If you’re an early-stage startup founder with an amazing business proposition, then you’ve surely considered raising funding. Leapfunder prepared an overview of essential things you need to know before you decide to raise funding.
There are three different ways of getting funding
There are only three financial instruments that make up your toolbox for classical private fundraising (we’re not discussing public funding in this article). Depending on your circumstances, you need to know which tool to grab:
Loans
A loan is an advance of cash. The person that gives a loan wants that cash back with interests or else gets some collateral. Startups don’t have a reliable income, and collateral tends to be thin, so loans are rare.
Shares
Shares are the most familiar way for funding startups. When you sell a share you are selling a % of your profits and votes, forever. So although selling shares is a good way to get funding, please remember: eventually you will run out of shares to sell. It’s always better to sell your product, if you can.
Convertibles
The convertible is a way of investing in shares without using a valuation. In practice, it’s impossible to determine an accurate valuation for startups in the pre-seed and seed phase. So a convertible is a share transaction, in which case the investor and the startup agree to postpone the final valuation. Because this is a common problem, the convertible has become the most common instrument for pre-seed funding in California.
You will need a shareholders’ agreement
A shareholders’ agreement is an agreement between all shareholders of the company, including the founders. It contains a number of things that are not normally in the articles of association of the legal entity, nor in the law… but you do need them! The most important parts of the shareholders’ agreement are:
Drag and tag along
The ‘Drag Along’ clause states that if a certain percentage (you can set the % value yourself) of the shareholders wants to sell the company, they can force the remaining shareholders to sell as well. The ‘Tag Along’ means that if one of the shareholders gets a cash offer to exit the company, they have to share this cash offer with all the other shareholders.
Good leaver/ bad Leaver
One of the most important things to regulate in a shareholder’s agreement is what happens when one of the founders leaves. Every startup should have a so-called ‘Good Leaver/Bad Leaver’ clause, which determines what happens to a founder’s shares when they leave: on ‘good’ or ‘bad’ terms.
Preferred rights
Some of your shareholders will want additional rights, especially VCs. They will likely want to have a liquidation preference: this states that the VC will get the amount of their investment back first whenever there is a cash exit. They will also likely want an anti-dilution clause: this gives them a compensation if there is ever a downround (a round with a declining valuation).
You will need a pool for small investors
An investor ‘pool’ is a separate legal entity that combines smaller shareholders into a single legal entity. This kind of legal entity is often called a Special Purpose Vehicle (SPV). Common legal forms for an SPV in Germany are the KG (Kommanditgesellschaft) or GbR (Gesellschaft bürgerlichen Rechts). You need one! Too many separate shareholders can ruin your company. All investors <€100K should normally go into an investor pool, so they appear to be one shareholder.
You will need to understand pre & post money evaluation
It’s very important to understand the difference between pre-money vs. post-money valuation. Here’s how to wrap your head around it: your company has a certain worth before a funding round (= pre-money valuation). Let’s say it’s worth €2 million. When you take on an investment round, say €100.000, then that amount will simply sit on your company’s bank account on day one. That means the company is now instantly worth €2.1 million. That’s called the post-money valuation and it’s always just the same as the pre-money valuation plus the amount of the funding round.
You don’t need a notary for your seed round
It’s now widely accepted in Germany that you can do a convertible note (“Wandeldarlehen”) funding round without a notary. For this to be possible, the Wandeldarlehen does need to be written properly. Any experienced startup lawyer can help you set it up.
To find out more about each of these 5 points, stay tuned for the next blogs by Leapfunder!