A company’s need for substantial amounts of capital is intensified when looking to grow quickly, or develop an innovative product that will disrupt the market in a meaningful way. This is true to any company, and is especially true to innovative and disruptive startups, which aim at creating new markets, revolutionizing existing ones and prevailing over traditional market participants. To be disruptors, a startups’ product may need to go through testing, the startup may need hire experts in a particular field to assist in the development of a product, or invest heavily to gain scale in the short run and be competitive in a specific market. Thus, raising capital is, without a doubt, a key element in the life of a startup.
Initially, when founders are jumpstarting the company, they will have no other option but to use their own funds. However, as the business grows, and expenses pile up, the founders will need to turn to other methods of financing.
Two mechanisms by which startups may raise capital are (i) equity financing, whereby shares of the company are sold; or (ii) debt financing, in which the company may be required to put its assets as collateral to secure the debt. The latter may not be a viable option for a seed stage startup given that it may not have any assets, or the assets that it has are not an adequate guarantee for the loan. Consequently, convertible debt (which we shall discuss in a subsequent article) or equity financing are typically the most viable routes that startup founders take when looking to finance the operations of the startup. In this new Startup Series’ article, we will summarize the particularities of startup fundraising, the participants, and the terms that a founder should be paying attention to when negotiating with investors in a financing round or series.
After founders have exhausted the seed capital, and require additional funding to keep financing the operations of their company, they will likely look for investments from close friends and relatives. At that moment, funding rounds involving friends and family, which will usually be informal compared to later rounds, will come into play. Because there is a certain level of trust between the investors and founders, the terms of the investment in a friends and family funding round will potentially be much more favorable to the founders, and investors will most likely not ask for special rights and protections such as voting rights over major decisions (or voting rights in general), board seats, or to be involved or actively participate in the management and operation of the company. However, founders must be sure to document every investment from friends and family, and have in writing all rights that are being granted to such investors.
In addition, ideally there will be:
i. A subscription agreement in which, among other things, the startup agrees to issue the shares and the investor agrees to transfer the money; and
ii. An adhesion to the shareholders’ agreement in order for both the investors and the founders to be clear on what are the rules of the game.
Nonetheless, there are certain rights that, due to their long term implications, founders should pay special attention to when thinking about granting them to friends and family investors, such as anti-dilution rights or the right to block subsequent rounds of financing, which might destroy the attractiveness of the startup from an angel investor or a venture capital investor’s perspective. Consulting a lawyer, even at these early stages, would be advisable so that founders may understand the reach of these provisions and will help save time and money down the road.
Next up, are the so-called “angel investors”. These are high net-worth individuals that will invest much more money into the startup than friends and family, will contribute their expertise, and will, occasionally, serve as mentors to the founders. Consequently, angel investors will likely require a certain level of control over management, and will ask for special approval rights over at least certain major decisions of the company, such as the sale of the business or a substantial part of its assets to a third party, or an exit to capital markets (an initial public offering or “IPO”). Although some angel investors may not be very sophisticated, they will often have legal counsel involved to assist them in negotiating better terms in a subscription agreement, or even bargain for convertible notes. Similarly, the founders must make sure to have a lawyer looking out for their best interest during negotiations with an angel investor.
Finally, the venture capital firm or “VC Firm” is where startups get the biggest investments from (if they get to that stage). VC Firms are highly sophisticated and will negotiate intensively to get the best deal possible from their perspective. They will often require the startup and past investors to agree to certain terms in exchange for their investment. For example, a VC Firms will often negotiate for drag-along clauses in which other shareholders of the startup will be required to vote in favor of resolutions that a majority of the shares voted for. This is designed to ensure that minority shareholders will not be able to veto acts that the majority of the shareholders are in favor of.
Typically, these key terms, and others which we discuss below, are negotiated through a term sheet, which will serve as a basis to be used to draft the documents that will be signed in order to formalize the VC Firms’ investment.
Every time a startup founder decides to go through a financing round, he/she must be prepared to negotiate the economic and control aspects contained in the securities or financial instruments being offered. Thus, below we list the most important terms that we consider should be taken into account when a startup is raising capital, regardless of whether it is friends and family, an angel investor or a VC Firm.
1. Investment Type
A founder must decide what securities or financial instruments he or she will give in return for the investment. The investment may be, for example, in exchange for preferred stock with certain liquidation preferences (which we will discuss later); or convertible notes, which act as debt that is convertible into a class of shares when and if a certain condition is fulfilled.
The type of investment is relevant, because it will affect the amount of money that a founder will receive when the company goes through a new round of financing or the company is sold, or taken public through an IPO.
Valuation refers to the value of the startup before (“pre-money”) and after (“post-money”) the investment. This is relevant because it will determine the percentage of the company the founders are selling, and how much they are diluting their participation, after finalizing an equity financing round.
For example, if during a seed series financing round, an investor puts US$ 500,000.00 into a startup with a US$ 2,000,000.00 post-money valuation, that means that the founder is selling 25% of his/her company in exchange for the investment. To determine the valuation of a startup, both the intrinsic data about the business (revenue, number of users, etc.) and the market value of the company (what investors are willing to pay for the company), must be taken into consideration.
NOTE: Take note that the “authorized capital”, as defined by Panamanian law, is not necessarily related to the valuation of the company, and that the nominal value of the shares will not necessarily define the price for which the shares of a Panamanian corporation may be sold.
3. Conversion Rights
Investors in funding rounds will require that they be issued shares which may be preferred and with a right to convert to common shares at any time. This may mean that if an investor is unhappy with the way a company is being run and decides to exercise it conversion rights, the investor will gain voting rights, which may lead to additional control over the company, and, in that case, there will be a risk that a founder is ousted a director or officer. To deter investors from converting their preferred shared into common shares before a liquidity event (usually defined as a sale of the company or a substantial part of its assets and/or stares) takes place, founders will typically offer liquidation preferences and participation rights (discussed in “4” and “5” below).
4. Liquidation Preferences
A liquidation preference is a very important and highly negotiated economic term in a funding round. The liquidation preference refers to the amount of money that the holder of a particular class or series of shares has the right to when and if the startup goes through a liquidity event.
Typically, an investor in a funding round will negotiate for a liquidation preference in the shares he/she is acquiring, in order to receive a certain amount of money per share if a liquidity event takes place. A common liquidation preference clause will say that the investor has the right to receive a per share amount of “X times the original purchase price of the shares, plus declared but unpaid dividends”. It is important to keep in mind that the liquidation preference, as its name indicates, gives the investor preference over the other classes or series of shares, thus, the investor that holds the liquidation preference gets paid before other classes or series of shares. A liquidation preference below “1x” would not make much sense, given that the investor would want to, at the least, recover his/her investment. However, investors may negotiate for a higher multiple (i.e. 1.5x, 2x, 3x and so on).
5. Participation Rights
In addition to a liquidation preference, startups may need to offer participation rights in order to make the investment more attractive (depending on the stage they are in and the successfulness of their business model). Participation rights are usually paired up with liquidation preferences, and the investor will have both if a liquidity event takes place.
During a liquidity event, a holder of shares with a liquidation preference and participation rights will have the right to receive payment for its shares before the holders of other classes or series of shares, and participate in the sale of the company as if its preferred shares had been converted into common shares. This combination of liquidation preference and participation rights is designed to ensure that the investor will at the least get back its investment (in the event that the company is sold for a price below the investor’s purchase price), or participate in the sale of the common shares and get a “premium” for assuming the risk at the time he/she made his/her investment (in the event the sale is over the investor’s purchase price).
Example A: Imagine that Investor A invests $20,000.00 for 20% of Startup S.A. in a seed series round (US$ 100,000.00 post-money valuation). In exchange for the investment, Investor A receives preferred shares with “1x” liquidation rights and participation rights. Thereafter, Startup S.A. is sold for US$ 1,000,000.00. If Investor A only had a liquidation preference, it will only get its initial US$ 20,000.00 investment back. On the other hand, if Investor A has a liquidation preference plus the right to participate in the sale, it will receive the initial US$ 20,000.00 investment back, and the participation rights will entitle Investor A to an additional US$200,000.00 (20% of US$1,000,000.00), as if the preferred shares had been converted.
If the situation is the opposite (Startup S.A. is sold for less than US$ 100,000.00), a liquidation preference guarantees that the investor will at least get back its initial investment.
Keep in mind that, as mention in section “3” above, investors will negotiate for preferred shares with the right to convert to common shares. Liquidation rights deter the conversion of the shares, because if the investor converts, then it loses its preference, and will only be able to participate in the sale of the company. The risk is that the company sells for a lower price than the investor’s purchase price and the investor loses its investment.
6. Composition of the Board of Directors
As one of the most important control aspects of a negotiation, an investor in a funding round will typically require the right to appoint at least one director to the board of directors in exchange for its investment. This guarantees that the investor will be represented in the board of directors and that the investor will be able to vote in board meetings, thus have control over the decision-making of the business.
7. Protective Provisions
Investors will negotiate for veto powers over certain major decisions of the company. Friends and family, and angel investors will seldom negotiate for veto powers. VC Firms on the other side, will require veto powers over, for example, mergers/change of control, incurring debt for over a certain amount, declaring dividends, and increases or decreases of authorized capital of the company, among others.
Founders will need to decide what type of major decisions they want to give investors control over. The important aspect here is that founders make sure that the same protective provisions are granted to investors of the various financing rounds. If different classes have different veto powers over major decisions, making decisions will be difficult and time consuming.
This is a term that a founder must be clear when entering negotiations with a potential investor. Generally, antidilution clauses will determine which shareholders get diluted when a new financing round takes place, and how much those shareholders will be diluted. This is relevant because, if not well defined, a founder may lose control of his/her company by diluting too much of his/her percentage in the company.
Keep in mind that each business and its financial needs must be evaluated taking into account their particular situations (amounts being raised, number of investors and shareholders, among others), so as to determine what economic and control terms deserve the most attention. We are at your service for any queries you may have on these issues.
For more information on these topics, please contact:
MORGAN & MORGAN
Tel: 265-7777 ext. 7783
|Miguel Arias M.
MORGAN & MORGAN
Tel: 507-265-7777 ext. 7687