In the high stakes world of venture capital, unexpected legal hurdles can derail a SaaS startup's quest for funding at the most inopportune moment. 

The software as a service (SaaS) market is worth an estimated $250 billion dollars, and growing every day. If you want a piece of the pie, you need to solve any potential legal issues before you head to the negotiating table. 

Venture capital transitions are complex and with billions of dollars at stake, understanding their legal aspects is essential to developing a successful financing strategy.  

At SVTech, we help our clients navigate the legal risks in venture capital financing and today we're going to guide you through the key SaaS startup legal considerations and venture capital funding legal requirements you need to know to execute a successful transaction. 

Understanding How SaaS Startup Funding Agreements Work

Venture capital (VC) is how some of the world's biggest companies like Uber, Airbnb, and countless others received the funding needed to get off the ground or take their businesses to the next level - and few business models offer the explosive growth opportunities that SaaS does, making them a favorite choice of VC firms.

Venture capital firms love SaaS companies because they offer investors predictable, recurring revenue streams with high scalability. Therefore, it's critical to understand how SaaS startup funding agreements work.

Investment groups pull their funds together to invest in startups that they have identified as having high growth potential. They do this in exchange for equity or ownership in the company. 

VCs offer funding in rounds that are aligned with the various stages of a company's growth. These stages include:

• Seed Stage - The earliest funding stage, providing startup capital to fund the initial research and development of a project. Companies may use this stage of funding to launch their minimum viable product (MVP) or reach other early stage goals.

• Series A - When an organization has a working product and needs financial help to scale and expand, they seek Series A funding. Here, investors will want to see evidence that your business model can scale. 

• Series B - Next level funding often seeks investments in the range of $20 million or more. Those funds are often used to expand into new markets, scale to meet demand, or develop new products and services. Seeking series B funding is a serious turning point for a SaaS company, and they must have strong KPIs to prove worthy of the investment. 

• Series C+ - Late stage funding for startups that have shown substantial growth and further market potential often require VC funding north of $50 million plus. This funding might be used to acquire other companies, develop new products, or prepare for an IPO. 

When submitting a funding offer, VCs do so in a formal document called a term sheet. While non-binding, this document lays the groundwork for a final agreement. 

The term sheet will include liquidation preferences, which dictate who gets paid out first in an exit. You must pay close attention to items like this. Some term sheets include a “2x participating preferred” term, which dictates that the VCs will receive 2x their investment before founders or common stock holders. These types of clauses are often missed without help of proper legal counsel to review the term sheet with you.  

The lending firm will relentlessly scrutinize the corporate structure, intellectual property ownership, contracts, customer agreements and other key parts of the business for any potential liabilities before extending an offer. They may even seek background checks on the founders before making a formal offer. 

No matter what stage of funding you are seeking, it is essential that you have a trusted financial advisor or legal counsel carefully advise you on the terms before you sign. 

Remember, a term sheet is not legally binding until it is signed. That means that there is still room to negotiate until you sign on the dotted line. 

Venture Capital Funding Legal Requirements

Now that we understand how VCs work, let's look at some of the biggest venture capital funding legal requirements that must be in order to receive funding.

1. Define Business Structure and Ownership - A SaaS startup (or any startup) must establish a formal business entity, such as an LLC or C-Corp. Most institutional investors will require a C-Corp. A capitalization table is used to break down the company's equity ownership between founders, employees, and early stage investors. 

2. SaaS Intellectual Property Protection - Your intellectual property (IP) is the cornerstone of your value as a SaaS startup. VCs want to see comprehensive IP assignment agreements with every employee and contractor. They want to see that you own all the code and technical innovations of your SaaS product, and have “Freedom to Operate” (FTO). This is non-negotiable for attracting serious investment.

3. Data Privacy - SaaS products must be in compliance with important privacy regulations like the EU's GDPR and California's CCPA, as well as employment laws, tax laws, as well as any other industry specific regulations before seeking funding. Third party security audits are essential, as well as incident response plans for data breaches. VCs must know that you take security seriously. 

4. Establish Terms of Service and Customer Contracts - Your customer contracts are incredibly important as a SaaS provider. Investors will want to review your customer agreements including recurring revenue streams, liability limitations, and terms of service. These must be compliant with all applicable laws before seeking funding.  

5. Financial Records Must Be in Order - Your financial documents will be heavily scrutinized by VCs, as will your metrics like CAC, LTV, churn rate and MRR. This data should be easily accessible for investors to examine. 

Avoiding Pitfalls: Legal Risks in Venture Capital Financing

Venture capital, like any form of financing, includes risks for both the investor and the borrower. However, as a SaaS startup you should be aware of some potential risks that can jeopardize your organization. 

Equity Dilution

By seeking outside funding you are ultimately selling a portion of your ownership to new investors. That means a reduced ownership share for you and other founders. This also means that new investors will inevitably expect a return. A smaller part of a bigger pie is better but you need to be sure you understand how different liquidity scenarios play out.

Loss of Control

Generally speaking the more outside funding brought in, the less voting control you retain. When taking investment, consider how the terms offered will affect the control you have over future decisions. It is always wise to ensure that your investors are aligned with your company's mission, and won't seek to make sweeping changes.

Negotiating Valuation

Valuation is far from an exact science, and founders and investors may use different methods of valuation. Work closely with your financial advisor to establish a clear valuation framework, and be prepared to back it up with financial data and market analysis. 

IP Infringement

Use of unlicensed code in any part of your SaaS product can trigger a lawsuit that can bring your funding negotiations to a grinding halt. Conduct a freedom to operate analysis and obtain any IP licenses if needed, before seeking funding. 

Planning for a Successful Exit: Legal Aspects of SaaS Mergers and Acquisitions

The ultimate goal of VCs is to see a return on their investment, which often comes through a merger or acquisition by another company. 

At the center of the legal aspects of a SaaS merger or acquisition is what is known as the exit waterfall. 

The exit waterfall is determined by the capitalization table, which reflects prior ownership decisions and investment negotiations.  It dictates the distribution of proceeds from the merger or acquisition after all expenses are paid. 

In turn the capitalization table is determined by the amounts invested, timing of those investments and the negotiations between the company and its investors over time and are ultimately reflected in term sheets and resulting investment documents.  

Venture capital firms are most often “preferred stockholders”, giving them priority in getting paid first. 

So called “common stockholders” include founders and employees, and receive their share of proceeds after the preferred stockholders have been paid first. 

Additionally, be aware of so-called “tag along” and “drag along” rights. These clauses can force or allow minority shareholders to participate in a sale, which can impact the overall exit returns. 

These are just a few considerations for negotiating with venture capitalists and other investors.  Please consult an experienced attorney for help with many other common and uncommon issues.

Conclusion

No matter where you are in your search for funding, it is always imperative to consult with a trusted legal advisor before accepting a term sheet or preparing for exit. 

At SVTech Law Advisors, we have helped our clients navigate the legal complexities of venture capital fundraising for over 25 years. We are committed to providing our clients with customized legal counsel and advice so that they can achieve their financial goals. 

If you're a SaaS organization in search of your next round of funding, contact SVTech Law Advisors for a consultation to discuss your needs and let us help maximize your company's potential and your return. 

Disclaimer

The information provided in this blog post is for informational purposes only and does not constitute legal advice. Please consult with a qualified attorney to address your specific legal needs.