Over the past couple of years, we have seen the start-up scene in Malaysia boom and grow vibrantly. The ever-changing market presents plenty of opportunities for start-ups to thrive, we see more promising start-ups emerging, and existing start-ups scaling up and growing bigger. In this article, we discuss the issue of fundraising for early-stage start-ups, and we hope that this article will shed some light and highlight some potential pitfalls to avoid, for those who are navigating through the complex journey of entrepreneurship and fundraising.
Some founders kick start the business by way of bootstrapping. In contrast with fundraising, bootstrapping is when the founders use their own funds to run the company, without any financial assistance from external investors. Bootstrapping allows the founders to retain full ownership and control of their start-up as there is no need to allocate equity to the investors. At the bootstrapping stage, most founders will be singularly focused on getting their Minimum Viable Product (“MVP”) up and running with little resources to allocate towards legal matters. To assist in such decision making, some pitfalls that a founder should avoid at this stage will be:
- Not incorporating a proper legal entity (PLT or Sdn Bhd being popular choices) – helps in shielding liability from founders and transacting with third parties;
- Not having confidentiality / non-disclosure terms or documentation attributing ownership of intellectual property to the company (with both internal hires and third party vendors) and protecting your MVP or intellectual property from unauthorized disclosure and undocumented ownership; and
- Not understanding the regulatory landscape – founders should have an awareness of the possible licenses, legislation and professional bodies that could apply and regulate the intended business.
Pre-seed / Seed round – Angel investors
This is the stage when the start-up is relatively small and young, and the founders are still working on building the MVP and need more resources to do that, or some may have even completed an incubator/ accelerator program and are looking for external funding to continue growing the company.
Angel investors are individuals who invested cash into the start-up in exchange for shares in the company. Often the high nett-worth individuals, angel investors could be the founders’ personal connections, or could be sophisticated investors. In Malaysia, Malaysian Business Angels Network (“MBAN”) is an association which puts forward the agenda of angel investing. They organize pitching events regularly so it is a good avenue for the start-up founders to pitch their idea to the angel investors.
While there is no standard rate on the investment amount put in by angel investors, it is common to see start-ups giving out equity in the company in exchange for the seed funding provided by the angel investors. Simplicity is key at this early-stage funding, and ordinary shares will usually be issued at the pre-seed to seed round funding.
Some pitfalls to watch out for at such early stage fundraising will be:
- Over-complicating equity terms to angel investors. Keeping to ordinary shares or even non-voting preference shares (if the start-up has a strong bargaining power) will be a safe start;
- Over-crowding the members’ register. Although a private limited company can have up to a maximum of 50 members, crowding out the members’ register at the start may put off future investors (especially the VCs). Consider setting up a legal structure that strikes a balance between keeping the ticket size affordable and not crowding the members’ register; and
- Under-providing on your shareholders’ terms. The casual and easy going nature of fundraising from family, friends and even angels often mean that start-ups often do away with not having a Shareholders’ Agreement.
Early Series Rounds A, B, C…
There isn’t any fixed rule on when a company should proceed to the next financing round. However generally speaking, Series A fundraising usually occurs after the company has gained some traction and when the company needs more funds to scale up, develop better technology, grow the team, acquire more customers or market the product to a wider public.
Typically, a “Series” financing round will involve venture capital (“VC”) funding, whether by a lone VC or by a lead VC together with a group of other VCs. VCs typically invest cash in exchange for equity with more complicated rights in preference over other shareholders in the company. Among others, VC firms often request for a right to board seat (i.e a representative from the VC firm will be a director in the startup company), which then translates into the VC firm having a say in the decision-making process of the company.
This is usually the pivotal stage where things can get rosier, or turn nightmarish. Some pitfalls to watch out for at such early-Series fundraising will be:
- Over-complicating equity terms to VCs – while VCs will often say that their Terms are ‘standard’, these terms come in all shapes and sizes and can vary tremendously between different VCs. Over-complicating the early stage terms will slow down the fundraising round where timing is critical.
- Setting precedents on terms that can never be turned-back, and in fact get more onerous (usually against the founders) in subsequent rounds.
- While fetching the ‘highest price’ possible is the aim for founders, setting a high price per share at an early stage may inadvertently lead to the next round being a technical ‘down round’ (i.e., issuing shares at a lower price than the previous round), resulting in a triggering of ‘anti-dilution’ rights to the investor.
Equity Crowdfunding – an alternative fundraising option
Equity crowdfunding (“ECF”) allows a startup to raise funds from the general public via an ECF platform. Since the introductory of regulatory framework to facilitate equity crowdfunding in year 2015, 50 SMEs in Malaysia have raised RM48.87mil through ECF. Currently, there are 7 ECF platforms that are licensed by the Securities Commission of Malaysia.
Under the ECF model, the general public who registers with the ECF platform gets the opportunity to be a shareholder in an early-stage start-up company, together with the benefits as a shareholder of the company. It also allows the start-up company a platform to publicize its offering and raise funds from the public by offering a stake in the company.
However, by opening your doors to the public at an early-stage, the start-up company will have a larger number of investors who have a stake in your company. While pitching on an ECF platform is a good way to publicize your start-up, the opposite is also true – now that your company is more “well known” and if the start-up is unable to cope, any negative news will also reach the market sooner and this may not reflect well for market sentiments.
An entrepreneur’s journey in building a successful and sustainable start-up is full of complexity and roadblocks, one of it being fundraising. In any circumstances, it is important for founders to be aware of the terms of the offering, and their consequences.
This update was written by Shawn Ho and Ee Lyne Chong from our corporate, property and tax practice group. Our corporate team advises on legal compliance, corporate governance, shareholder and founder arrangements, joint venture and partnership structures and corporate tax matters. Have a question? Contact us.