The Ultimate Guide to Starting a Startup in Texas

As a startup lawyer in Texas, I get a lot of people asking questions about the Texas startup/business scene. I work in Dallas, Texas and Houston, Texas, but I have clients all over the state of Texas including the Austin-area.

So I wanted to create a place for a lot of information about Texas startups that’s easily accessible for individuals, entrepreneurs, founders, investors, those in the industry, and just the plain old curious readers. Thus here is a guide to starting a startup in Texas. This guide serves to answer a lot of questions about Texas startups and the general format of this piece goes from broad picture explanations of the scene, to formation, to growth & operations of the business, to funding and financing your startup So let's go through it. 

Table of Contents

I. What are Texas Startups Like?
II. Getting a Startup Lawyer in Houston or Startup Lawyer in Dallas
III. How to Start your Startup in Texas Step by Step
IV. Operating and Growing Your Texas Startup
V. Funding Your Texas Startup
VI. Startup Investors in Texas
VII. Accelerators and Incubators in Texas
VIII. International Investments in Texas startups
IX. Convertible Debt in Texas Startups
X. Startup Equity Financing in Texas/Series A Financing in Texas 
XI. Conclusion

Let’s go through some general notes about Texas startups and the scene.

The first question I get asked is if the scene is really that different from other locations—the northeast, west coast, etc. And the answer is NO. I just got back to Texas from San Francisco and the Bay Area. Also just recently I was in Estonia and Germany. (By the way, you may be a bit surprised to hear that Estonia has quite a burgeoning startup scene.) I travel a lot for my work. I’ve also done legal work in Japan and Taiwan. There too each place has a startup scene. Japan is very interesting and they use a very collaborative way in how they solve issues.

Are there differences that people will point to and say “this is different”? Absolutely. But the fact of the matter is that people, places, and things, are actually pretty similar everywhere—and I mean this on a deeper level than just startups and entrepreneurship.

But essentially what I’d like to say is this: the scene in Texas is pretty much the same as the scene any where else. 

As they say, the sky is the same and the earth is the same no matter where you are. People have the same desires, wishes, and ambition everywhere. Sure, there is some difference in degree, but that’s really it.

Speaking more specifically about Texas, certain industries here in Texas are stronger than others. What counts as a “Series A” financing in one industry might not necessarily trigger the same terminology in another industry. Texas is strong in all industries as you can imagine. It is particularly strong with the following:

- clean technology and energy ventures

- oil and gas startups

- medical devices and biomedical technology startups

- information technology (IT) startups

- medical technology and health science startups

- services startups

- aeronautics and engineering startups

I would say that Dallas is stronger with IT startups and Houston is stronger with energy/oil and gas startups. 

Additionally, Houston is home to the largest health sciences/medical complex in the world and is the energy capital of North America. Houston is ripe for these kinds of startups to form and grow.

I did mention that the Texas scene does have some differences from elsewhere. The differences are mostly found in the degree or size of things. This concerns the size of the community, the size of the deals, the degree as to which investors or founders emphasize certain terms, even the size of agreements and contracts. 

Relatively speaking, you don’t need to worry about those issues much. It’s a global economy. You can pull investors and have teams come from anywhere. It’s fine. 

Another observation that I have made is that since Texas is centrally located, you get investment groups and individuals from both the west coast and east coast and those centrally located to come to Texas to do business. 

Do you need a lawyer for your startup? The answer is yes. As a startup lawyer in Texas I may be a bit biased, but I want to give it to you straight.

There are times that you need a lawyer and times that you don’t. I’ve already mentioned this. For example, check out the article about how to analyze a contract. In that article I mention when to and when not to use a lawyer. 

The fact of the matter is that if you want your Texas startup to go somewhere you need to use a lawyer. If you don’t want it to go somewhere, you might want to think about what your goals are. And it is better to do get a lawyer on board earlier in the process. It is better to get it right from the beginning rather than try to fix it later on when it is more costly.  Get the foundational issues correct from the beginning. Think of it like building a home or large infrastructure. You can fix fundamental issues later down the road, but it becomes a lot more complex and difficult. 

It is important to use an attorney whose expertise is in these business/corporate matters. There are a lot of lawyers out there--general practice attorneys, immigration attorneys, estate planning attorneys, eminent domain attorneys, sure--even bird law attorneys. The best attorneys are highly focused on a particular area of law. 

In Texas, in addition to using a corporate lawyer, I also highly recommend using a skilled accountant. Here too it is better to get one from the get-go. 

In the next section I will go into the practical steps of this get-go.  

1. Find a startup lawyer in Texas

As mentioned a startup attorney is pretty important. If you need help or if you have any questions, shoot me an email or let’s get some coffee. You can find my email at the bottom of this page.

2. Check employment issues

Make sure your startup is not doomed from the start. Your prior or current employment can be a complete block to your starting a startup. There are two main ways that that employment can be a hindrance with your startup creation. One is by non-compete agreements and another concerns intellectual property (IP).

Non-compete agreement: A non-compete agreement is an agreement (contract) between your current (or previous) employer that states that you are not able to enter certain professions that would be in competition with that employer. Unlike California (which strongly and completely frowns down on non-compete clauses), Texas considers geographic scope and time limits with non-competes. So this matter is very jurisdictional. Some individuals would make an argument that non-competes hinder the expansion of startups and growth of a startup community. Some states recognize this idea. For example, Hawaii does not allow high-tech companies to have their employees sign non-competes. 

Intellectual property: The other main concern with previous or current employment is with intellectual property (IP). The IP that you create and work on in your employment with a company belongs (or at least should) belong to that company. You almost certainly have signed an agreement or contract saying as much. This becomes an issue when you are using ideas, time, tools, etc. of your employer to work on the IP for your startup. When you do those things the employer has a strong basis in saying that the IP you are creating actually belongs to them and not to you or your startup. 

Before you formally create your startup there are some important steps to take. I’ll give you some actionables here. The big picture items are these:

i. Contracts: look at contracts between your employer and you. What you want to do is see what kinds of agreements you have with your employer. What restricts you? Is there a non-compete agreement or an IP issue that is a block? How about a no-moonlighting agreement?
ii. Duties and roles: Look at your role within your employer's company. Sometimes issues can arise even if there is no formal written agreement in place. These are employment issues that need to be looked at that go beyond contracts and regard roles within a company, duties, etc. Do you have a key role at that company? If so you may have duties to not take certain actions that harm that company.
iii. Raiding, etc.: As always, regardless of contracts, don't raid and solicit other individuals from your employer. This is ripe for litigation.

If you feel like there's an issue that may be relevant regarding your employer, do some more diligence and read this article here: https://www.startuplegalstuff.com/protect-startup-from-employers/

3. Check immigration issues

Now for most of you reading this, this won't be an issue and you can simply skip this step. But I deal with a lot of individuals that are not citizens in the U.S. or are here on certain types of visas doing work or have some other situation going on. 

Because of the international nature of this subsection, I want to make a quick note and remind you that YES you can create a Texas startup business even if you live overseas. Contact me if this is what you want to do. This is actually extremely common. The bigger questions concern whether or not you are a foreign individual in the U.S. and whether or not you can work under various types of visas.   

4. Make a business model 

You may think that this is unnecessary and just something simple that you can gloss over but I urge you not to. It can really help the process in thinking through matters with your business co-founder. Or if you don't have a co-founder yet, then thinking through things yourself is extremely helpful. Do not underestimate this part of forming your startup. There are plenty of books out there that teach you how to make a business plan or business model, so I will not go into that here. I urge you to figure out these items before you decide to incorporate. Be on the same page as your co-founder and figure out items such as vesting terms, roles within the company, and a pre-incorporation agreement (as necessary).

5. Read this site thoroughly

There's a lot of information on this site that will be helpful for starting and operating your startup in Texas. It's all here in a systematic manner. Use it. The main focus should be on the sections entitled New, Phase 1, Phase 2, and Phases 3A-C. You can read the blog posts as appropriate. Check the sidebar.

If you don't have enough time to read this site, then make more time. 

6. Protect your IP 

Many founders I speak to are familiar with the movie called The Social Network concerning Facebook in its early startup days. If you’ve seen that movie, think about a lot of the issues in that movie—particularly the legal ones. Do you see now why protecting IP is important? 

So make sure IP is accounted for. In particular, you need to make sure that IP is transferred over from the co-founder to the company and that future IP created also is assigned to the company. I want to talk about how these two concepts work and how they play a role in the startup: 

i. Transferring IP over from co-founders to the Texas startup: 

The easiest way to understand this concept is to think through an example yourself. Let's say that IP created by Bill Gates belonged to or stayed with him instead of with Microsoft. Do you see how it can be problematic if investors wanted to invest in Microsoft but Microsoft didn't even own the IP it was using for products? Do you see how Bill Gates' partners would be wary if one day Bill Gates had decided that he doesn't want to license IP belonged to him to the company? The company could be held hostage by the wims of one of the founders. Co-founders do not want that. Investors do not want that. Customers/clients would not want that. Heck, even if you owned the company and the IP you would not want that because it is fundamentally not good for the company. 

So make sure that IP gets transferred over.

ii. IP that is created by employees and others need to belong to the company:

This is also similar to point (i) above. Keep the IP within the company. This point also plays a role when it comes to employment issues similar to what we talked about above. Above we talked about how your employer can protect itself from you using what is their IP in your startup. Now its your Texas startup's turn to protect itself from employees and others from running off with your startup’s IP. 

If you fail to protect your IP, your startup may be doomed. So make sure this is taken care of. 

7. Texas Startup Formation Steps and Checklist

Most of the above was more big picture. Now I want to be a little more specific regarding the actual formation steps. These are the steps and they overlap with the above information.

i. Decide on key business matters

You'll need to talk to your co-founders and make sure you are all on the same page. Do this before you do the other stuff. It's better to get things right from the get-go and make sure that you're in agreement on these important matters. 

ii. File with the state

You'll need to file documents with the Secretary of State of Texas (or Delaware if that’s the way you’re going).  

iii. Authorize common stock

Stock of the company must be authorized. For now authorize common stock. Preferred stock comes into the picture later. Common stock is for founders. Preferred stock is stock with extra rights and benefits on top and is for investors. 

iv. Hand the company to the initial board

The company will be governed by a board of directors. This type of corporate governance is important. Make sure everything is right and in order. 

v. Apply for an Employer Identification Number (EIN)

An EIN or Employer Identification Number is similar to a social security number except it's for a business. You'll need to apply to the IRS in order to get this number. 

vi. Get a corporate bank account

You'll also need to take care of various other real world issues with getting the company set up. Get a corporate or business bank account. A bank will let you know what they need in order for this to be set up. Usually they need your formation papers and EIN. 

vii. Execute consents and collateral documents

Various stockholder and board consents needs to be completed in order to formalize the company and get the ball rolling. 

viii. Protect IP

This is what we talked about above. Make sure this is done. IP can be the life of the company. 

For more guidance on these formation steps and for more specifics check out these two articles: https://www.startuplegalstuff.com/how-to-start-a-startup-part-1/ and https://www.startuplegalstuff.com/how-to-start-a-startup-part-2/

Above I discussed getting a startup attorney in Texas and the formation of the company. Once you’ve done all of that you need to move into the next phase. The next phase concerns company growth and operations. This is where the real grind is.

1. Hiring people in Texas

One of the most daunting tasks for a number of business executives is hiring individuals to work in the enterprise. This human element is naturally fraught with uncertainty. To this I say the same thing as I say with everything: just do the best you can reasonably do and don't worry about it from there. Here are the steps for hiring people.  

i. Get your EIN (Employer Identification Number)

As mentioned in the section regarding formation steps listed above, this is similar to a social security number for the company. You'll need this in order to file properly. 

ii. Decide on whether you are hiring an employee or a contractor

One of the first issues is to decide whether you wish to hire an employee or a contractor.

What is the difference between an employee and an independent contractor?

Generally speaking, both an employee and an independent contractor are hired to accomplish some work. The IRS uses a control test to determine if a worker is an employee or a contractor. An employer has more control over an employee than it does over a contractor. An employer sets an employee’s hours, scope of work, tools, supplies, how paid, etc. A contractor operates more or less on their own and is simply hired by the company.

Why does this matter? Besides employment laws kicking in or not kicking in, the distinction is highly relevant for taxation purposes. Employers have to pay certain taxes for individuals that are deemed employees that they do not have to pay for individuals that are deemed contractors. 

Follow this guide for more information on whether or not you are hiring an employee or contractor and for other tips: how-to-hire-people-checklist

For more specifics on employment matters in Texas here is the contact information for the Texas Workforce Commission:

Julian Alvarez 
Commissioner Representing Labor 
Texas Workforce Commission
101 East 15th St., Rm 651.
Austin, TX 78778-0001

(512) 475-2670
Fax: (512) 475-2152
http://www.twc.state.tx.us/

iii. Figure out how to pay the individual in Texas

Not only do you need to pay the individual but you'll need to make sure that you can pay them competitively. This is a huge issue that I see time and time again. This can be a challenge to some early startups if they are competing with hiring personnel in certain sectors with a lot of competition. For example, in Texas and particularly Houston. As an employer in the energy IT field, you will have to make an attractive offer to a potential employee who is also getting offers from large oil companies/energy companies. This is also true for health sciences companies in Texas as there are quite a great deal of these large businesses in Texas. 

You will have to use a combination of cash plus other incentives. See this article for the basics:

https://www.startuplegalstuff.com/how-to-pay-people/

iv. Understand how stock options work

This is a subset of the above but it will likely be the method to use for, at the least, early and key employees.

Giving stock options to an employee for incentive purposes is important. This can be an intimidating subject but I've laid out all of the fundamentals for you. See the articles from Phase 2: 1A-1C here: https://www.startuplegalstuff.com/phase2-company-growth-operations-home/

v. Understand an employment contract and the fundamentals of understanding such a document

Hiring a person, like many business operations is largely a function of contract and contract law. 

Use this link to understand these concepts: https://www.startuplegalstuff.com/how-to-evaluate-an-employment-contract-checklist/

vi. Hire the person

Use these steps: https://www.startuplegalstuff.com/how-to-hire-people-checklist

2. Contracts

As mentioned, after formation of the company you’re going to be in the growing and operating phase of your company. At the heart of everything done in this phase are contracts.

These contracts are the basis of everything that is going on with a company. They governs everything. A startup lawyer knows that every contract is essentially a time-bomb. It's a reason why lawyers are used. 

In reading or thinking about a contract the main issues to pay attention to is to look at the money, the risk, and the end game. 

That is to say--track the money--when, how, why, and why not it's paid; look at how risk is controlled through various qualifiers; and end game--see how the contract can come to an end and who can terminate based on what. 

If you need more assistance, read this article and contact me. You’ll know more than 99% of the population just by reading it: https://www.startuplegalstuff.com/contracts-checklist/

3. Corporate Insurance in Texas

Get your insurance agent on board. In Texas certain types of insurance are not required, but may be beneficial to your company. 

This is an extremely broad topic. The best way to make these determinations is to assess what types of risk the company is taking and will take. Work with your insurance provider to see what is appropriate. 

4. Houston startup events and Dallas startup events

There are plenty of startup events in Texas, generally every other day. The best way to keep abreast of this is to check out the website startup digest:

Dallas startup events:

https://www.startupdigest.com/digests/dallas

Houston startup events:

https://www.startupdigest.com/digests/houston

Austin startup events:

https://www.startupdigest.com/digests/austin

A lot of startup events in Texas are not listed on these links. But the best way to get involved in the community is to sign up to some of the program email listservs and get plugged in the events and happenings. Programs will tell you about other programs and events, etc. 

I want to take a time-out for a minute. A large part of the rest of this article concerns funding or financing your business. You'll see that along with growing/operating your company, this becomes one of the most important aspects of running a business. 

Financing or funding your Texas startup is one of the biggest keys in making your company succeed. As I've said before, after formation of your company all you're really doing is growing the company, funding, growing, funding, growing, and then exiting. 

When it comes to funding a Houston startup or funding a Dallas startup or a Texas startup located elsewhere in the state, here's what to do: 

1. Understand the basics of how funding works

Why funding your Texas startup is important

If you want your company to really grow then at some point you will need to finance your company. There are ways to go about growing your company without investors or without seeking financing, but the problem is that if you don’t get them, then your competitors will out market you, out-produce you, grow quicker than you, and crowd you out. 

How to fund your company in Texas

The two primary ways to fund your company is by either debt financing or equity financing. 

Debt financing means borrowing money like a loan from a bank or similar. Generally speaking, bank financing is not used by startups because startups are high risk for banks. Have I seen it done? Yes. Is it advised? No, unless there are some special circumstances.

However, debt financing through family and friends is used frequently depending on your individual circumstances. This can be a great resource if it's available to you. 

Equity financing on the other hand is where your startup company issues ownership of the company to an investor in exchange for cash. The company is selling stock for private investment. The startup and the investor negotiate a price at which the investor purchases stock. The stock purchased is preferred stock and comes with all sorts of rights. The upside of equity financing is that in a certain sense the startup company does not need to pay back the investor, but on the downside the other owners of the company get diluted. That means that the ownership percentage of the other owners of the company goes down. See the article regarding dilution in the left panel for more information. 

There is a hybrid investment vehicle called a convertible note or convertible debt. Convertible debt is debt that converts into equity upon a certain trigger. In that situation, an investor loans money to the startup company and based on certain triggers, instead of the company paying back the money to the investor, the money purchases stock of the company and the investor becomes a shareholder. This is an extremely common method of investing in Dallas and Houston, Texas. I will go into this more in detail down below. 

You can also finance the company using revenue that comes in to the business, and while that is an extremely good way to finance the company, it is best to leverage on some level in order to grow more quickly. 

Where to get startup funding in Texas

Debt financing: 

Banks will provide loans, but again as mentioned, this is often not the route that startups take. 

My experience has been that when it comes to financing for startups, founders, etc., smaller banks are easier to work with than large global banks. There are a great deal of good, reputable banks in Dallas and Houston. Their fees are also not as ridiculous as some of the larger banks. And, interestingly enough, they are also more ethical. 

Startups will often get debt financing through family and friends. If you have a relative that is experienced in business matters, talk to them. 

Equity financing: 

See the section below entitled Startup Investors in Texas. 

2. Know the different types of funding

Below I list the main different types of funding. These are broad categories and are not meant to be strictly taken. For example, friends and family can definitely do and partake in convertible debt (it's not just meant for institutional investors). You’ll notice that each of the below categories are either a form of debt financing, equity financing, or a hybrid.

Bootstrapping

This is where you proverbially pull yourself up by your bootstraps. Texan readers will note that the phrase pull yourself up by your own bootstraps is impossible, but nevertheless, the idea is that you do it yourself. Basically you use whatever financial resources you have such as your savings to fund the company. You can do this either as a form of debt or equity financing. Equity is better.

Equity Partner

This is a type of “funding” that people don’t think of when it comes to funding. Let’s say you need a developer for a project. Regular rates for a developer for a similar project would be $100k per year. If your company doesn’t have that kind of cash to splash around, getting a equity partner/co-founder who has that skill set can effectively act as a way to “fund” the company.

Straight Debt

Debt is money given to the company that has to be repaid by the company. This has it’s advantages and disadvantages. One benefit is that debt holders do not effectively have control of the company. On the other hand, the money has to be repaid—those funds that will be used to repay the debt holder can’t be used to further grow the company. In other words your returns need to be of at least of a certain level.

Friends and Family Loan

This is a highly advisable way to fund your startup particularly when other methods are not accessible. Make it clear to the friend or family that this would be a high risk deal. Make sure the deal is in writing.

Convertible Debt

As mentioned, convertible debt is debt that converts into purchasing shares of the company. The purchase happens alongside a “qualified financing”. More on this below.

Equity Financing/Priced Rounds

An equity financing or a priced round is when an investor purchases shares of the company at a certain valuation. This may come in the form of a seed financing round or a Series A financing, Series B financing, or other. More explanation and information on this below.

3. Interface with the right investors

This is a topic that definitely deserves it's own section, so see down below for more information on this. 

4. Funding steps

There is definitely a method to funding your company and an expected (but by no means required) order. Here are the steps:

Bootstrapping/friends and family --> Seed Financing --> Series A Financing --> Series B Financing, Series C Financing, etc. --> Exit/Public

For more help and understanding on the basics see this article: http://www.startuplegalstuff.com/startup-financing-101/ 

This could technically go into the category about funding your Texas startup but I wanted to create a special category just for this since it's such a big topic. 

I want to mention something straight from the get-go. There are a lot of investors in Dallas and Houston. If you are not able to find these investors, then you're not looking hard enough. 

Like anywhere else there are different types of Texas startup investors. The main categories are the same as elsewhere. The main difference is that in some areas the players and overall size of the industry is smaller or bigger than in other industries. 

In the last so-many years, Texas has also seen universities really try to increase their startup foothold. Baylor University (e.g. the Baylor Angel Investor Network), University of Houston, Rice University, Texas A&M, University of Texas and others all have venture arms that work or invest in these types of entrepreneurial companies. A number of them also have subgroups that specialize in certain fields. So for example, an arm in the University of Texas investment group may focus on healthcare ventures. 

In so many ways this whole financing process is similar to dating. And like dating, be careful about getting married to the very first potential mate you come into contact with. This is a very psychological matter. I've seen founders get extremely attached to the first investor. Do not be too desperate. Shop around a bit. See what else is out there. Just because someone or some group has money does not mean that it's necessarily a good fit for your company.

I’ve noticed that many individuals like to say that dating sucks in whatever city they are in. Or that there are no good men or good women (good investors) in the city. That dating is not good for x, y, or z reason. Similarly people say the same thing about trying to find funding in their city for their company—that financing is not good for x, y, or z reason. Try not to fall into this trap. The answer is to just make yourself and your company better and to improve upon it. .

I do have to say that in Dallas and Houston that the investor community is generally pretty good. I've seen some real slimey individuals though that are throwing around outrageous deals around. But most have been very reasonable. 

Also, I'd like to point out that there are a LOT more investors out there than you may think--a lot of very experienced, very knowledgeable investors that you just don't know about. 

As I've written about before, a lot of these investors know other investors. So try to plug yourself in if you’re having trouble.

We can talk about investments in Texas for quite some time, but here are some keys to remember when it comes to financing from which investors: 

- Make sure the investors are accredited.

- Think about how long they can play for (i.e. if you need additional financing from them a few years from now, can the deliver?)

- What can they do beyond money? Bringing in money into the company is great, but a lot of folks can actually do that. But what can they do beyond that? Can they plug you into certain distribution channels and such? This is important to think about and to always keep in the back of your mind.

Like many areas of the country, we have seen a huge surge of incubators and accelerators in Texas in recent years. 

In addition to a number of private programs (including international based ones) a number of the universities and programs in Texas I discussed above help run or sponsor these kinds of programs for founders and startups. University of Houston has Red Labs and Rice University has Owl Spark which are fine programs. There are other more public rather than private accelerators and incubators in Texas. A number of these more public accelerators focus more on the community and aren't so much about taking an equity stake in a startup. 

So are these programs good? They can be. The answer is it depends on the needs of your company and where you are at. 

As a corporate attorney in Texas, I've been seeing a lot of investments coming in from overseas. There's definitely a large international presence. There are investment groups from Israel, China, India, and other places investing in companies in Houston and Dallas. This isn't a surprise considering that Houston is one of the most diverse cities in all of the United States. 

There's also another model of investments. What we're seeing now, and this is not just Texas but all over the U.S. (it's definitely getting bigger in Texas) is the model where an investment firm invests in a startup AND/OR helps develop the technology overseas in India or Asia. This model is particularly good for Texas startups in the IT field. For aeronautics, robotics, and other more advanced tech, this model may not be as suitable unless you find a really good fit with an investment/development firm. 

Regarding international investments, there's a fantastic program put on by US-China Innovation Alliance here in Houston. There you can meet many investors from China and those focused on the development of cross-border investments.  

Frequently what I see is that many investors/investments from China and other places want to establish joint ventures. There are also ample M&A opportunities. By investing in technologies in Texas--be it medical, energy ventures, health sciences tech, etc. they hope to bring these methods and technologies to China, Asia, etc.

So should your Texas startup seek out and try to go the international route or just stick to more, relatively local money? It depends on what you're trying to do and your intentions. 

If you're going in with the intention of seeking money from Asia because it is "easy money", then no, that's not a good idea. A lot of individuals and entrepreneurs believe that getting funding from overseas is easy. But often they find that it can be more difficult than they think.

What these investors from China, etc. want to see is some purpose for this kind of international cooperation. If you want funding for your Texas startup from China, then there needs to be for a reason for that and there needs to be a business purpose. Is there a particular reason why the Chinese market would be suitable for your company? Is there a reason why it makes business sense? If you can satisfactorily answer those types of questions then you should go for it. 

Convertible debt is widely used as an investment structure in Texas. It’s a loan that converts into equity.

What is convertible debt? Here's a quick rundown on how convertible debt works:

1. Investor makes a convertible debt 'loan' to the Texas startup

On the face of it, convertible debt is a loan but with added features. The investor will negotiate the financing amount as well terms of payment, conversion, etc. with the company. 

2. The company must pay back the loan by a certain time or the loan will convert into purchasing stock of the company

Convertible debt is often called a "bridge loan" because it bridges the company over between regular equity financings. Some times a company just needs a little injection of cash in order to hold it over, say, between a rough patch or during strategic parts of its growth. These regular equity financings are more involved than a convertible debt financing. 

3. The loan converts when there is a qualified financing

The qualified financing serves as the trigger in making the debt convert into equity. However, it is important to note that the convertible debt investor wants to make sure that not any old equity financing will trigger the debt to convert. The equity financing needs to be of at least a certain size to be the trigger. Why? Because it gives some assurances to the convertible debt investor that the terms of the financing have been properly negotiated and that inequitable results will not occur. 

4. Discount, valuation cap, and other terms

The convertible debt investor will be able to purchase the same type of shares that the equity financing investor purchased the shares at. However, the convertible debt investor did come in time first and should be rewarded for that. This reward comes in the form of a discount. The convertible debt will convert into equity at the price that the equity financing investor paid plus the convertible debt investor will get a discount on that price. 

The convertible debt financing deal documents will include a number of other terms. One of the more important ones is the valuation cap. The valuation cap serves to maximize how high of a price the debt will convert at. If this is a concept that you need more information on then this article will give you more guidance: https://www.startuplegalstuff.com/convertible-debt-101/

Like many other areas in the country, we have been seeing an increase in protections for investors using convertible debt. The fact of the matter is that there are many, many startups in Texas. Some will succeed. Many will not. Smart investors will have some convertible debt protections, but smarter ones will know that its better to just have a few protections and the better focus is getting it right to start off with. 

Convertible equity in Texas

Convertible equity is different from convertible debt. What is convertible equity? Convertible equity is similar to convertible debt except there is no repayment feature and no interest. The investment simply becomes equity at a later date.

This type of structure in Dallas and Houston is used from time to time but not with a great deal of frequency. Many in Texas are hesitant to use this kind of mechanism. I recently spoke to a pretty large investor here in the Dallas area. They had just been confronted with convertible equity as part of a deal they were contemplating but they were not familiar with the concept—so it didn’t fly. Here in Texas you will need to feel out the investors to see if this type of vehicle is one that would work. However, I would like to note that I have been seeing convertible equity used with some frequency indicating that convertible equity is indeed picking up some steam in Texas. So we will see how this goes.

The most substantial form of financing in a company pre-IPO comes in the form of an equity financing or what is called a priced round. During this type of financing, the investor purchases stock of the company by giving the company funds.

An equity financing is called by many names. Some times it is called a venture capital financing, or a priced round, a series seed round, or Series A financing, Series B financing, etc. 

In form, all of these are fundamentally similar except the difference is the amount of rights, robustness, and etc. that are negotiated and dealt with. The deals vary in complexity as the deals approach larger in size, but if you have a good understanding of the fundamentals, that should aid you throughout the growth of the company as you do more of these deals.

Here’s a rundown of these fundamentals: 

+ Purpose: Investors want to purchase stock of the company in the hopes that the stock value will increase over time. They look forward to an exit or liquidation event of some kind in the future where they can recover their investment and make a return.

+ Type of stock: The type of stock these investor purchase from the company is preferred stock. Founders have common stock of the company, investors get preferred stock. Preferred stock has certain rights and privileges above the common stock. Preferred stock can also convert into common stock at the decision of the holder of preferred stock and upon the happening of certain events. In a buy-out or liquidation event of the company, preferred stockholders receive proceeds first before common receive any amount. Quick note here: debt holders will receive proceeds even before preferred gets their return.

+ Rights: In order to purchase this preferred stock, the investor approaches and negotiates with the company and lawyers. What the investors want to do is also receive a bundle of rights associated with the purchase of preferred stock. Some of those rights include: anti-dilution rights, preemptive rights, and others. A lot of these rights are associated with safeguarding their investment. It gives them control to make sure that this investment does not get mishandled over time. 

+ Purchase price: The investors and the startup company will also negotiate a price that the shares are worth. This process can involve all sorts of metrics. Because a price is negotiated this type of financing is also called a priced round. Allowances are also made for an employee stock option plan. 

+ Dilution: Dilution happens. Dilution occurs whenever more shares of the company are given out. The prior owners of the company have their ownership percentage of the company go down. You can think of the company as a pie. You start off with 100% ownership of the pie. As you share slices of the pie with other people, your percentage ownership goes down. Broadly, anti-dilution rights is like saying, hey, instead of my ownership percentage going down, let's make it so the other owner's ownership percentage goes down. 

+ Term sheet: The investors will do all sorts of diligence and look through the company history, finances, etc. If things go well the lawyers will have the investors and the startup company sign a term sheet that briefly state the desire to enter into a stock purchase and the terms of such.

+ Lawyer: A startup lawyer will draft all of the deal documents that effectuate all of this. This whole thing is actually a pretty complicated affair. But you have to go through this process if you really want your startup to go anywhere. 

+ Investors become holders: After all of this is done, the investors will become preferred stockholders of the company by purchasing preferred stock at the price of $X. The financing amount should help the company operate and hopefully grow substantially. 

+ Conversion of convertible debt: Remember the convertible debt? If the startup company has that on the books and if the priced round is for a high enough amount (a "qualified financing") then the convertible debt will convert into the same preferred stock as the ones negotiated in this priced round of financing. The convertible debt investor will essentially purchase the same preferred stock at the same price (but with the bonus of a discount because they came earlier in time). 

+ Series B, Series C, etc.: Future financings can and should be done to operate and grow even more. Those financings may be called Series B financing, Series C financing, etc. They are in some ways similar in form. Generally speaking, those investments that come later in time will have the same types of rights as the previous investors if not better. 

+ Expansion: With these types of investments, the game becomes more expansive and global. In Texas we see investors from all over the country and all over the globe come make investments in Texas startups. Again, it often depends on what industry you are in. 

+ Further reading: I've gone through the basics here but if this is something you're going through here's the gameplan for you to best understand this process. 

• Read the articles in Phase 3A: Fundamental Concepts

• Read the articles in Phase 3C: Venture Capital

Those articles will more than prepare you going into these processes.

After your equity funding, you should be fully into the growth, financing, growth, financing cycle. You will be presented with more challenges the further along you go.

This article serves as a good overview of startup a startup in Texas. The most important thing is to have a good attitude and to keep on doing what you’re doing, as cliche as that sounds. Make sure to read the articles on the left to flesh out any ideas that you are struggling with. Remember to always keep an eye for the end game—do you have an exit plan? What will it look like when the company sells? Pay attention to the process and to the system of what you’re doing.