Most new ventures are self-financed. But, they often need additional financing soon after they are formed in order to bring a product or service to market. If the business is small enough, the founders may be able to get an investment or loan from family members, friends, or banks. For larger operations, companies may need angel investors or venture capital.

The financing process varies depending on the stage of the enterprise. Venture capitalists usually describe businesses as being in one of the following six stages:

• Seed Stage
• Start-up Stage
• Second Stage
• Third Stage
• Bridge Stage
• Liquidity Stage

The Seed Stage

The seed stage is where an idea for a product or services is first formed. As the name implies, it is the earliest stage in the life of an enterprise. The entrepreneur seeking financing in this stage faces a difficult challenge, to convince the investor that the venture will one day be profitable.

The risk is high for the investors early, so very few ideas attract outside financing at this time. For those that do, the process usually involves submitting a report to an investor on the technical and economical feasibility of the idea—-a Feasibility Study. In some cases, the founder may include a rough prototype with the study.

The investor then considers the study and the prototype in deciding whether to take action. He is unlikely to invest more than minimum needed to determine whether the idea deserves further consideration and investment, however.

The legal risk for the entrepreneur at this stage is protecting the idea. Most investors are scrupulous and ethical people. But, it is especially important for the entrepreneur to obtain a fully executed non-disclosure agreement from the investor in advance of revealing any details and to make sure that all of her intellectual property is legally protected through the use of patents, trademarks, or copyrights, wherever possible. That way, should the investor decide against the project, the entrepreneur can proceed without fear that the investor might try to steal it.

If an investor does decide to provide an early investment, he will want to know that the entrepreneur is fully committed to the project financially. The investor will want to know that the founder won’t walk away if the going gets rough. So, he will usually require that the entrepreneur places most or all of her assets at risk in the venture.

Of course, that’s not really in the founder’s best interests. She should consider sheltering personal assets with a sound asset protection plan. A good plan will allow her to truthfully say that she has fully committed her personal assets while keeping a cache of funds in an uncollectable class of asset so that she can start over if the venture capitalist divests or she needs more money in later stages to save the business.

Another issue for the entrepreneur is how the financing deal is structured. There are various investment vehicles in play, everything from a straight purchase of stock to a convertible debenture (a loan that can convert to stock). The risks associated with each type of instrument vary. It is important for the founder to consult with one of our venture capital attorneys before executing any agreements.

The Start-up Stage

In the start-up stage, the entrepreneur decides, with or without investor participation, to bring the idea to market.  He should form a business entity, such as a corporation, limited liability company (LLC), limited liability partnership (LLP), limited partnership (LP), or limited liability limited partnership (LLLP) to operate the business. In fact, we recommend that valuable assets are placed into a separate holding company for protection against creditors and that the choice of entity is made in a manner that provides for favorable tax treatment and will foster future investment.

At this stage, the founders decide on a management team and board of directors, although they may assume many of these duties in a small venture to preserve capital. If the business involves an original product, management will start extensive testing of the prototype and concurrently they will refine the business plan. The team will also try to attract its first clients to help offset expenses with early revenue.

Investors will provide additional capital in this stage only if the prospects look strong. They will also usually closely monitor the feasibility of the product and the capabilities of the management team. As the company beings to enter the market, these outside investors will start carefully assessing scalability—the potential size of the market; the larger the market, the more interested the investor.

It’s especially important for the fledgling business to have a solid baseline set of contracts in place with key vendors, employees, and customers. This creates long-term enterprise value and puts the venture capitalists at ease that the organization is well protected. If funding has not occurred, the lack of solid contractual relationships may cause some professional investors to take a pass on the business.

The Second Stage

A company enters the second stage after the company starts to take market share. Not all companies at this stage are profitable, but their potential for profitability should now be more certain. But, the enterprise probably needs more capital for equipment purchases, inventory, and receivable financing.

At this stage, the venture capitalists start looking at the long-term viability of the company. They may suggest changes or restructuring in management. If the company doesn’t look profitable or a territorial dispute arises between them and management, they may cut funding. If things continue smoothly, they’ll usually do what needs to be done to take the company to the next stage, including providing more capital or finding more funding sources.

The legal risk to management at this stage is in focus. It is not uncommon for some investors to get greedy or panicky and start taking steps to further their interests at the expense of the organization. Key staff may also decide to jump ship and make deals to start up competing enterprises. It is important for management to shore up these risks with solid legal advice and clearly written agreements if they haven’t already done so.

The Third Stage

The third stage is where the company moves into solid profitability but still lack expansion capital. For third-stage companies, sales growth is probably fast, and positive profit margins have taken away most of the downside investment risk. But, the rapid expansion requires more working capital than can be generated from internal cash flow. New venture capitalist funds may be used for further expansion. At this stage, banks may also be willing to supply some credit if it can be secured by fixed assets or receivables.

Threats to the enterprise at this stage are the same as in the previous ones. But, in addition to these risks, the business will also find itself in occasional disputes with its competitors, often in the form of claims for unfair competition, patent or trademark infringement, or tortious interference. Our litigation team can advise and protect management on how to deal with these treats. We recommend having a sound litigation policy in place before trouble starts brewing.

The Bridge Stage

This stage is the last in the venture capital financing process. The main goal here is to search for a way to allow the investors to cash out. The investors will not usually put in additional capital at this point, so the enterprise usually obtains bridge (mezzanine) financing to sustain growth while the company looks at those options.

The Liquidity Stage

The liquidity stage is where the venture capital investors finally cash out of most or all of their position in the company. The liquidity may come in the form of an initial public offering, an acquisition, or a leveraged buyout.