Nearly all startups and small businesses must consider raising capital at some point. To ensure you’re best suited to take full advantage of a potential opportunity, work hard to avoid these common pitfalls.
1. Ghost Ownership
A downstream claim to ownership by a party who was once considered a founder or early stage contributor can create lots of problems. Startups and small businesses frequently start with a couple of friends with a shared business idea or vision. As the idea gets rolling, one or two of the initial founders/contributors may fail to deliver on their end of the bargain, and the party is then voluntarily or involuntarily removed from the company.
Because so many early stage companies forgo the assistance of legal counsel, as time marches on it becomes unclear how much, if any, this original founder/contributor owns if the removal process is not managed and documented clearly.
It’s much easier to negotiate with such a party before a big financing round begins to materialize, the company is rushed, and the early stage contributor now has much more leverage. Thus, working with counsel to sort out these issues early on can go a long way to ensuring a deal doesn’t get blown up.
2. Organizational Issues
We’ve seen it happen all too frequently. A company has a great idea, but the structure of the company is less than ideal for investors. Choices made at an early stage which may have made lots of sense at the beginning – such as forming an LLC to create only one layer of tax – can inhibit a startup’s ability to attract the right suitor for its current investment needs.
Once a company is looking to market its offering outside of friends and family, it often finds that investors are hesitant to invest in a “pass through entity” such as an LLC or S-Corp. Instead, investors typically want to invest in a C-Corp structure. Often they want a Delaware C-Corp, as Delaware is considered “business-friendly,” a jurisdiction that the investors’ counsel are familiar with, and has well-known, established legal precedent that investors can rely on.
3. Valuation
Valuation is far from an exact science, but the final valuation determination can have dramatic consequences on both the attractiveness of a fundraising round, and the downstream ownership issues of the founders. Valuing the company too low runs the risk of devaluing the current investors’ equity and overly dilutes their ownership; however, valuing the company too high can make it hard to attract investment and could damage the company’s reputation if the company does not understand how to properly project value.
As your general counsel, we can help manage these considerations to ensure they are taken care of before they become issues that might hold up a prospective deal. Investing in the future with sound legal counsel can seem tough when every dollar matters for an early stage company, but for those with lofty ambitions to raise capital, this investment can pay dividends in the not so distant future. If interested, you can contact us at info@bendlawoffice.com or at (415) 633-6841.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.