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Legal implication: how a startup can properly raise investments at different stages of development

Legal implication: how a startup can properly raise investments at different stages of development

23 Oct 2020

According to CB Insights statistics, in almost a third of the cases, the reason for the failure of a startup is the lack of funds. It is not surprising that aspiring entrepreneurs often resort to raising outside investment. Alexey Sheverdyakov, a lawyer and a member of the Moscow Bar Association, will tell you how to minimize legal risks when conducting such deals.

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Typically, the development of a startup involves several stages:

  • Pre-Seed — testing an idea, creating an MVP;

  • Seed — achieving Product-market fit, searching for effective channels to attract customers;

  • Series A — scaling customer acquisition channels, product improvement, positioning and strengthening your market position;

  • Series B + — scaling the company, entering new markets, launching new products.

In the early stages of Pre-Seed and Seed, family and friends, business angels, crowdfunding and accelerator investors, and venture capital funds are usually the ones investing. During the Series A stage, a startup can be funded by venture capital funds, strategic investors, private equity funds and banks. During Series B + private equity funds, banks and the stock market often become external partners.

At the same time, each type of investor has different types of possible transactions to attract external funding. For the first group of investors (relatives and friends, business angels, crowdfunding investors, accelerator investors, venture capital funds), these are formats like purchasing and selling a share in the authorized capital / block of shares, an issuer’s warrant / option, mezzanine financing, as well as various loan types: convertible, profit sharing and bridge loan.

Strategic investors, private equity funds and banks normally purchase and sell a share in the authorized capital / block of shares, they also opt for mezzanine financing, bridge and subordinated loans.

Each type of investment deal has its own conditions, features and associated legal and financial risks.

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Legal implication: how a startup can properly raise investments at different stages of development

General legal specifics

The specifics of each type of investment transaction initially depend on whether the external partner is strategic or financial, as well as on the type of investment. With equity financing (purchase of a share in the authorized capital / block of shares), the investor becomes a co-owner of the company (founder / shareholder). With debt financing (bridge loan, profit-sharing loan, etc.), funds are invested only to generate income in the form of interest or part of the profit. The hybrid finance deal combines both types of investment and allows the depositor to convert the debt obligation into a share in the authorized capital / shareholding (convertible loan, mezzanine financing, etc.).

Depending on the type of investment, a startup, as a rule, enters into one of the main investment agreements with an external partner:

1. Stock Purchase Agreement — an agreement on the sale and purchase of a share in the authorized capital / block of shares. It’s a type of investment agreement that provides for equity financing. It’s the main document whereby the investor becomes one of the participants in the company.

2. Debt Financing Agreement is an investment agreement that provides for a loan to a startup in exchange for receiving interest or part of the profit. Its types are bill, bridge loan, profit-sharing loan.

3. Hybrid Financing Agreement is an investment agreement that combines debt and equity financing instruments. It allows you to convert a promissory note into a share in the authorized capital / block of shares. Its types are convertible loan, subordinated loan, issuer’s warrant / option, mezzanine financing.

The minimum set of documents that a startup approves with an external partner as part of any investment transaction usually includes:

1. Term Sheet is an agreement on the main terms of the transaction. It includes agreements on the main legal and financial parameters of the upcoming investment transaction.

2. Certificate of Incorporation is the founding document. For LLC and JSC it is the charter. It’s the main document defining the legal status of the company that secures agreements on its creation. It contains information about the size of the authorized capital, the number, value and categories of shares, the composition and competence of corporate governance bodies, etc.

3. Shareholders Agreement is a corporate agreement. For LLC it’s an agreement on the exercise of the rights of participants, for JSC it’s a shareholder agreement. It allows startup participants to consistently exercise their corporate rights: manage a business, acquire and alienate shares in the authorized capital / blocks of shares, etc.

4. Investors Rights Agreement contains provisions that ensure the protection of their rights to participate in corporate governance and obtain information about the company’s activities, as well as protect their rights from dilution of their share in business, etc.

5. Non-disclosure Agreement (NDA) indicates the information that is transferred to the investor and is considered confidential in detail.

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Legal implication: how a startup can properly raise investments at different stages of development

Benefits and risks of investing at different stages of startup development

Of course, when a startup is just beginning its journey in business, it is unprofitable and unsafe for the founder to give a large share (over 30%) to any investor. Besides, the alienation of such a share may complicate and even make it impossible for external financing in the future since the founder’s share gets diluted. This is also the reason why crowdfunding is gaining popularity among startups, because it has an important advantage: the ability to maintain full corporate control through debt financing, as in the case of raising funds from relatives, friends and acquaintances. For a business, crowdfunding has rather soft restrictions on the amount of possible investments, and the return often exceeds all expectations.

And yet, crowdfunding is only suitable for the very early stage — after all, an attempt to take money from an interested audience when a startup has already “gotten to its feet” is often perceived negatively. Therefore, later on entrepreneurs often resort to the help of business angels. Unlike venture capital funds, which tend to invest at a later stage, angels prefer to invest in the startup’s “adolescence”. The earlier an investor finances a project, the less money they need to invest and the more share they will receive. So, in 2004, Peter Thiel became one of the first outside shareholders of Facebook, spending half a million dollars. Eight years later, Thiel sold the shares and got $ 640 million for them.

From the moment a startup built its business processes, passed the breakeven point and scaled quickly, it basically stops being a startup. New and new partners join the successful company. At this stage, large players come into play, who, as a rule, need operational management of the business and membership in the board of directors (strategic investors, venture funds, private equity funds and banks). There are both pros and cons here. On the one hand, more reliable and experienced external partners come, with whom various risks are reduced, on the other hand, the share of the founder can rapidly get diluted, and he can lose corporate control. At the same time, even the presence of the cherished 51% is not a guarantee of security. Thus, the founder of the Banki.ru portal Philip Ilyin-Adaev (who owns 60% of the shares), in his December post on Facebook, accused a large investor (Russia Partners fund with 40% of shares) of trying to get him out of business. Despite the smaller number of shares, external partners received the formal right to remove the founder from the operational management of the company. They took advantage of his insufficient attention to the documents being signed and, in the opinion of the entrepreneur who went to court, initially built a plan to establish control over the entire business.

To avoid such situations, it is very important for a startup to be attentive to securing agreements and signing documents with investors. A founder can protect his rights, in particular, for operational management of a business, in the charter and corporate agreement, as well as in the regulation on the board of directors.

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When to involve a lawyer

Ideally, the sooner the better. In practice, when a new investor enters a startup, the package of necessary documents is wider than described above, and there are pitfalls in any of them. Typical templates that can be found on the Internet often do not reflect the full picture of a particular business. I would also advise to involve other experts in document development — for example, technology startups can use the services of IT specialists. It is best to entrust the supervision of the entire process to a professional lawyer with relevant experience.

23 Oct 2020

 

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