Starting a Startup: Where to Start - Part 6: Money, Money, Money: Funding

24.03.2019
Shira Teger, Associate at Yigal Arnon & Co.
This series was written for you: the entrepreneur with a dream. We want to help you turn your dream into a thriving reality by sharing our expertise with you.

What follows is a series of articles outlining the basics you need in order to start a startup in Israel; it contains terms you need to know, steps you will have to take, and considerations to ponder when making choices about how to run and grow your company. We'll add a new chapter each week – so keep coming back for more! As always, we welcome your comments below.

If you missed Part 1 (Making it Official: Incorporation)Part 2 (Who's Who and Who to Hire)Part 3 (Division of Labor)Part 4 (Picking a Supporting Team), or Part 5 (Protecting Ideas: Intellectual Property) - be sure to check them out. Otherwise, we are proud to introduce Part 6 of this series: Money, Money, Money: Funding.

Most likely, a new company requires capital in order to get started. The amount of funding necessary depends on the needs of the company, and its business plan. And depending on the amount of funding necessary, there are different ways to raise that funding. Below are a handful of the most common ways startups raise money at the beginning of their paths, along with brief descriptions and factors to consider (including the infamous "finder").

Founder Loan.

Many times, the people who start the company kick in a little of their own money in order to get started – whether it's a few hundred dollars to pay incorporation fees, or thousands of dollars to get the business rolling. If a founder decides to provide the initial funds for his new company, he should make sure he has a simple loan document signed between him and the company that specifies how much money he lent the company, and how and when he expects to be paid back. Be prepared for the possibility that future investors will ask for this loan to be written off, or to postpone repayment of the loan.

Friends and Family.

Sometimes, instead of – or in addition to – a founder loan, a founder's friends and family will invest money in the new company in order to help it get started. In total, these types of loans can amount to tens of thousands of dollars, if not more. Most often, in exchange for the investment, the friends and family are granted equity in the new company – normally in the form of ordinary shares.

Convertible Equity.

Other times, investors (friends and family, or outsiders) will choose to put money into a new company in exchange for a promise of future equity. This type of investment can take the shape of a CLA (convertible loan agreement), a convertible note, a SAFE (we'll discuss elsewhere), a KISS (keep it simple security) and other types of agreement. If a loan or other form of convertible investment is given, instead of getting repaid, the investment is used to buy shares of the company later down the line, when the company undergoes a more significant financing. There are typically conditions in this type of investment regarding what class of shares it will convert into, when, and at what price (often, the company will offer a discount on the price per share to investors, in return for them taking a chance on the company, and a maximum valuation upon which the price per share can be based, called a "cap"). There are also terms regarding what happens if the company runs out of money, or if it has an exit before the investment can convert.

Equity Investment.

An equity investment is normally what people mean when they refer to a "round" or a "financing". In an equity investment, investors invest in the company in accordance with an agreed-upon valuation of the company, from which a price per share is derived. The shares purchased may be ordinary shares, or they may be preferred shares. Negotiations will typically revolve around what extra rights the investor will receive in the company in exchange for its money. These rights normally have to do with the ability to invest more money in the future, the right to receive, before other shareholders, any profits in an exit or dividends when distributed, and the power to direct – or at least have a say in – the company's future. Many times, investors will receive a seat on the company's board of directors, either as directors or non-voting observers. Additionally, investors will most likely conduct due diligence on the company (commonly abbreviated to "DD") during which they will ask questions and request all of the documents the company has, in order to make sure it is being run legally and wisely, ie. their money is not being thrown down a hole. This is one of the reasons it's so important for startups to keep good, clean records from day one – to make the company more appealing to investors.

Venture Loan.

Venture lenders are somewhat of a hybrid between investors and a bank. They will give a company money in exchange for repayment with interest, and in exchange for a warrant (or option) to purchase shares. The venture lender will also require the company offer securities for the loan, typically in the form of a pledge over all of the company's assets. Because a venture lender tends to have more power than a startup, the terms are not always negotiable to the extent a company may want. But a venture lender has the ability to put forward millions of dollars without taking too large of a stake in the company.

Finders.

One of the ways companies locate and snag investors is through contractors often referred to as "finders" or "brokers". These kind folks will provide you with a list of people or funds they can introduce you to, get your ok, set up a meeting, do some more liaising – and in exchange, they'll take a cut from the investment they brought in. Note that this cut can be in cash or in equity, or a combination of the two. Sometimes the cut is only demanded for the first investment, but other times, it includes future investments made by that same investor the finder brought in. Sometimes the "cut" is from friends of the investor. Sometimes the "cut" is not only from investments, but rather from revenues, loans and even the proceeds of an acquisition of the company by such introduced person. You should always strive to create incentive for the finder to go and get only the deal that you need (usually it's just a straightforward financing) from only people that you want approached (and not their friends or contacts), and as quickly as possible (no fee should be paid if a deal is closed only years later). The size of the "cut" can be anywhere from 2%-7% of the investment amount (this is just a general range), with industry standard firmly hovering around 5% (very few deals with a lower or higher fee). Be cautious and firm when negotiating a finder agreement: Investors don't like to see a company's money "wasted" on these types of services, and it's pretty painful for you, as a founder, as well. (As a side point, similar concepts can be found in companies seeking potential customers.)

The content of this article does not constitute legal advice.

Shira Teger is an associate in Yigal Arnon & Co.’s high-tech practice. In her previous incarnation (before choosing a life of law), Shira was a journalist.