Overview
Having a scalable business model is the key feature of a startup, and scaling up requires cash. That is why raising capital becomes a common key activity for startup founders.
In this article we will look at:
- The stages of startup funding (pre-seed, seed, Series A and beyond);
- How to navigate the due diligence process;
- What legal documents are needed to issue shares to an investor; and
- When a disclosure document is required under Chapter 6D of the Corporations Act 2001 (Cth).
Stages of startup funding
The stages of startup funding are:
- A pre-seed funding round, which is where startup founders, after first bootstrapping the startup with their own funds, raise capital from family and friends. The average amount invested by friends and family into startups is $23,000 per year, according to Fundable. Having family and friends involved in your startup at an early stage can impact the trajectory of later funding rounds, so startup founders should proceed with caution here.
- A seed funding round, which is first round where startup founders raise capital from external investors. The investors in this round will usually be investors who will add strategic value to the startup, instead of just being passive investors. If your startup has participated in a startup accelerator program, a condition of the program will usually be that the accelerator will get percentage of your startup in exchange for providing strategic services. High net worth individuals, known as “angel investors”, also tend to be active participants in the seed funding stage for startups.
- A Series A funding round, which is where a startup raises capital to optimise its product or service and expand to different markets. Series A rounds are currently now the size of Series C or D rounds only a few years ago. For example, Brisbane-based Octopus Deploy recently raised $US175 million in its Series A round earlier this year. Given the size of a Series A funding rounds, this is the stage when venture capital firms tend to invest in startups. The investors who participated in the pre-seed or seed rounds may also participate in the Series A round.
- A Series B funding round, which is where further capital is raised form existing investors and venture capital firms to enable the startup to continue to scale and maintain momentum.
- A Series C funding round (and sometimes Series D and Series E funding rounds for privately owned unicorns), which is the last stage of funding before going public. Series C funding is usually raised to fund the acquisition of competitors and the continued growth of the startup. As funding becomes more complicated and private equity starts thinning out, investment banks start becoming more common.
- An initial public offering, which is where a startup is listed on a stock exchange for the first time.
Due diligence
Before investing in a startup or raise capital, an investor will usually conduct the following due diligence investigations:
- financial due diligence (this will involve the investor analysing financial material disclosed by the startup to verify the valuation sought by the startup);
- commercial due diligence (this involves the investor assessing the commercial viability of the startup’s business); and
- legal due diligence (this is where the investor analyses legal material disclosed by the startup to verify the legal structure of the startup and that the startup has all the necessary legal documentation in place to raise capital).
What to have in place before raising capital
The due diligence process can be extremely time consuming, so it is important to ensure you have the following items in place before raising capital:
- (an appropriate corporate structure (you cannot raise capital if you are operating your startup as a sole trader, partnership or through a discretionary trust);
- a shareholders agreement (otherwise a new one will have to be negotiated with the new investors, which will slow down your capital raise);
- trade mark protection for any important brand names;
- employment agreements or independent contractor agreements for all team members, including co-founders;
- an updated cap table, showing the fully diluted share capital of the startup (including all unconverted warrants, employee share options, convertible notes and SAFE notes).
Legal documents
The key legal documents required to issue new shares to an investor are:
(a) a share subscription agreement, which usually sets out:
(i) the subscription amount to be paid for the shares;
(ii) the amount and type of shares to be issued to the investor;
(iii) the completion date for the transaction;
(b) a share issue pack, containing:
(i) a board resolution approving the issue of the new shares;
(ii) an updated member’s register;
(iii) an allotment journal, recording the allotment of the new shares;
(iv) a new share certificate to be issued to the investor;
(c) an accession deed, which is where the investor agrees to be bound by the shareholders agreement relating to the startup.
Post-sale
After the investor has paid the share subscription amount to the startup, the startup will need to formalise the share issue by:
- passing a board resolution approving the issue of the new shares;
- updating the member’s register;
- issuing a new share certificate to the investor; and
- notifying ASIC of the changes to the shareholdings.
When is a disclosure document required under Chapter 6D of the Corporations Act 2001 (Cth)
Before making offers to investors to raise capital in the startup, it is important to ensure the startup either:
- complies with the requirement to lodge a disclosure document (such as a prospectus) with ASIC; or
- falls within an exemption from the requirement to lodge a disclosure document.
The exemptions from the requirement to lodge a disclosure document are:
- The 2/20/12 rule, which essentially provides that a company can raise up to $2 million, from 20 people, in any rolling 12-month period without issuing a disclosure document (any offer made under this exemption must be a personal offer made to the recipient, and cannot be advertised); or
- Investments by sophisticated investors (which requires a certification by a qualified accountant that the investor has net assets of at least $2.5 million or has had a gross income of at least AUD$250,000 per annum for the last two financial years); or
- Where an investor invests at least AUD$500,000, they will be considered to be a sophisticated investor even without a certification from a qualified accountant.