Seed round legally explained

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This article is a crosspost from SME Law.

During the past three years, the economic cycle of the region, coupled with the influx of western-educated college graduates returning to the Gulf, spurred a high level of attention to startups and technology, and a venture focus that was hardly seen before.

Young and capable entrepreneurs (commonly referred to as ‘founders’) and seasoned venture stage investors started coming together and looked to combine efforts to build business and generate value in the region.

Within this ecosystem, it is worth explaining the first real capital injection the ‘founder’ receives: the seed round.

Square one of investment

In simple words, the seed round is the first organized investment round received into a business from a third-party investor. Founders commonly raise seed round during or at the end of the proof of concept stage of the business. It is geared to obtain funding allowing the launch of the product as a service.

Before the seed round, the business would have been funded by the founders and some of the ‘three Fs’: friends, family, and fools. This third party investment is done by professional investors, thus the founders must expect it to be a turnkey in their business cycle.  

Phases of the seed round

Founders seeking to raise a seed round start by applying for funding with various venture capitals and angels. Meetings will include a one or two pages’ teaser about the business and a well prepared pitch presentation. This process ends with an investor or a syndication of investors offering a term sheet to the founders setting out a proposed investment terms.

The Term Sheet

Once a founder receives a Term Sheet, it is highly advisable that he/she appoints a counsel to help with the rest of the transaction. But it is also common to see seed round without founders’ counsel if the investment amount is small. The term sheet commonly sets out the following terms:

1. Subscribed shares by the parties.

2. Pre-valuation of the company and its authorized capital.

3. Distribution of shares among the shareholders.

4. Amount of investment injected in the company and the milestone (if any) set to reach this agreed investment.

5. Agreed liquidation preference rights.

6. Management of the company.

7. Transfer restrictions.

8. Employees share option plan (if applicable).

9. Intellectual property (IP) rights.

10. Confidentiality and non-compete provisions.

11. Governing law and the competent jurisdiction.

The Definitive Agreements

Once a Term Sheet is signed, the founder and the investor are ethically committed to negotiate and reach closing on an investment into the business. With that commitment, the lawyers can proceed with the drafting of the Definitive Agreements. These involve the following:

1. Subscription agreement: where all the parties and the company undertake their representations and warranties, the allotment, and the issuance of subscribed shares.

2. Shareholders’ agreement: draws the relationship between the shareholders and the legal structure of the company. This agreement will include more details on most of the points agreed on in the Term Sheet.

3. IP assignment agreement: to ensure that the founder will assign and transfer to the company all the copyrights and IP related to the project, including but not limited to trademarks, domain names, et cetera.

4. Founders’ agreement: an agreement between the founder and the company to ensure his/her commitment and to avoid any malpractice by the founder. This agreement is usually requested by the investors in order to protect their investment.

Completion

Once the Definitive Agreements are negotiated and finalized, and closing takes place, (funds are wired) the process is perfected by the various issuance of shares, enactment of resolutions, appointments of directors, and putting in place the new management structure.

The seed round is a very critical step for a business as it marks its graduation from a project that the founders are passionate about to a business others believe in.

Feature image via Pixabay.

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