How to fund a startup (and legal pitfalls to avoid)
Funding can make or break a startup. But each kind of funding brings with it opportunities, challenges and legal considerations. Learn more in our article.
Funding is a make-or-break issue when starting a business. It comes with as many challenges as opportunities – including several legal considerations.
In this article, we look at some of the ways you can raise funds for your startup and outline some legal pitfalls you need to avoid.
How can you fund a startup?
There are five main ways to fund a startup – each one with its own advantages, disadvantages and legal considerations.
First, there's bootstrapping. This is where you fund your startup entirely from personal savings and revenue. To do this, you need enough money in the bank to tide you over for at least a year.
The main advantage is that you have complete financial control over your business. You're not answerable to any external investors.
But there's an important legal consideration with regard to the legal structure of your company. If you're a sole trader, you're personally responsible for any debts incurred. If, however, you form a limited liability company, those responsibilities are passed to shareholders.
Next, there are angel investors. These are individuals who invest their funds in startups.
The key legal consideration here is to recognise that angel investors aren't just giving you money. By becoming shareholders, they become involved in your business operations. This means you need a clear written agreement from the get-go.
This agreement should cover, among other things:
- The funds that the investor will provide
- Any restrictions on how the funds can be used
- The investor's expectations with regard to return on investment
- A timeline for when the funds should be repaid
Venture capital firms are like angel investors in that they provide funding in exchange for share equity. The difference is that they do this as an organisation, rather than using personal funds.
As with angel investors, venture capital firms become part of the business – so legal clarity is essential. Mixed signals will only lead to financial pain down the road.
Another route you can go down is crowdfunding. This is where you raise funds from lots of different people, typically through an online platform like Patreon or GoFundMe.
In the UK, crowdfunding is regulated by the FCA (Financial Conduct Authority). In its own
words: "Under our regulations, firms are only allowed to promote crowdfunding offers to certain investors. These include experienced or sophisticated investors – or ordinary investors who confirm that they will not invest more than 10% of their net investable assets."
If in doubt about crowdfunding your startup, contacting the FCA or seeking legal advice can be wise.
Finally, there are bank loans. These need to be in line with your revenue projections – otherwise, you might find yourself saddled with interest on repayments.
Small startups can use a credit card to take out business loans. Either way, it's worth talking to a financial advisor before making a decision.
What legalities do you need to consider?
Your main consideration when seeking funds for your startup is compliance. This is a complex issue which we can't fully explore here. Your priority is to ensure your funding is in line with laws and regulations.
Your best bet is to get the advice of an experienced corporate lawyer. They'll be across all the relevant legislation and be able to spot any potential issues.
You should also be diligent when drafting or signing contracts with external funders. Ambiguities and mistakes can lead to conflict that has to be undone at your own expense.
As with the issue of compliance, it can be worth getting expert legal advice about contracts early on. This ensures you're in the best position to secure funding without putting
yourself at risk.
What legal documents do you need?
When raising funds, you need several documents to hand.
1. Certificate of incorporation (COI)
This is a document issued by Companies House that contains your company's vital information. When an external individual or company invests in your firm, you need to reflect this in the COI – and the change to the document will have to be approved by a majority of shareholders.
2. Term sheet
This is a document for would-be investors that spells out the who, what, when and how of the investment. It's a non-binding agreement but should still be drawn up in light of legal advice.
3. Investor rights agreement (IRA)
This document sets out the rights of investors. It's an important document – without it, investors may get cold feet and give you the cold shoulder.
It covers things like ownership rights, the right of first refusal, participation rights, voting rights and the investor's right to financial details and reports.
4. Stock purchase agreement (SPA)
Last but not least, there's the SPA (sometimes called a "preferred stock investment agreement"). This outlines the terms and conditions of the share sale. As well as covering essentials like the share price, it includes agreements about compensation, warranties and what should happen in the event of a dispute.
Having these documents in place puts you in the optimum position to forge good relationships with investors. Writing them in the light of advice from legal experts is better still as it massively reduces the likelihood of your documents including errors or ambiguities.
Conclusion
Seeking funding for your startup is primarily a time of opportunity and adventure. But without considering the legal implications, you run the risk of creating problems for yourself in the future.
Whether you're crowdfunding, taking out a loan or seeking funds from angel investors or venture capital firms, it can be wise to get expert legal advice from experienced corporate lawyers. The alternative is patchy paperwork and conflict down the line.
Are you looking for legal guidance with regard to startup funding? At Milners, we have a crack team of experienced, no-nonsense
corporate lawyers who'll be happy to answer your questions.
Get in touch today for a free, no-obligation consultation.
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