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Saturday, July 2, 2022

Startup Constitution by Nordic Law – A Legal Perspective to a Seed Round

As startup-orientated Finnish legal counsels, we at Nordic Law have assisted numerous startups on the verge of their very first official funding round, officially known as the Series Seed, or more commonly as seed round.

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By Jon Hautamäki, partner at Nordic Law

Nowadays, the Series Seed can consist of multiple funding rounds, for example, pre-seed, series seed and the second seed round. Long gone are the days when there was a traditional structure regarding funding rounds for startups, but this can only be seen as positive as startups can attract more sophisticated investors already at a very early development stage.

To keep it simple, we will in this blog post focus on the original Series Seed, although the same basic fundaments apply to all seed funding rounds.

At the Series Seed stage, the startup often consists only of the founding team rather than an actual company and the founders have had just enough of money to get some early development done. When the founders have got a concrete business idea, if not even a functioning prototype or an MVP, the exciting moment of the Series Seed approaches. Before an official funding round, your startup should have certain legal basics in order as even though an investor will often invest in the team itself, there are certain legal requirements that are a must for professional investors.

Your first order of business should be to set up the actual company and in our view, to make things more simple, your startup should be a limited liability company (LLC) as in LLCs the liabilities are restricted. There is also the possibility of using a cooperative (co-op) as a limited liability business entity, but as the relevant legislation regarding co-ops, especially in Finland, is quite complex, using a co-op is not recommended unless you truly know what you are doing. You can also do business through an open company or a limited partnership, but an investor will have far fewer ways of investing in these kinds of company forms.

During the formation of your startup, it is advisable that you and the other founders sign a Shareholders Agreement (SHA). The SHA should always be signed before the company is established to make sure that all founders will abide by the common rules of the startup once it has been established. With a well-functioning SHA, the founders of a startup can solve, even possibly severe, problems beforehand. Prospective investors will pay close attention to especially the SHA or the lack of it. Without an SHA between the founders of a startup, a prospective investor might start to question why the founders have not been able to sign an SHA, which in the end could scare off the investor.

Especially if the startup’s Series Seed is approaching rapidly after the company formation, the SHA should straight from the beginning reflect that to make sure that prospective investors are able without major hassle to join the startup as shareholders. The SHA should in those cases contain clear and comprehensive provisions stating in which way and how funding rounds are decided, how a new shareholder may join the current SHA and how the SHA may be amended if requested by an investor. If you want to know more about the legal ‘do’s and don’t’s of an SHA, you can have a look at our previous blog posts, where we have discussed how to write a well-functioning SHA.

Quite often Series Seed investors demand certain amendments to the startup’s SHA. In that situation, the founders should in general, what rights they are willing to give up and what rights are given to the investors, such as, a priority to investors to participate in subsequent issuances of new shares and a right to a seat on the Board of Directors of the startup. That being said, amendments to the SHA are quite common during the Series Seed, but it is unlikely that an investor will already during the Series Seed require a completely new SHA. When your startup hits the larger funding rounds, such as the Series A, with VCs joining the startup, you should mentally prepare yourself to sign a new SHA giving up certain vital rights. It is a cruel VC-world out there, and you should always keep that in mind as a startup founder.
However, not to worry – you are still in the sweet Series Seed excited to finally join the big leagues as a serious startup contender receiving its first official funding. What is then the next step as you already have founded the startup and you have a foolproof SHA locked up in your safe (meaning somewhere under a pile of papers)? Well, of course, that is a no-brainer – you start to seek investors.

When seeking for investors, as a piece of advice, do not go and offer your startup’s shares openly to an unspecified group of people. In the worst-case scenario, you may run into trouble with the Finnish Financial Supervisory Authority, as the Finnish legislation regarding securities, crowdfunding and fundraising are – surprise, surprise – very complicated.

The safest way to seek funding, at least during the first funding rounds, is via proper channels, such as investor syndicates, accelerators or business angels. There are even certain companies that specialise in startup funding, fundraising and go-to-market services enabling them to lead your startup’s funding round if you are having trouble finding the necessary contacts. However, keep in mind that said companies would in most cases require some arrangement fee as well as possible equity during the funding round.

By the time you have gathered all investors for the Series Seed, you should at least have some basic legal documents ready. These include a subscription agreement (also called an investment agreement), basic templates regarding the necessary minutes of board and/or general meetings, where is decided the issuing of new shares to the investors participating in the Series Seed as well as adherence agreements to the SHA. Certain investors may also require a term sheet during the Series Seed negotiations – for those unfamiliar with funding round legal lingo; a term sheet is a document outlining the terms by which an investor (business angel or VC) will make an investment in your startup.
As your startup’s business is not venture capitalism or fund seeking, you should always focus on the perfecting of your product or service and, as hard as it may sound, strive to leave the legal loops of funding rounds to the lawyers.

That way you can make sure that all relevant legal aspects are duly taken care of. The founders should always have their own legal representation as of the first funding round as that is the very moment when you need someone to look after the interests of the founders. Keep in mind that the investors, especially VCs, may have an army of lawyers with the primary task of looking after the interests of the investor – not the founders. The larger the funding round, the more you should pay attention to the legal aspects. You should also remember that in general the startup shall pay the legal costs of the investor in regards to the funding round. If that is the case, you should require a cap for the legal costs. That way you can make sure that the majority of the received funding goes to the further development of the startup, not to legal costs.

No matter how much funding you get and on what terms, the most important thing during your Series Seed is, not only to have fun – c’mon, you have a valid business idea receiving cold, hard cash – but to also start to think about when you are going to need more funding. You should be prepared for both the Series Seed and any future rounds of funding. You should always attempt to look as far into the future as possible when preparing your startup to the Series Seed.

Lastly, if you have got an approaching funding round, perhaps even a Series Seed, and you want to make sure that the legal footwork is in the clear, then do not hesitate to contact us at Nordic Law. We are here to guide you through the jungle called startup funding.

Editor’s note: This is a sponsored post by Nordic Law

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