The only way to achieve a high enough return on an investment in a startup (to compensate for the very high risk of failure) is through an equity investment or a hybrid debt-equity investment.
So, how is an equity investment accomplished from a legal perspective? There are five distinct steps.
Step 1: Valuation. First, an estimated value of the company for investment purposes must be established. This valuation methodology is focused on the key elements of any startup: gross margin and cash flow.
Using this method, you’ll have a somewhat defensible position on how you’ve come up with a pre-money valuation for your company and a gauge on whether your company can raise outside money. Of course, this is subject to negotiation with the ultimate investors. In addition to the detailed method, there is a rule of thumb method (of course, best used for measuring thumbs) that states the first $1 million of investment in an early stage, pre-revenue company should purchase 33 to 40 percent of the company.
If your number from the detailed valuation process is out of line with the rule of thumb, there has to be a “special factor” to show why your company is unique Usually this is due to the company already generating cash flow and customers. But be careful about your figure being too high. It’s just one more reason for an investor to reject your company.
If, on the other hand, your valuation is too low (and you have to give up too much equity to raise the capital you need), it means your business model may not be able to support outside investment.
Step 2: Capitalization Table. After a value is established, a capitalization table is assembled. A capitalization table (or “cap” table) shows the ownership interests in the company over time in a snapshot format, starting with the founding and stepping through the various capital changes, showing the dilutive effects of each subsequent issue of equity by the company.
The valuation is used to calculate how much equity must be issued to raise the desired amount of capital and the purchase price of each share (or other security). The cap table creates the game plan for the ownership structure of the entity as each amount of money is raised.
Step 3: Terms Sheet. Next, a terms sheet is prepared, describing the investment based on the cap table. This step is optional, but it can be a good practice to avoid the cost of preparing the investment documents and either having no purchasers or having to revise them because of deal term changes.
The terms sheet is used during discussions with potential investors and is intended to secure indications of interest and comments on the proposed arrangement. Because the securities laws (state and federal) govern the offer and sale of securities, the terms sheet isn’t actually an offer. There’s no obligation on either side.
Step 4: Investment Documents. Once the deal terms are fairly well established, the legal documents to complete the investment are prepared. These documents (as well as the offer and sale) must comply with federal and state securities laws.
First are the entity-related documents. If the startup was organized as a limited liability company, it will usually be converted into a corporation. If it is a corporation, the capital structure may have to be revised, and the governing documents and corporate housekeeping updated or revised. Changes to the capital structure can include increasing the number of authorized shares or creating a preferred class of stock.
Then offering-related documents are prepared. They include the stock purchase agreement, private offering memorandum, investor questionnaire, shareholders agreement and the board of directors’ written consent for the sale.
Finally, the documents to be filed, including an SEC Form D, are prepared and filed.
Step 5: Offers and Sales. The last step involves the offers and sales of stock. The founders (usually without additional compensation) make offers and sell the stock to the investors. Investors sign the documents and submit checks for the purchase. For certain offerings, these are held in escrow until a minimum amount of capital has been raised. For others, the funds are immediately available to the company.
When the sale is complete, the company issues a stock certificate to the investor as well as copies of the signed documents. Also, no later than the time of the first sale, a Form D is filed electronically with the SEC.
Editor’s Note: Ed Alexander is founder of the Entrepreneurship Law Firm PL in Orlando and author of the book “10 Common and Costly Business Killing Legal Mistakes and How to Avoid Them.”