Startup Lawyer Scott Smedresman Explains When to Get Lawyers Involved in a Fundraising Round and Why
Whether you’re new to fundraising or have raised capital before, there are still questions that come up or situations that arise with investors where you could probably use a legal expert’s help. Labs mentor Scott Smedresman, partner at McCarter & English LLP, held a Labs session all about the legal side of fundraising, from when to get a lawyer involved to why you should only consider taking money from accredited investors, and more.
On when it makes sense to do a priced equity round early on
“If you’re raising a million dollar round, you can do it as an equity round if you’re really diligent and focused about what you do and do not include in the terms,” Smedresman says. “You can do them for less than a Series A or Series C price, and investors really do like priced equity rounds. And over the past few years we've done more and more less than a million dollar capital raises on preferred equity.”
Another reason to consider an equity round is that “there’s a lot of uncertainty and confusion around these SAFEs and convertible debt instruments,” Smedresman says. “For example, it can be hard to calculate with specificity how much dilution the founders are taking. You can run a lot of analysis and use some assumptions about what the next round will look like, but we still get founders asking us what percentage of the company their investors will own. And if you’re not doing an equity round, the answer is that we can’t tell you exactly because it depends on the next round. That can be hard for less sophisticated investors to wrap their heads around, too. That can create a comfort barrier to getting people to invest. A priced equity round removes that barrier because you can tell investors with certainly how much they’ll own at the end of this round, and that’s very attractive to people,”
Just remember that choosing to move forward with a priced equity round has to make sense from an economical point of view. “You can’t spend $30,000 raising $750,000, for example,” Smedresman says. “It just doesn’t make sense.”
How much it’ll cost you to do priced equity round and why you should get experienced lawyers involved early
“You could do a Series A or a Series B for $25,000 if they’re not complicated rounds,” Smedresman says. “And often times later rounds can be even cheaper than the earlier ones. But the best advice I can give to people who are doing early-stage rounds, whether they’re seeking venture capital financing or convertible debt financing or using a SAFE is to work with a legal team that does a lot of that type of deal. They’ll be able to help you identify ways you can generate cost savings. They can cut through what matters and what doesn’t and bring the cost down. Because it hurts when you’re raising a million dollars and you have to cut a fairly large check for legal fees that aren’t really adding any value to the business enterprise—they’re just a transaction cost.”
The dangers of going too far down the path without a lawyer
Say you’ve signed a term sheet on your own and now have some concerns about the deal you’ve agreed to, so you bring a lawyer in. “Often times there’s nothing to be done,” Smedesman says. “It’s not great practice to go back to an investor after you sign the term sheet and try to renegotiate. You could kill the deal.”
That’s why it’s smart to enlist legal help before the term sheet is signed, ideally when the terms are still being ironed out. “The deal really gets done at the term sheet stage, and that’s where lawyers can add the most value,” Smedresman says. “And the fundamental business terms that are being decided at that stage are what drives the cost of raising the round. For example, are you doing board seats, are you doing investor rights, pro-rata rights, redemptions, etc. Sometimes those aren’t necessary at the early stages and we may be able to talk the investor out of it,” but that’s easier to do with the help of a legal expert.
Take a Series A, for example. “A lot of times in a Series A, an investor will ask for all kinds of schedules and disclosures—of customers, of revenues, software stats, open source strategy, data practices, etc.,” Smedresman says. “You’ll have to create all of those lengthy disclosure statements. And that can take a tremendous amount of time. So you have to think about whether that really adds value to the deal, especially if the investor is asking for these things pre-Series A. At that point, I’d say that no, they don’t and they investor doesn’t need them. A lawyer can help convince an investor to skip them, which cuts a tremendous amount of cost. But unless you get legal help involved early to try to cut those issues off at the pass, sometimes it’s just too far down the road and it has to be done.”
“My general advice is that you don’t need to have a lawyer on retainer and ready to go months and months before you start negotiations on a term sheet, but when you start to get term sheets or you’re in talks that you expect to get to the term sheet stage, that’s the time to bring in a venture lawyer,” Smedresman says.
On only taking money from accredited investors
There are a lot of factors to consider when you’re deciding who to take money from, but in the very early stages of raising capital, you need to ensure, first and foremost, that everyone you’re considering is an accredited investor. “There are requirements under SEC laws about who can invest,” Smedresman says. “Especially at the friends and family round, you may have people in your personal network who want to invest some money, but unless they meet the requirements, the strong advice there is not to take their money. There are legal ways of taking it, but they’re expensive and the cost of doing it in a legally compliant way will exceed the check size. So just don’t do it.”
The requirements to be an accredited investor are simple. “It’s a matter of assets,” Smedresman says. “The test is whether you have over a million dollars excluding the value of your principle house or if you’ve made over $200,000 in the last two years with a reasonable expectation of making at least that amount within the present tax year. There are other tests, but that’s the one most people use to determine whether someone is an accredited investor or not. So if someone doesn’t meet that standard, the advice is not to take their money. Plus, you should really ask yourself if you want to take money from friends and family who don’t meet that criteria. It’s not a tremendously high net-worth requirement and early-stage startups are very risky. Statistically speaking, their money will be lost, so do you really want to be in a situation where you’ve lost a lot of money from family or friends who didn’t have much in the first place? Again, that’s why the recommendation is to not take that money.”
This post is based on content from a WeWork Labs programming session.
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