Once your startup is ready to seek investment from professional investors, your fundraising checklist should include obtaining the right legal documents. Understanding the purpose of each of these documents and the reasons why they’re important will help set you up for success when it comes time to secure funding.
There are four basic, standard documents that all early-stage investors require. Below I’ll break down what they entail, where to find them, and why they are necessary. Note that there will be additional documents that you need to provide depending on your company’s individual circumstances and the circumstances of the investor.
Certificate of Incorporation
A Certificate of Incorporation or COI is a legal document pertaining to the formation of a private corporation under state law. To receive this certificate, you must submit the proper incorporation paperwork to the state. While some entrepreneurs choose to incorporate in their home state, founders of high-growth startups will want to incorporate in Delaware as it is the most familiar to investors and “business-friendly.” The necessary details to include in this document are the business name, name and address of the incorporator, address of the registered office, business purpose, and the total number of shares of stock that can be issued. While this can be done by engaging a lawyer, you can also easily submit these documents online through platforms like Gust Launch. Once you sign and submit your incorporation documents, you should receive your COI within 3 to 14 business days depending on which service you use.
A Certificate of Incorporation is a relatively simple and straightforward document in terms of the information it provides. Despite its simplicity, a COI is still important because it is proof that your company is registered as a legitimate entity, and that it has the legal right to issue shares. Investors prefer to invest in C-corporations because they are designed for ownership distribution and are easier to work with from a tax perspective. Without a COI, it would be incredibly difficult to get anyone to invest in your company given the procedural and tax-related implications involved.
A term sheet is a non-binding agreement that lays out the features, terms, and conditions of the financial investment. Some people compare a term sheet to a prenuptial agreement: just like a prenup, the term sheet outlines the agreement both parties are making before they officially begin their relationship.
It is fairly easy to obtain sample term sheets online or generate your own through free tools provided by law firms. While the information on a term sheet may seem overwhelming, its main content can be simplified into two concepts: who controls what, and what happens to the investment in the event of an exit. The document is divided into three major sections, which include funding, corporate governance, and liquidation.
For early-stage investment, term sheets typically include details about the following subjects:
- Investment amount: how much capital the investor is contributing
- Post-money equity allocation: what percentage of the company the investor will own
- Valuation: what the company is worth before and after investment
- Liquidation preference: the amount investors will receive in the event of company liquidation
- Anti-dilution: a way to protect investors in a situation where the company issues equity in a later round of funding at a lower valuation than the previous round
When creating a term sheet, both you and the investors should consider your goals and objectives carefully so that the document represents them clearly. You should design your term sheets to ensure that the investors and the company are appropriately aligned on the terms of investment. Having everyone on the same page from the beginning can eliminate confusion, prevent future disputes, and help you avoid unnecessary legal fees, as making changes after the agreements are finalized can be difficult and often costly.
Investors’ Rights Agreement
An Investors’ Rights Agreement or IRA details the rights of the investors with regard to their investment in the company. The key points in this document include the following:
- Right to maintain proportionate ownership: allows investors to maintain their share percentage of the company in the event of future stock offerings
- Right of first refusal: gives investors the right to purchase shares sold by stockholders before they can sell their shares to other parties
- Participation rights: allows the holders of preferred stock at the company’s liquidation to first get paid back their initial investment and then “participate” pro rata (proportionally) in the remaining distributions with the common stockholders
- Corporate governance: lays out voting rights relating to the election of directors and the potential sale of the company
- Information rights: assure investors that they will be made privy to necessary information, such as reports and financial details pertaining to the company
You should consult an attorney to ensure that you are handling these documents correctly.
Investors want to know more than just what their shares are worth. The Investors’ Rights Agreement ensures that you and your investors agree on the entitlements beyond ownership. It also helps investors feel more comfortable investing in a new company, knowing that they have a say and that their rights are being protected.
Stock Purchase Agreement
A Stock Purchase Agreement or SPA is an agreement that dictates the terms and conditions pertaining to the purchase and sale of shares. It encompasses the following aspects:
- Share price
- Number of shares
- Dispute resolution provisions
- An agreement on compensation for unforeseen costs related to fundraising
- Regulations and outcomes regarding transfer of shares
- A comprehensive detailing of all statements that both the buying and selling parties are signing. This is also known as the representation and warranties section.
A Stock Purchase Agreement is necessary because it provides protection for both you and the investor. It allows you to demonstrate to the investors that you are the legal owner of the stock being sold. Similarly to a term sheet, the SPA is a way to avoid confusion and complicated legal battles down the road. Investors will be sure to take the time to examine the details of this document as thoroughly as possible.
Knowing what documents you need and why you need them is an important step in preparing for investment. Assembling these documents allows you to think more critically about what you are looking to obtain from your relationship with investors, beyond capital. Putting together all the necessary agreements also ensures that you are conducting your transaction in a fair and law-abiding manner, which is as important as the investment itself.
Written By Ryan Kutter