Startups Funding & Legal Considerations

Published on: October 21, 2022 (Updated on: April 28, 2024)

1. Introduction 

While fund is greatly required at the startup inception stage, it is a major setback suffered by most startups as they have no proven track record of success and investors therefore consider them as high-risk investments. Notwithstanding, there are options of funding available to startups. The aim of this article is to explore the startups funding options as well as highlight some legal considerations.

Startup Companies aim at introducing new innovation in the marketplace which usually offers a new path from what has been obtainable by consumers. Although, one major requirement for startups to introduce and grow their idea is funds.

Having a new innovation in the marketplace that could be beneficial to the economy as well as generate income for the owner of the innovation is not enough if the amount of capital required to kick-start and grow the innovation is inaccessible.

2. What is a startup?

A startup is a young company founded by one or more entrepreneurs to develop a unique product or service and bring it to the market1. These companies usually lack adequate capital to fund their innovation, they therefore, solicit for funds from different sources. These sources of funding are discussed below.

startups funding

3. Sources of funds for startups

There are generally two types of funding that are available to startups. These are debt funding and equity funding.

Debt Funding2: This involves startups borrowing money from external sources to fund the operation of the business. The money borrowed is to be paid back at a future date with interest. A major form of debt funding is loan (bank loans or government loans).

Equity Funding: Startups rely on capital investment from investors. The capital invested into the business by the investors is exchanged for equity/shares in the company. What the investors get in return is not their money back but ownership in the company through the shares acquired. There are different equity funding options that are available to startups.

Before highlighting the various forms of equity funding, it is important to know that a major difference between debt funding and equity funding is that startups who use debt funding only have to repay the loan with the interest. They do not have to give up shares in the company to the lender like equity funding. 

4. Startup equity funding could derive from:

Angel investors: These are wealthy individuals, who could be friends are family. They invest capital in startups in return for equity in the company. Angel investors usually invest at the early stages of startups as they are focused on helping startups kick start the business by providing useful guidance.

Crowdfunding: This is the use of online platforms by startups to raise capital in small amount from a large number of people. There are three types of crowdfunding;

  1. Donation-based crowdfunding:  They are mostly for non-profits projects or humanitarian projects. These donations are not usually paid back to the member of the public who donated.
  2. Reward-based crowdfunding: Members of the public who make donation to these kinds of projects are usually rewarded with products of the project.
  3. Equity crowdfunding: This is offering shares to the investors in exchange for the capital provided or investment made.

Venture capital: These are funds invested by professional investors into startups in exchange for equity in the startup company. This means that startups give up a portion of ownership in the company. Venture capitalists do not involve themselves in the early stage3 funding like angel investors because of the high nature of risk involved. 

While these options are available, it is important to know the stages of funding before approaching investors. The stages of funding are;

  1. Pre-Seed Stage: This is the earliest stage of business development when founders try to turn their idea into an actual business. At this stage most founders use their own resources, friends and family may also contribute. A US 2019 survey showed that personal investments was the first source of capital used by 57% of startup founders4. Startups at this early stage are not advised to seek venture capitalist.
  2. Seed Funding Stage: The startup at this stage is already in operation and requires funding to grow the business. This could include funding for product development, marketing etc. Startups at this stage can seek for fund from angel investors of venture capitalist. 
  3. Series funding Stage: Once a business has developed a product, it will need additional capital for further production and sales. At this point, the business will need one or more funding rounds to achieve this.

5. legal considerations and documentation for startup funding

Regardless of the option of funding chosen by startups, the process involved is usually contractual in nature. It usually involves lengthy and complex transactional documents which may not be fully understood by the startup. Professional/legal advise should be sought by startup to ensure that they understand the depth of these documents and that they are not signing their rights away legally

Some of these documents include:

  1. Term sheet: it is a non-binding document upon which other binding documents are drafted. It outlines how prospective investors can negotiate binding agreements.
  2. Shareholders agreement: it defines the rights, obligations and relationships of shareholders in respect of the company and its management.
  3. Subscription agreements and subscription letters: it stipulates the number of shares that will be issued to the shareholders and the order and timing by which funds will be advanced.
  4. Share sale and purchase agreement: it provides for purchase of shares from existing shareholders who are exiting the company or selling down their stake.
  5. Confidentiality agreement or Non-Disclosure agreement: a founder, in order to protect his idea would require investors to sign a confidentiality agreement before he pitches his idea. This document ensures that information regarding his ideas are not disclosed by the investors to a third party.
  6. Intellectual property assignment agreement: this document ensures that founders intellectual property are protected.
  7. Incorporation documents: this ensure that a startup company is legally formed.

6. Conclusion

There are different funding options available to startups, knowledge its current stage before approaching any kind of investor is essential and advantageous to the startup. Startups should also seek professional/legal counsel as they are more thorough with contractual documents.

References

1 https://www.forbes.com/advisor/investing/what-is-a-startup/

2 https://corporatefinanceinstitute.com/resources/knowledge/finance/debt-financing/

3 I. O. Nwanna, and U. O. Chiekezie, Venture Capital As A Source Of Fund For Entrepreneurs (2016),  NG-Journal Of Social Development, Vol 5, No 3, June

4 https://clutch.co/consulting/resources/startup-funding-sources-new-businesses

Author:

Preye Ezonfade, LLB