Deciding the Future of your Startup: Type of Contracts
“In general, it’s important to understand what drives your current and future investors since their motivations will impact your business” Brad Feld & Jason Mendelson
All startups at some point in their life raise capital. This is not only about preparing an investor deck, talking to investors, and receiving the money in the bank account; it also involves establishing the legal framework to carry out the transaction. Most entrepreneurs tend to avoid two major elements that every entrepreneur should be aware of. The first is the entire financial side of the startup, including the financial model and its valuation. Second, they tend to avoid all legal issues, leaving them in the hands of their lawyers.
Sometimes the lawyer selected by the entrepreneur could be an experienced professional versed in Venture Capital issues. However, on many occasions, especially at the beginning of the startup’s life, they select friends or recommended people who do not have experience in Venture Capital transactions, which is more costly since it derives from erroneous approaches in the structuring of transactions such as capital raising.
When raising capital, three instruments are used to legally execute the transaction: Convertible Note, SAFE and Equity Investment. Each instrument is used in different circumstances and mostly depends on the preferences of the entrepreneur and the investor with whom the transaction is to be closed. One of the main considerations is the stage at which the startup is raising capital, typically in the early stages it will use a Convertible Note or a SAFE and in subsequent stages direct equity investment.
The convertible note is used in the first rounds of capitalization of the company. For practical purposes, it is debt which allows investors to have the investment commitment derived from the protection provided by this instrument in order to recover the principal and receive an interest rate. It also includes the option of convertibility into shares at a discounted price or at a valuation ceiling. The convertible note is usually the instrument that provides the most protection to the investor in the early stages, it does not require a valuation of the company and has a maturity date.
It is a widely established document and widely understood by entrepreneurs and investors alike. It also provides operational flexibility since the founders maintain control of the company. The big disadvantage is that they must be repaid in the event of maturity or default. However, investors usually extend the maturity date until the next round of capitalization. They also have liquidation preference, even over preferred investors.
Y Combinator in late 2013 introduced an alternative to convertible notes that it called Simple Agreement for Future Equity (SAFE). The goal was to facilitate investment in startups through a standard document accepted by entrepreneurs and investors. SAFES can have a discount to valuation, a valuation ceiling, both or neither. The first of these could benefit entrepreneurs, provided they have the ability to raise a round at a valuation well above expectations at a later date. The valuation ceiling establishes a future indication of the valuation the startup could achieve in the next round. Investors benefit from having both the discount and the valuation ceiling in this instrument.
Another variable of the SAFES is the pre-money and post-money valuation, the former benefits the entrepreneurs since if they raise a significant amount, they will have a lower dilution derived from the previously established value. The post-money valuation usually benefits the investor since it sets a valuation ceiling, regardless of the amount raised by the entrepreneur in the round.
The startup may have multiple SAFES with investors, which may complicate the coordination of documents at the time of conversion and may also have multiple valuation Caps and perhaps pro-rata rights, increasing the complexity of raising additional capital.
When the startup raises a significant round of capital, usually from Series A onwards (over USD$10mm and upwards) it usually structures the investment as an equity contribution. At this point the startup will define a valuation by the investors and the rights they will have. The investors will participate in the preferred equity of the organization and the founders will retain the common equity.
- Preferred Stock
Investors entering a priced round in a startup gain access through preferred equity. This allows them to have a priority in the capital structure subordinating the common investors. Preferred equity investment requires further negotiation between the investors and the startup, as five main documents are usually signed: the share purchase agreement, certificate of incorporation, investor rights agreement, voting agreement, right of first refusal and resale agreement. This requires extensive negotiation of terms such as liquidation preference, protective provisions, board seats, preemptive rights, etc.
2. Common equity
The founders of the startup usually always own the “common equity”. At the time of the IPO all the different classes of shares will become one and the same to have the same rights.
Each round of capital has a price that each founder must pay. That price is somewhere between economics, how much money can be raised and at what valuation, and decision making control over the direction the company will take.
Every entrepreneur should understand the operation of Convertible Notes, SAFEs and Equity Investments, in order to make the best decisions when negotiating in each of the capital raising rounds. In addition, not to be left in the hands of the lawyer but always understanding the advantages and disadvantages of each instrument.
Note: please refer to the original publication at ALTO NIVEL: Decidiendo el futuro de tu startup: ¿cuáles son los tipos de contratos? (altonivel.com.mx)
Hector Shibata Salazar, adjunct Professor at EGADE Business School and Director of Investments and Portfolio at AC Ventures Fund
Ana Maury Aguilar, VC Investor at AC Ventures
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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