Legal 101 For Startups: Funding And Valuation Matters

In this post, we will talk about the two most important things when it comes to your startup: funding and valuation.

Seed or angel funding is the first step and when you’re trying to find an angel or seed investor, always make sure your investor is a known name as he can then help you lead the next round. Do not raise funding just because you need money at the moment but raise funding keeping in mind how it’s going to help you raise successive rounds in the future. Hence, find an investor who’s a ‘known devil.’

Another phenomenon that seems to be doing the rounds is every Tom Dick and Harry with a pot full of gold fancy themselves an investor. For example, shop owners with tonnes of money lying around are also calling themselves investors now. We strongly suggest you do not go to these guys unless you’re absolutely desperate as they could mess up your business and ensure you lose your credibility.

One key factor to consider carefully is how you go about distributing equity as every time you raise money, you’re going to have to part with some amount of equity. Since equity is limited to a 100% you must choose your distribution very wisely as being a founder, all you have is equity.

Few things that you must consider are:

Is Your Investor Going To Be The Only Investor You Can Bring On Board?

If so, you can throw 30% at him. However, if you’re going to raise another round of funding, keep in mind that the more you give him right now the less you’ll have to give during the second round of funding.

You’re going to start hiring employees to hold senior positions such as a CTO and a CFO. Now being a startup, you’re not going to have the resources to pay these guys the salary they demand. Hence, your only play will be to give them employee stock options. You’ll have to give each of them a percentage, as well. Hence, do not give away too much stock in the form of employee stock options as the amount you give away to the investor and your employees shouldn’t end up eating away into your own share. As being a founder, all you have is stock.

Another very important thing is the distribution of equity amongst the founders. This is always the trickiest because often you’ll have one guy who has the money, one who has the vision and another who has the execution ability to convert that vision into reality. Always distribute the equity based on the skill sets of the co-founders. When doing this, keep all friendships on the side as it’s a business at the end of it.

Valuation

Now let’s look at valuation and all that goes into it. Every investor will always want to value you at a lower price and you’ll want to be valued at a higher one. The quick fix to this problem is to approach a CA and have him create a valuation report for you. Ensure you give him accurate and realistic projections, based on which he will create the report for you. Take this report to your investor when you’re going to pitch your deck to him. This will greatly help you, as an investor will always try and squeeze you for all your worth.

There are a few documents you’ll need to have in place in order to seek valuation. Let’s look at what those documents are:

Co-founders agreement: This contract will basically highlight each co-founder’s role, equity, and time they’re going to invest in the business and any other provisions you deem important.

Investment agreement: This will mention the amount coming in from the investor and the form in which it’s going to come. Is it going to be straight equity that you’ll get on day one or is it going to be convertible equity which is in the form of debentures? This agreement will also explain how the investment will work.

One thing you must keep in mind is that investors always over promise. They say you’ll get your money within a week and they end up taking six months. Do factor this when you’re looking for funding and ensure you create your deck three months before your deadline.

Shareholders Agreement: This is the most important agreement when it comes to a round of funding as this will set in stone the rights the investor gets for the stake that he holds. Typically the investor will lay out a set of affirmative rights. 10-15 items without which you will not get your funding. This is how an investor exercises control since he’s going to be least bothered about day-to-day functions and leave that to you.

As a startup your ability to challenge the investor on any of those points is very limited. You can probably do that later once your company is established, well known and has two-three rounds of funding below its belt. During the 1st round, the scope of negotiation is very low, the investor usually gets what he wants!

We hope these posts helped clear out any major doubts you had in context to the legalities that go into setting up and running a startup. If there’s anything else that you’d like to know more about or even if there’s anything you’d like to add to everything we’ve spoken about, feel free to tell us.

[This post first appeared on 91springboard.com and has been reproduced with permission. 91springboard is a vibrant coworking community created for startups, freelancers and business owners with a startup mindset.]