Executive Summaries Jan 22, 2019
What Issues Can Arise During a Series A Financing Round?
There are a number of financing options available to a company seeking external financing at its early stages or to sustain its growth.
It is important that a company properly understands the various forms of financing available and assess them according to its needs, objectives, stage of maturity, sector of activity and other important factors. This article focuses only on venture capital financing — an option preferred by a number of innovative and high-growth companies (for purposes of this article, a “company”).
Venture capital financing may be required at various stages of the company’s development and depending on its stage of maturity. These different types of financing are referred to as follows, their respective names reflecting the development stages of the companies seeking funding:
1. Pre-seed capital,
2. Seed capital, and
3. Series A, B, C (and any subsequent) rounds.
For the purposes of this article, we will focus on the Series A financing round, which is the first round of venture capital financing after the raising of pre-seed or seed capital, if any (kindly refer to our previous article which specifically addresses this form of investment). A Series A financing round is significant as it often focuses on the company’s growth and the funds raised generally range between $2M and $15M, although they may be higher. At this point, the company is usually in the optimization stage, experiencing and pursuing strong growth and moving towards “scalability”.
What Are the Typical Issues in a Series A Financing Round?
In a Series A financing round, the investors involved are mostly venture capital funds, i.e. sophisticated investors with a strong understanding of the issues related to their investments.
Unlike in the pre-seed and seed rounds, investors at this stage want a bigger say in the company’s affairs.
It is important that the founders have sufficient knowledge and adequate understanding of the issues when negotiating with the investors in a Series A financing round, in addition to consulting with advisors who have extensive experience in this field. Here are some of the issues that can be encountered during a Series A financing round.
During a Series A financing round, as in the pre-seed and seed rounds, investors will insist on conducting due diligence, which, although it may vary in scope, will generally be fairly thorough at this stage. A well organised, well documented and legally orderly company facilitates the process.
After the issuance of shares to the investors, the founders will hold a smaller percentage of shares than before; this is known as “dilution.” The company’s valuation is therefore an important factor, as the number and value of the shares issued to the investors will depend on it. It is also important to clarify from the outset whether the valuation is pre-money or post-money, to avoid (bad) surprises. A pre-money valuation refers to the value of the company before the investment and, conversely, a post-money valuation includes the amount of the investment. In any case, the higher the valuation, the less dilution for the founders. On the investors’ side, a lower valuation gives them a bigger stake in the company for the same amount invested.
Board of Directors
In a Series A financing round, the investors, or at least the major investors in that round, generally expect to be represented on the company’s board of directors. Some may insist on the right to appoint observers. In this respect, the founders’ priority should be to maintain control of the board of directors.
Following a Series A financing round, the investors usually hold a minority stake in the company and do not control the board of directors. They therefore generally insist on a veto right (so as to block a decision) over a number of the company’s decisions, such as the amendment of its governing documents, the creation and issuance of new shares, the redemption of shares, and the sale of the business. This list can be considerably extended following the investors’ requests and can be subject to negotiation with the founders, who will wish to retain control over the majority of the company’s decisions and maintain their latitude.
Some investors insist on having some form of anti-dilution protection against any possible share issuance at a valuation lower that the one to which they subscribed. There are a number of mechanisms, sometimes quite complex, that provide for this type of protection, which can be the subject of heavy negotiations between investors and founders.
To assure that the amounts invested have some degree of protection, investors often insist on obtaining a preferential right in the case of a liquidity event, in the form of an amount of money expressed as a multiple of the initial investment, which they are entitled to receive should such event arise. The value of this multiplier must be negotiated and the definition of “Liquidity Event” must be agreed upon by the parties (such definition often refers to a subsequent investment, the sale of the business, a public offering or any other liquidity event).
Investors also generally insist on several other rights that are found in the shareholders’ agreement. If a shareholders’ agreement is already in place, the investors will insist on amending it or terminating it and drafting a new agreement so they can include certain specific rights. Such rights will often include pre-emptive rights, rights of first refusal, piggyback rights, and drag-along rights. Shareholders’ agreements require careful negotiations by the parties’ legal counsels.
Future Rounds of Financing
There is a possibility that the company will resort to subsequent rounds of financing. This reality can have various impacts on both investors and founders. For example, will the investors have the option or the obligation to subscribe for additional shares in these future rounds? If so, according to what terms? These concerns are usually addressed in the shareholders’ agreement and need to be analysed by the parties’ legal counsels.
A Series A financing round can be crucial to a company’s growth and have many positive benefits, but it also entails its share of issues. Some of these are summarily dealt with above but, in reality, can prove to be very complex. There are also a number of other considerations and factors to take into account during a Series A financing round. In that context, BCF’s venture capital team assists clients and helps them fully understand and address these issues.
To learn more about venture capital, sign up for our Strategic Forum on Corporate Financing, which will be held on Tuesday, February 19, 2019 in Montreal and Quebec City.