Startups III: Alternative financing channels (Part 1)
Once the product or service to be offered by the startup has been validated as a “Minimum Viable Product” and a business niche (among other things) has been identified for it, startups generally need to obtain financing as a prerequisite to be able to start, and develop, their business.
Where to obtain financing? What alternatives exist?
Financing is usually obtained from outside investors, which means letting in new investment partners. The process of investment in a startup, and the consequent entry of new partners, is something that must be considered with great care, as it will condition the future development of the project.
In view of both the importance and the breadth of this issue, we have decided to split it into two parts. In this first post we will describe the most common investment channels in the initial stages of any startup.
At this stage, financing can generally be obtained through two channels: Friends & Family and Business Angels.
Friends & Family (F&F)
When startups need capital to finance their business, Friends and Family are usually the first port of call.
As their name suggests, these investors belong to the close circle of family or friends of the startup founders and they generally have no commercial interest in the project; in fact in most cases these are almost altruistic contributions. However, even though they are apparently disinterested contributions, it is important not to overlook the legal issues that must be considered when an investment is received.
Bearing in mind the relationship that generally exists between an F&F investor and the startup, we believe it is essential for clear rules to be established and, in respect of the investment, for the relationship to be kept strictly professional. This can be achieved by drawing up a contract or agreement outlining the obligations of each of the parties and protecting their interests. We understand that the document must be straightforward and must, in any event, regulate in a clear and precise manner the amount of the investment, the level of involvement, the consideration for the financing and an exit strategy, among other things. F&F financing is generally channeled through a silent participation agreement, a participating loan or a minority interest.
Business Angels (“BA”)
Business Angels are the second most common source of investment for startups at the initial stage. These are generally persons who have experience in company management and who have at their disposal both capital and time to invest in growth companies.
The first characteristic of this form of investment is that these investors usually take an active part in the company. In contrast to F&Fs, who usually play only a passive role, BAs are actively involved in the business, contributing not only capital but also the relevant know-how and technical expertise.
In exchange, the investors usually receive shares in the startup, although they generally play a less aggressive role than private equity or venture capital investors.
When BAs enter a company, the rules established in the shareholder agreement on the entry of shareholders, and hence the entry of an investment partner, become particularly important.
Likewise, once an investment partner has joined a company, we recommend that he/she sign the existing shareholder agreement, if there is one, or that a new shareholder agreement be drawn up. Investors will generally want to impose certain clauses relating to the working and management of the business that will allow them to exercise some kind of decision-making power at the startup, determined in most cases by the amount of the investment made and the shareholding acquired.
As we have seen, outside investment is essential at the initial stage of a startup to get the business up and running. When investments start to appear, it is crucial to have a set of clear rules that will help get the startup on the right track and support the working and development of the project. In the words of Pablo Neruda: “Let us sow the plain before ploughing the hill.”
Garrigues Corporate/Commercial Department
