The full extent of the laws that govern early-stage investing are, as is so often the case, exceptionally complicated and constantly evolving. You should always check the most current legislation for the country in which you wish to make your investment before proceeding.
A good lawyer is worth their weight in gold. While legal help isn’t cheap, it’s better to spend a little now to protect your interests in the long run. Make sure you get advice from a trusted professional before you sign anything. Similarly, you should make certain that your accountant understands the relevant tax ramifications and completes the necessary filings on your behalf, specifically around SEIS and EIS.
The following are considered by many early-stage investors to be the most basic investor protections.
Check whether your shares come with pre-emption rights. These allow investors to ‘follow’ their money by getting first dibs on future raises, thereby giving them the opportunity to maintain their percentage ownership. Without pre-emption, you could find your investment diluted to virtually nothing. (For those of you who watched The Social Network and wondered how Facebook managed to dilute the shareholding of Eduardo Saverin from 30% to just 0.5%, this is how!)
Should the majority shareholder sell their stake in a business, tag-along rights give minority shareholders the right (but not the obligation) to sell their own stake on the same terms and conditions as the majority shareholder.
This gives minority shareholders some protection against a potential majority shareholder that may wish to change the business in a way that could put the minority at a disadvantage.
Drag-along rights are the contractual obligation that allows majority shareholders to force minority shareholders to join in the sale of a company on the same terms, valuation and conditions as the majority shareholders, effectively ‘dragging’ the minority along with them to force an exit.
This prevents minority shareholders from digging in their heels if a buyer who wants full ownership of the company proposes an offer to the majority shareholder.
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Stages of funding
The seed stage refers to the period just after a company has launched, when it’s working on its proof of concept. During this time, it’ll also be looking to gain initial transaction and receive feedback from early adopters to refine its offering before moving into the growth stage. Seed-round investors tend to be the friends and family of the founders, or a specialist early-stage VC.
A company’s first significant round of financing. The money raised at this stage will be from more arm’s-length investors rather than family and friends, which are likely to have participated in the Seed round. ‘Series A’ refers to the class of preferred stock given to these early investors in the business.
The second big round of finance a company raises, normally after hitting certain business development milestones. Successive rounds are referred to as C, D, E and so on.
Note: this post is written with reference to UK legislation.