Common types of VC investment agreements
Telling about the main tools we use in the ICLUB — convertibles, SAFEs, and priced rounds
Every deal between an investor and a startup takes place under certain conditions. At the same time, each party has its own claims. For example, as an investor, we are interested in getting our money back. Besides, what are the options to put money into a startup? How and when exactly should the startup pay us (or not)? To meet these needs, the venture industry practices certain ways of investing and raising capital.
Startups are a special business. And non-standard situations, as we know, require non-standard solutions. It is practically unrealistic for such companies to get an ordinary loan from a bank. The reasons: high risk, vague prospects, lack of collateral, and much more. Since the traditional methods of working with investments are not suitable, venture capitalists have come up with alternatives, which we will talk about in this article.
In general, there are many more ways to invest in startups than those listed here. It also depends on the company’s stage, the parties’ wishes, and the circumstances. We will focus only on the tools we use most often in ICLUB and TA Ventures practice.
I would like to thank ICLUB lawyer Sofia Brutsyak for her significant help in preparing the material.
Convertibles and Priced Rounds
All the ways to invest capital in a startup can be divided into two broad groups: Convertibles and Priced Rounds.
Convertibles are one of the most popular ways to invest in early-stage startups. Their essence is to provide capital in exchange for a future stake in the company (not necessarily, more on that later). In short, it's a kind of loan. The advantages of convertibles are simplicity, cheapness, and speed. These features are achieved due to bypassing the startup evaluation and postponing the question to a later date.
All in all, this instrument favors the startup side. The company can afford less bureaucracy, promises, and specific KPIs. Also, the startup retains the fullness of management, because investors will only get a stake in the future and only under certain circumstances (or maybe not at all). It is important to remember that when investing through convertibles, the investors are not company shareholders at the beginning.
On the other hand, convertibles have advantages for investors, too. From legal protections such as discounts and valuation caps (discussed in the next section) to a better organizational component.
The fact is that convertibles allow the startup to raise money from multiple investors separately, without having to sign documents with all of them at once. This gives the startup more investment options and more flexibility to close the round.
Among the different types of convertibles, we will highlight convertible notes and SAFE, but first, let’s finish this section.
Priced rounds, or simply equity, are the second group of ways to invest in a startup. The key feature here is the preliminary calculation of the company valuation. The valuation results determine the share price, the participants' equity in the deal, and other terms and conditions.
As a rule, priced rounds, on the contrary, favor the investors’ side. The obvious advantages for us are more confidence in the future, less uncertainty, and access to the management decisions of the startup.
But there are also disadvantages. These include huge paperwork, timelines, and legal costs. In addition, priced rounds are suitable for more mature startups that have traction and other statistics under their belt. For early stages, such as pre-seed, this type of investment will likely not always be relevant.
So which way to go? Each has its pros and cons for each party. Whatever we choose, we will have to sacrifice something. The stage of the startup, the parties' position (for example, the startup has problems and is ready to raise money on the investors' terms), and also the participants' compromise and mutual agreement play a role here.
Convertible Note
Also known as a convertible loan, or CLA. A form of loan designed for the venture capital world. An investor gives money to a startup with the obligation to pay it back with interest or to convert the loan into equity if certain circumstances occur in the future. The interest rate can be as high as 10%.
The first feature of convertible loans is that investors do not get a stake in the company immediately. They have to wait for one of two triggers in the agreement – maturity date or qualified financing.
Qualified financing means attracting a certain investment amount by a startup, after which a payoff to the lender occurs. For example, the deal terms may state that once the company raises an additional $7 million, the initial investors' loan will be converted to equity or repaid with interest.
The maturity date, in turn, is the date after which the conversion or loan repayment takes place regardless of the qualifying financing. However, nothing prevents the parties to the deal from extending the maturity date according to the situation.
The second important feature of convertible loans is the lack of company valuation. That is why this type of investment is so popular for early-stage startups when there is insufficient data. The company's valuation will only appear in the future when the business is mature and participates in one of the priced rounds.
Now let's talk about the universal benefits of this type of investing. First, it's cheap, fast, and easy. Literally. Because there is no startup valuation clause, the deal can be done in a week. With priced rounds, this process takes at least a month. Convertible loans require a minimum of legal and monetary costs.
What else is a convertible loan good for? The valuation cap and the conversion discount. These are investor protection tools designed to safeguard investments over the long term.
The valuation cap sets a ceiling on the company's value, regardless of its future assessment. The point is that the higher the startup’s valuation, the more expensive the share. Now imagine a situation where you invested in a startup at an early stage, taking a big risk. However, the startup performed well and raised a significant round of investment, which increased its valuation. But it didn't just increase. The company's valuation broke the ceiling. Everyone thought the valuation would be $10 million, but it turned out to be $20 million.
As a result, the valuation cap allows early investors to buy shares more cheaply based on an assessment of $10 million, while new investors do the same but at $20 million. This approach helps to encourage investors to invest in early-stage companies.
Now let's talk about the conversion discount. Here everything is simple, it is a fixed discount on the shares’ purchase (if the investor wants to buy them). For example, initial investors are entitled to a 20% discount.
In the agreement between the startup and the investor, either one of these discount options or two at the same time may be available. In this case, the investor chooses one of the two options at his own discretion, depending on the benefits.
Another advantage of a convertible loan for investors is that they act as creditors rather than shareholders. Investors can even give up the shares and be satisfied with the interest. In other words, there are two ways to make a profit.
The main disadvantage of convertible loans is the lack of voting rights and influence on the company's management decisions. In essence, all that remains is to trust the team and wait. In the future, we will still be able to get some shares, but until then a lot can happen.
SAFE
SAFE stands for Simple Agreement for Future Equity and is an evolution of the previous paragraph's hero. SAFE also belongs to the group of convertibles. However, this instrument is slightly modified, taking into account the experience and specifics of investing in startups.
SAFE also implies the provision of capital in exchange for a future equity stake in the company. In general, there are similarities with convertible loan agreements, but there are important differences. Let us start with them.
First, SAFE is not a loan; it is legally considered a warrant. There is no interest and investors are not listed as lenders.
With SAFE, investors get a stake in the company faster than with convertible loans. The point is that the conversion into shares becomes available after any future priced rounds, rather than when certain triggers are reached. The amount raised in the next investment round and a number of other factors critical to CLA do not matter because SAFE has no notion of maturity date and qualified financing.
In fact, investors will become shareholders in any case, unless the startup decides to die early.
In addition, SAFE includes benefits for investors, such as the valuation cap and conversion discount mentioned in the previous section. Talking about bureaucracy, the situation is similar to convertible loan agreements. It is quick, cheap, and pleasant.
As with convertible loans, there is no valuation of the startup at the SAFE stage. This part is carried over to the future priced round.
Priced Rounds
Priced rounds, or equity financing, are the antipode of the previous two agreements. In priced rounds, investors only provide capital based on a formal valuation of the startup. Investors also receive an equity stake in the company immediately, not sometime in the future.
Typically, priced rounds are more attractive to investors for several reasons. By receiving a startup valuation at the outset, investors understand their stake and the degree to which it may be diluted in the future, and the stock price will not come as a surprise. This approach instills more confidence in the company, which appears to be reliable.
There are two other benefits for investors. First – along with a stake in the company, investors get a share of control and influence (this, of course, depends on the size of the investor's stake). Investors do not act as silent passengers. They can intervene if necessary.
The second advantage is insurance in the form of anti-dilution rights. Such rights allow investors to maintain their shareholding when new stocks are issued. We have a separate article on this.
But equity rounds also have drawbacks. This method is not always suitable for early-stage startups. It's either impossible or not justified to calculate the valuation of such a business. Also, early-stage startups do not always like priced rounds because investors (especially lead investors) have a significant amount of rights to influence the company's decisions and management.
Equity rounds are also a long and complex process that can take months. Evaluating the startup requires data collection, calculations, and the work of specialists. There is also a tangible legal burden and financial cost. The game should be worth it.
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