Investing in startups can be a complex process that requires thorough consideration of various approaches and investment structures. In this blog post, we will present four key ways of investing: equity financing, convertible notes, SAFEs, and loan agreements. Each of these approaches comes with unique advantages and challenges, tailored to the needs of both investors and startups. By examining each investment structure, we will uncover the optimal situations for their application and key decision-making factors. Get ready to learn how to best utilize these strategies to maximally support the growth and success of your startup!
Equity Financing
Equity financing is a crucial way for startups to raise capital, where investors directly purchase an ownership stake (shares) in the company in exchange for investing money. This type of financing allows the startup to obtain the necessary funds for growth, product development, or market expansion. In return, investors receive a share of the company’s profits, proportional to their stake, as well as voting rights on important company matters at shareholder meetings.
The process of equity financing usually involves valuing the company before the investors’ entry, which can be challenging in the early stages when financial data is limited, and the startup’s value has not yet reached its peak. After determining the value, investors buy shares at that price, thus becoming partial owners (shareholders) of the company. This can include various clauses and rights, such as the right to dividends or participation in capital gains.
One of the key advantages of equity financing is that startups can leverage the capital, knowledge, and network of contacts that investors bring, which can contribute to further company development. On the other hand, investors have the opportunity to profit from the company’s success through the appreciation of stock value or dividend payments. This model of financing often attracts startups that seek long-term partnerships with investors and are willing to share control over the company in exchange for financial support and strategic growth assistance.
Convertible Notes
A convertible note is a form of financing that combines the characteristics of a loan and an equity investment. Initially, it is treated as debt, but it can be converted into equity at certain conditions, usually during the next financing round. This method of financing is concluded more quickly and has lower costs, providing flexibility for both investors and startups. However, complications may arise during conversion, and there is a risk of diluting the existing shareholders’ stakes.
Key elements in a convertible note are the valuation cap, which is the maximum price at which the investment can be converted into shares during the next funding round, and the discount, which is the percentage discount the investor receives when converting their loan into shares compared to the price at which shares will be issued in the future round.
Example:
Anna, the founder of a startup developing advanced eco-friendly materials, seeks funding of €200,000 to expand production. An investor, Milan, offers a convertible note with a term of three years. According to the agreement, the loan will convert into equity during the next funding round, with a valuation cap of €2 million and a 20% discount on the share price.
Scenario:
Anna uses the money to increase production and attracts additional investors in the next funding round, where the company is valued at €3 million. Milan’s loan converts into shares at a lower price, allowing him to acquire a larger stake in the company. Anna succeeds in expanding the business without the obligation to repay the debt, and Milan becomes a co-owner of a fast-growing startup.
SAFE (Simple Agreement for Future Equity)
SAFE is an innovative agreement often used in the startup ecosystem as an alternative to traditional financing methods such as convertible bonds or direct equity investments. It allows startups to attract capital from investors in the early stages of development without determining the company’s current value. Instead, investors get the right to convert their investment into equity in the future, during the next funding round, or another event such as the sale of the company.
The key advantage of SAFE is its simplicity and flexibility. Unlike other financing methods that have complex terms and require a valuation of the company at the time of investment, SAFE focuses on future conversion, simplifying and speeding up the investment process. This means that the startup does not have to immediately assess its value or conduct complex legal procedures common to traditional financial instruments.
SAFE can also include various clauses that protect the interests of both the investor and the startup. For example, it may include a provision for automatic conversion of the SAFE into shares under certain conditions, or the investor’s right to withdraw their funds if certain events do not occur within the specified period. SAFEs are not fully regulated by the legal system, so they are often used in combination with equity solutions to achieve the desired effect. However, legal uncertainty in some jurisdictions can be problematic, as well as potential challenges during future funding rounds.
Loan Agreement
A loan agreement is a traditional way of financing where the investor lends money to the startup with the expectation that it will be repaid with interest. This is a direct approach that can be less risky for the investor as it has clearly defined repayment terms. However, for the startup, it can be challenging as it creates an obligation to repay the money regardless of the project’s success. The advantage of this approach is that the terms and repayment periods are clear, and the risk for the investor is lower. On the other hand, the startup takes on the obligation to repay the debt, which can limit the company’s cash flow and resources.
Example:
Imagine Marko, the founder of a tech startup, seeking funding to develop a new app. He approaches Ivan, an investor willing to invest €100,000, but under the condition that the money is repaid with 10% interest over two years. Marko and Ivan sign a loan agreement that clearly defines the terms of loan and interest repayment.
Scenario:
Marko uses the €100,000 to develop the app and launch it on the market. However, due to unexpected challenges and slower growth than anticipated, Marko struggles to repay the loan and interest. Although the app is promising, the obligation to repay the debt limits the company’s resources and hinders further development.
The situation becomes more complex when the investor and the startup are from different countries. In such cases, the involvement of the Central Bank as a regulatory body is required to approve the inflow of funds from abroad and to be regularly informed about all changes regarding the loan and the repayment of funds. Notifying the Central Bank and making any changes are done through the borrower’s commercial bank, i.e., the startup, which incurs additional administrative costs. Therefore, in cases where the investment amount is significant and economically justified, it is advisable to consider the loan option to cover all additional costs that the loan entails.
Loan in Cryptocurrency: The Future of Startup Financing?
In a world where technology rapidly changes how we do business and invest, loans in cryptocurrency are becoming an increasingly relevant topic. Imagine a scenario where the founder of a startup, Ivana, seeks funding to develop her educational platform. Instead of a traditional loan or convertible debt, Ivana opts for a loan in cryptocurrency, say in Bitcoin or Ethereum.
How does a cryptocurrency loan work?
In this model, the investor, Marko, transfers a certain amount of cryptocurrency to the startup’s digital wallet. Ivana uses the funds to develop her product, and instead of repaying the loan in fiat currency (such as euros or dollars), she repays it in the same cryptocurrency. This approach has several advantages, including faster transactions, lower transfer costs, and greater transparency thanks to blockchain technology. The downside of this method of financing can be seen in legal gaps, as this area is not yet fully regulated in Serbian law.
Choosing the right investment structure depends on several factors, including the startup’s development stage, funding goals, legal aspects, and investor preferences. In the early stages of development, SAFEs and convertible notes are often preferred for their flexibility and quicker realization. In later stages, equity investments may be more appropriate as both parties have a clearer picture of value and ownership. If the goal is to quickly raise capital with minimal costs and bureaucracy, SAFEs might be the best choice. If the goal is clear ownership and control, equity investment is more suitable. In some jurisdictions, the legal framework may favor certain types of investments, so it is advisable to consult thoroughly before investing.
When choosing an investment structure, it is important to keep an open mind and consider different options. Many investors and startup founders tend to choose familiar methods within their comfort zone. However, innovative approaches can often bring greater benefits and better suit specific needs.
What is a Term Sheet?
A term sheet in the context of startup investing is the starting point for negotiations between the investor and the startup. It is a document that summarizes the key terms and details of the investment between the investor and the startup before entering into formal contractual obligations. This document is generally not legally binding but serves as a basis for further negotiations and the eventual conclusion of the final agreement. However, it should be noted that some parts of the term sheet can be legally binding, which can have significant consequences for the startup even if the investment does not materialize with the specific investor. Therefore, it is very important to be cautious with the term sheet.
A term sheet typically includes the following elements:
- Company Details: Includes basic information about the startup, such as the company’s name, registered seat address, ownership structure, etc.
- Investment Terms: Defines the type of investment (e.g., equity, convertible note, SAFE), the amount of the investment, the company’s valuation (if applicable), terms for potential conversion or buyout, and other financial clauses.
- Investor Rights: Specifies the investor’s rights, such as preferential access to future funding rounds, rights to participate in management or decision-making (if applicable), the right to information about the company’s operations, etc.
- Startup Rights: Defines the rights and obligations of the startup toward the investor, such as restrictions on future borrowing, the right of first refusal on shares, etc.
- Closing Conditions: Describes the conditions under which the investment will be considered closed, such as the execution of the final agreement, execution conditions, timeframes for execution, and other procedural details.
A term sheet is an important tool for aligning between the investor and the startup before moving on to detailed legal documentation. It allows both parties to clarify key points of the investment and the terms on which they will negotiate further, thereby reducing the potential for misunderstandings and facilitating the process of finalizing the investment.
The term sheet is concluded immediately before the due diligence process. How to best prepare for the due diligence process can be read in our earlier text, Don’t Let Legal Issues Prevent You From Raising Venture Capital. Know What VC Investors Look For in Advance.
Choosing the right investment structure for your startup can be challenging, but with the right information and legal support experienced in startup investments, you can make the best decision for your business growth.
