Introduction
Raising capital can be an exciting and challenging moment for you. Whether you are trying to find an angel investor, perhaps a venture capital or maybe a few humble investments from your friends/ family, you will always have to keep the following in mind: how to legally structure your investment deals to maximize the benefits for your business.
Legal structure is not only the paperwork, it is also your safety net when things do not go as planned. Which happen quite often. One regulatory misstep can set your business back both financially and legally. Let’s see how you should legally structure investment deals and strategically approach the scaling of your business.
Why Is It Important To Have A Legal Structure?
In simple words – structuring everything legally helps your business to address the issues of ownership, investor rights, tax obligations and long-term scalability at a much earlier stage. The longer you run your business on an ad-hoc basis, the more legal and regulatory issues you will face down the road.
Best way to understand this is to take an example.
Example: Let’s say a startup accept $100k from an angel investor for 20% equity. But, the startup puts in place a poorly drafted, ChatGPT version of a shareholders agreement, without understanding the local laws or the full extent of each clauses. When the startup starts growing and scaling, it will struggle to raise more money because the new investors will be concerned about early equity giveaways and the lack of defined rights.
Essentially, imagine giving away almost 25% of your company early on – without even realizing the impact it will have on the next investor round. A poor legal architecture can create the risk of dilution or even the risk of losing control of your company to early investors.
Y Combinator provides a list of financing documents that you can take a look at to get a more detailed idea of each.
Regulatory laws: It does not matter in which country you reside in – Canada, US, UK, etc, each country has their own securities laws which are triggered as soon as you start raising capital.
For example in the United States of America, the US Securities and Exchange Commission, or SEC, lays down very detailed regulatory frameworks, that you will need to comply with. Often, there are some exemptions that are provided as well, which can help your business in the early stages. In Canada, for example, each province has its own regulatory requirements the are overseen by the Canadian Securities Administrators. They not only govern the regulatory frameworks but also provide various helpful documents to help you navigate the minefield of penalties, frauds and common pitfalls.
Failing to comply with your country’s local security laws can not only result in heavy penalties, but can also result in lawsuits against your business and serious reputational damages. A great place to turn to for model legal documents is the National Venture Capital Association. This organization provides various model documents that you can use to understand the key legal terms that are required in investor contracts and venture capital industry. Note that this is US focused, so you might have to look for something similar in your country.
Some Common Legal Structures
Generally, most startups use the following 3 types to legally structure investment deals when raising funds. Each has pros and cons and offer different levels of complexity and protections:
1. Equity Financing: You sell a percentage of your company in exchange for some capital. The investors generally receive either common or preferred shares. This is generally ideal for startups that already have a revenue and clear valuations. One of the cons is that equity deals often involve a lot of legal paperwork and legal costs. Corporate Finance Institute has a very informative Article on Equity Financing.
Generally, you would require a Term Sheet, Shareholders Agreement, Subscription Agreement and a Cap Table to track ownership. Remember to check your local laws to confirm all required documents.
2. Convertible Notes: These are essentially debt instruments that convert into equity in the future, mostly in the next funding round. Think of them as a short-term loan. These are ideal for early-stage startups that do not have any set valuations. A major con is that they are essentially a debt that you have taken. Corporate Finance Institute has a very informative Article on Convertible Note.
3. SAFE Agreements: This was invented by the Y Combinator. Called Simple Agreement for Future Equity, the offer much more simplicity than the above two. Some of the pros with this one is that there is no interest or maturity, there is considerably lower legal fees and it is also faster. One cons is that too many SAFEs have the potential to complicate your cap tables.
Following is a comparison chart:
| Feature | Equity Financing | Convertible Note | SAFE Agreement |
| Complexity | High | Medium | Low |
| Requires Valuation | Yes | No | No |
| Legal Cost | High | Medium | Low |
| Investor Protections | Strong | Moderate | Minimal |
Legal Documents and Terms
We understand that legal paperwork can get quite overwhelming. We also understand you are not a lawyer. You are an entrepreneur and a business owner. But you must understand that these documents provide various forms of protection to your business and set relationship terms and standards for your investors. As the old saying goes, Build a strong foundation to construct a tall skyscraper.
Following is a quick overview of some documents that can help you in protecting your business.
1. Term Sheet: It outlines the proposed terms such as investor amount, type of security, valuation and several other key conditions. Think of it as a investment deal blueprint that you and the investors are agreeing to. It is quite helpful in setting expectations – any issues here are a sign of trouble for later.
2. Shareholders Agreement: This can be a challenging document as it contains various clauses such as voting rights, board structure, drag-along/tag-along rights and transfer restrictions.
3. Subscription Agreement: It is a formal agreement that codifies the equity purchase by the investor for a specific amount. It includes the number of shares, investor details, purchase price and payment terms.
4. Cap Table: A way to track ownership. Very important for VCs. These are detailed spreadsheets that show who owns what property in the organization. VCs always look for a clean and organized cap tables as any messy tables are a big red flag.
5. Security Filings: Various regulatory filings require multiple documents that are generally available online. For example, in US you need to file Form D with the SEC. In Canada, you submit Form 45-106F1. We recommend checking your local securities and exchange body.
Conclusion: Build A Legally Startup on a Legally Strong Foundation
In your journey, raising funds is an extremely critical step and the pillar on which you will build your business. Laying a solid groundwork by ensuring regulatory compliance and having strong agreement will help build your trust with investors who may end up being with you for decades.
The way you legally structure investment deals when raising funds can be the key difference between a smooth fundraising process that helps you in the long run, or a future for your business that is full of disputes, ownership issues, cap table chaos and legal liabilities.
A few things successful founders do:
- They understand the difference between different forms of legal structures and take steps in a strategic manner.
- The ensure that the paperwork is correct from the start and each deal is documented and defensible in a court of law.
- They bring on board experienced legal counsels early and do not rely on ChatGPT/ Google templates.
When you raise funds in a strategic and legally experienced manner, you build credibility, scalability and peace of mind. Investors see that you take your business seriously, which gives you access to the big leagues.
Always remember, investors are not dumb. They are experienced, and they only fund people and systems that they trust to generate revenue.
We can help you build the legal and business architecture.
Book a free 15-minute consultation to get your documents reviewed, your workflow & structure optimized and be investor ready.