Introduction
Founders of early-stage startups usually share one common headache – securing investment for their business. When the money is finally on the table a new challenge might arise that sometimes leads to disagreements and canceling the deal at the very last moment: a legal way to put money into the company. It should be done with careful consideration in the mutual interest of the founders and investors, and as smooth as possible. So, how exactly?
What is Investment Legally
You might hear much about Investment Agreements when nurturing potential investors and discussing the terms. However, behind each contract stands a legal framework that enables the terms of the contract to be enforced by law. If it’s a good contract, of course.
Thus, an Investment Agreement includes only two legal essences which may be used in different variations – loan or share issuance as a result of capital injection. Keeping this in mind, you will be on the top of any negotiations because you will know the sacred thing: if someone gives money to your company, in the future you will either have to:
- give money back; or
- keep money, but give the % in your business.
Very simple.
But sometimes – very complicated.
The main conclusion at this stage is that investment is always a loan or a payment for a stake in the company.
Investment as a Loan
The first and most straightforward way to secure investment is to get money as a loan under the Loan Agreement. In this scenario, the startup will be the Borrower, the Investor – the Lender. Be attentive to the details and sign the Loan Agreement on behalf of the company and as the officer of the company – the Director or other person authorized under the Power of Attorney. Make sure that the Lender is your startup’s legal entity, not you as an individual.
Otherwise, when the time to pay back will come, you will be paying out of your personal funds, not from your business. And if the outcome is not so favorable, all legal claims will be directed towards you. This relates to all types of the contracts concluded by the company, not only the Loan Agreement.
So, the Lender lends your Company some funds – the investment. After the funds hit a startup bank account they immediately become debt. The basic condition of the Loan Agreement is for the loan to be repaid to the Lender till a certain date (for example, in a year or three years, etc.).
Very common for the loan to be granted with the interest, because what is the point of giving someone your funds for free when they can be used during this period and generate income for you? Naturally, your startup will be offered a loan with the interest, however, the percentage may be significantly lower when you deal with the investment fund compared to if you go to a bank for such funding.
It may seem like a very obvious framework to inject money into your business. However, it’s not widely used within the startup ecosystem as it has one very unfortunate disadvantage – in the end, you have to give money back (with interest even more), and this might be a big problem for an early-stage startup. Because the early-stage startup might not generate any revenue for the first few years at all, not to mention generating income to pay back the debt. And this is not a secret to the investors and founders.
Thus, as the law evolved, new legal methods were developed to tailor all the business needs.
Investment as a Purchase of Startup Stake
Another common and more traditional way to secure investment legally is to sell part of the company's share capital. Usually, startups are registered as Ltd. or Inc. which means that such a legal entity has a share capital divided between the shareholders. This helps to clearly establish the ownership in the form of the percentage in the company stock. Often it’s a number one choice for the founders since, for instance, LLC does not have shares, only a membership interest, thus each founder will not receive the exact number of shares, only some kind of % in the participation. I will describe the most preferable legal forms for startups and the differences between them in the next articles.
Such a scenario would mean that the company will issue a particular number of shares for the investor towards the amount of investment. As a result, the investor will become a shareholder and the company will increase its share capital.
The general terms of such a transaction are usually set out in the Term Sheet which is negotiated and signed by both parties before the investment is made. Please pay attention that Term Sheets are not binding, and if you have successfully negotiated everything and signed, the investor may turn back without any legal consequences. What is important at the Term Sheet stage is to calculate the price per share and the percentage for new investors correctly as this will also be reflected later in the Share Purchase Agreement (SPA).
SPA is the main legally binding instrument in this type of investment which outlines all terms and conditions – when money will hit the startup bank account, and how many shares should be issued. Very often founders skip the calculation part and do not reflect necessary changes on the company cap table which should be maintained properly.
This later leads to unwanted confusion and misunderstanding between current shareholders and new ones when the price per share differs for the same class of shares and existing shareholders are diluted to an unexpected extent.
Pros and Cons of the Equity Investment
The main advantage of the SPA is that your company gets funds almost immediately after the agreement is signed, and does not have to repay them back as in the case with the loan. Because it’s not a loan, it’s a purchase of the company asset – its equity. And of course, there is no interest, so you do not lose money.
The drawback of the capital increase is that existing shareholders will always be diluted (but it’s natural when it comes to investment engagement). This can be slightly rectified by creating different classes of shares for each round of investment which will bear different rights for shareholders. For example, you can create preference Series AA shares without voting rights which will eliminate the undesirable participation in company business for the new investor. However, such a class of shares will give them the highest priority in dividend distributions and liquidation preferences.
Another side effect of selling the company stake is that investors, depending on the percentage acquired in the startup, will most probably want a seat on the company Board of Directors or otherwise participate in the company management. It is not good or bad, it’s the fact you will have to deal with.
Very often investors bring essential expertise to the startup management and founders benefit from that. But what needs to be taken care of when a new shareholder comes into play is the corporate side of relations between all shareholders, directors, and management. This can be regulated under the Shareholders’ Agreement and Board Member Agreement and will save you a lot of energy for the company business in the future.
Loan and Equity Purchase Combined
Convertible notes and SAFE are the most widely used legal frameworks when it comes to early-stage investments. These types of agreements were developed by startup accelerators to cover the main purpose of each investment – that the investor will either have their money back or money will be automatically converted into equity without intermediary share purchase agreements.
The basic idea behind convertible instruments is that the investor lends money to the business and when a certain trigger takes place – money should be paid back or they will be converted. Such triggers may be various – Equity Financing, when another investor joins an investment round; Change of Control, when the ownership over the significant part of the company shareholdings is changed; or Maturity Date (for the Convertible Note) when the decision is made to pay back or convert.
The beauty of SAFE and Convertible Note is their well-structured form which eliminates any unclarity for the investor in the future. In other words, if you have agreed on the Valuation Cap – you can be sure it will apply to all other investors in this round. If you decide to choose a discount instead – you will gain a more favorable outcome at the time of conversion.
Naturally, there are many differences between Convertible Note and SAFE. The first is the debt itself which sometimes can be required to be repaid under a Convertible Note ans the interest rate is usually negotiated. While SAFE tends to be treated as a legally simpler document and more affordable for the early stage entrepreneurs. We will dive into a detailed analysis of the pros and cons of each instrument in the next articles, but as for now, the main conclusion is that both of these agreements are the number one choice for any startup to quickly get funds injections into the company share capital and focus on the product development.
Conclusion
SPA, Convertible Note, and SAFE are legally valid and proven instruments to secure investment. It’s up to the entrepreneurs to choose the most suitable way to move forward with the investment process. Usually, it may seem that in the long and complicated process of engaging new investment – sending investment decks, SWOT analysis, market penetration plans, and business model overviews – aww, this may take months!, the contract part is the final stage when everything is agreed and nothing to worry about. However, it’s not (unfortunately).
Agreement negotiating and signing is a crucial part of closing the deal, thus, do make sure it is properly managed. Sometimes inaccuracy with defining valuation cap or discount, or not updating captable in time which is demonstrated in a meeting to all investors in the round, can ruin all previous achievements and roll back the negotiation process.
Author – Yuliia Verhun, IT Lawyer
All intellectual property rights to this Article belong to Yuliia Verhun.
