potential investors to conduct due diligence; 
• whether you need potential investors to sign non-disclosure agreements; 
• intellectual property ownership; 
• the terms of the investment; and
• the implications of the investor’s exit strategy. 

If you require legal advice about financing options for your startup, 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. 

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