UK review by David Bresnick
“Friends and family” financings: tapping your personal network
Entrepreneurs often need only modest amounts of capital in the early stages to cover expenses incidental to the business. Sometimes entrepreneurs cover the company’s early expenses through personal savings or even credit card debt. However, in many cases they turn to people in their personal network, or “friends and family,” for early capital needs. At this stage, the company may represent little more than a business plan laid out in a PowerPoint presentation and more “formal” sources of capital are invariably not yet available to the entrepreneur.
Friends and family financings can vary in size and structure, but are usually small investments structured as equity subscriptions, unsecured loans or sometimes convertible loan notes (for more information about convertible loan notes, see our Primer on Convertible Debt. However, it is not unusual to see the money invested without any documentation or due diligence whatsoever. While the convenience, low cost and speed of this approach is tempting, and many friends and family investors don’t seem initially concerned about their investment, it is important to properly document the terms of the transaction to avoid misunderstandings about equity ownership to ensure that these investors understand the high risk nature of their investment, and to avoid frightening off later stage investors.
Seed financings: the first round from experienced, startup investors
The definition of a seed investment will vary somewhat depending on whom you ask. It would not be unusual for someone to refer to a larger friends and family financing as a seed financing. However, the term seed financing usually denotes a company’s first round of financing from third party investors who regularly invest in startup companies. These investors are typically individual angel investors, formal angel organizations or even venture capital funds. Seed investments are usually made through a mix of equity and loans, or sometimes convertible loan notes (often with a cap on the conversion value – see also The (Troublesome) Convertible Note Cap), simplified (short form) “series seed” financing documents or (often if led by a VC) “full” Series A style investment documents (see below). The structure selected for the investment will depend on investor preference and the availability of tax incentives, and will be influenced by the amount raised. As a general matter it is fair to say that the larger the amount raised, the more likely that the investors will use more formal and detailed investment documents.
Subject to the caveats above, investment amounts under USD/EUR 1,000,000 or so will often use convertible notes or Series Seed investment documentation. Series Seed investment documents tend to be less extensive than Series A documentation and impose fewer restrictions on the company/management. They typically provide for simple, nonparticipating liquidation preferences (reimbursing the investor first), limited investor protective provisions, as well as participation rights and information rights, among other matters. Larger seed financings often use full Series A style investment documents.
In such cases, it is not unusual to still refer to the securities issued as “Series Seed Preferred Stock/Shares” simply because the company and/or the investor want to preserve the lettered rounds (e.g. Series A, Series B, etc.) for subsequent financings to signal that the company still is in its early stages of development. A common goal of a seed financing is to delay the need for the Series A financing until such time as the company can attain a significantly higher valuation.
Series A financings: the new beginning
Typically, the money raised in a Series A financing is used for “scaling up” as opposed to “starting up” and the investment amounts are larger than in seed financings. The larger investment amounts result in higher investor ownership levels. Series A investors, usually venture capital funds, often end up with 20% to 40% ownership of the company post-financing. More importantly, it can be a time for significant governance changes – a revamped board of directors with professional venture capital investors serving alongside founders and industry experts and, in some cases, less founder representation. The process for raising a Series A financing from initial contact to closing may take considerably longer than raising a friends and family or seed financing and will require more polished presentations from the management team, more detailed legal, financial and commercial due diligence, and more involvement from legal representation (on all sides).
The Series A financing documents are generally considerably more extensive and contain many protective provisions that will impose significant restrictions on company actions outside normal, day to day operations. The Series A terms may also contain more onerous versions of the terms included in Series Seed investment documents and will often introduce new concepts, such as anti-dilution protection (i.e. not already introduced), and perhaps even accruing dividends, among other matters. The National Venture Capital Association (US) and British Venture Capital Association have developed sample documents that are often used as a baseline for Series A investments, but the use of such model documentation is far from universal and most law firms and indeed the majority of venture capital funds prefer to use their own forms. The Series A terms must be negotiated with care as the terms can prove difficult to change in subsequent financing rounds.