Venture Capital Financing
Venture Capital Business
The term of “Venture Capital” is very popular among the small medium enterprises and start-ups player. These entrepreneurs/start-ups need resources in order to expand their business, in other words, they need business funding as most of these entrepreneurs/startups couldn’t secure a loan from Bank due its negative cash flow, VC is always considered for them to secure the funding. Why VC? Because most of the VC does not require a payback like Bank does, also the loan interest from the Bank might not friendly to these entrepreneurs/startups.
It is quite safe to assume that Venture Capital plays a vital role to entrepreneurs/startups business history.
These days, we can classify VC industry into two types, the Corporate VC (CVC) and the traditional VC. The difference between CVC and VC is mainly at its investment strategy. While traditional VC usually only provides capital injection to the start-ups, the CVC also provides access for the startups to enter into new potential business objectives, more exposure and value-adds that helps startups strengthen its position in the competitive market, this also can be considered as the other reason why entrepreneurs/startups prefer to get funding from VC rather than the Bank.
- Financial Instrument for VC Funding
When it comes to the instrument for VC Fund, we need to be clear on “what stage the startups is currently at?”
Seed Stage to Early Stage
Seed stage round is the earliest round of financing, also It is well-known that the Seed Stage startups is on the Death Valley Curve — during this period, startup companies must operate without any existing or less existing revenue, only relying on their initial invested capital. The most investment instrument that VC commonly used on this stage is Convertible Note (CN).
CONVERTIBLE NOTE
A Convertible Note is a form of loan that converts into equity. This instrument is commonly used by VC or Angel Investor (“Investor”) to invest in the seed stage startups. Based on common practice, there are some Key Terms for CN:
- Pre Money Valuation — Investors need to know the current valuation of the startup when they decided to invest.
- Interest Rate — just like a regular loan, because it is basically a loan, so there is an interest rate, however it stays more often in the 3% -5% range annually. The purpose of the interest rate when dealing with CN is usually to ensure the Investor at least receive a minimum return or to reduce to risk of financial inflation during the term of the CN.
- Maturity Date — same as above, because it is basically a loan it also has its maturity date for startups to make a repayment or to convert its CN into Equity (if the startups may not be able to secure Equity Financing Round that triggers the CN to be converted) — the maturity date of CN is quite variable in the range of 2 up to 3 years, depending on the mutual arrangement between the startup and the Investor.
- Discount — it is more like a reward to the Investor when it comes to the follow on funding in the form of Equity (Equity Financing Round). Seed Stage Investor takes great risk with their monies, the earlier the investment the greater the risk, so the CN will be converted at a reduced price (%), which means they will have the equity of the startups in way cheaper than the Equity Round Investors subscribed.
- Conversion Method — as mentioned-above, VC usually does not require payback from the startups, instead they want their money (CN) will convert into equity and gains money multiple from its investment. There are 2 ways of CN Conversion:
- Automatic Conversion — when the startup be able to secure its Equity Financing Round, or exit event (VC also set qualification of equity financing round that triggers the conversion, such as the minimum fundraising amount), the CN will be converted into equity along with the interest accrued and discount. VC also set a “Cap” or maximum valuation for the conversion rate to avoid unreasonably high valuation determined by the new Investors — also may result in greater number of shares.
- Optional Conversion — this conversion is commonly at the Investor’s discretion whether prior to the equity financing round or if the startup has reached the maturity date and has not received any equity financing from new Investor.
- Conversion Price — the price per share calculation upon the conversion
- Liquidation Preference — any Loan made by the Company must be priority over the Shareholders in the event the Liquidation Event occurs to the company. This is why investing with CN is less risky than investing with Equity.
- Most Favored Nation — this is the downround protection for the Investor, the term that allows the Investor (existing) to elect to inherit any more favorable terms that are offered to any subsequent investors following the existing investor’s investment.
- Repayment — it is not a conversion, it is a payback. Usually comes if there’s any breach or any action by the startup that may cause a material adverse effect to the startups.
SAFE (SIMPLE AGREEMENT FOR FUTURE EQUITY)
SAFE was introduced by Y Combinator as an alternative to Convertible Notes in late 2013,since then it has been used by most of YC Graduates startups for fundraising.
SAFE is a little bit different than the Convertible Notes, it is neither a Loan nor Equity, it is basically a Hybrid of Loan and Equity. Many startups these days are more comfortable fundraising with SAFE than with Convertible Notes.
There are some main keys for SAFE:
- SAFE has no Maturity Date — means if there is no equity financing round that triggers the conversion into Equity, the SAFE will remain as SAFE and the startups has no obligation to make any repayment (unless, if they put a Redemption clause on the Agreement)
- SAFE has no Interest Rate accrued — because it is not a Loan, so there is no interest rate, which is more favourable to the startups.
- SAFE has no valuation cap — it means if the new Equity Investors determine high valuation of the startup, the SAFE has to be converted at such valuation, no maximum capped value.
- Discount — SAFE Investor will receive cheaper price per share upon the conversion at the Equity Financing Round.
- Most Favoured Nation — if the startups have another SAFE is issued, let’s say “SAFE B” has more favourable terms than “SAFE A”, by MFN, SAFE A is entitled to ask the startups for the same terms with SAFE B.
Conclusion, SAFE is much more favourable to the Startups than the Investor. Although, what’s still confusing me:
- How’s the order of asset distribution upon the liquidation preference? Since SAFE is neither a Loan nor Equity?
- From financial records perspective, is it recorded as a Warrant?
Early Stage to Growth Stage
On this stage, the financing round happens when startups has a proven business model, stable revenues, and has achieved product-market fit. As they may already have the growth metrics plan, they will need more capital injection from the Investors in order to expand the business.
The most common instrument that VC uses for this round is: Equity / Shares
Equity / Shares
Equity represents the value of Investor’s (Shareholder) ownership at the Company. The company issues equity/shares to be subscribed by the Investor based on the valuation of the company. There are 2 types of shares issued by the company: (1) Preferred Shares; (2) Common Shares; (3) ESOP Shares. While the Common Shares are mostly owned by the Founders of the Company, the Preferred Shares are owned by the Investors.
Most VC requires the company to issue the Preferred Stock for Equity Financing Round, Why? Because this class of Shares has some special rights, such as voting rights and Liquidation priority on top of the Common Shares, in other words, less risk compared to Common Shares.
When Investing with Preferred Shares, the company will provide the Share Subscription Agreement (SSA) & Shareholders’ Agreement (SHA) to be signed by the Investors and the Company.
Share Subscription Agreement
This agreement sets out the terms and conditions of the Transaction to be made by the Investor to the company. Key Terms of Share Subscription Agreement:
- The number of shares, class of shares that the company has issued — you will find this on the recital of the agreement, it also determines how much the valuation of the company based on the issued shares.
- The Subscription — it consists of the price per share that the investors may subscribed, the number of shares, the resulting ownership, the name of the Investors and also the class of shares.
- Conditions Precedent — acts, and/or deliverables which must occur or completed before the agreement comes into force or before the payment is made by the Investor, for example : obtaining all the necessary approval by the board and shareholders of the company, etc.
- Completion Date — the dead line when the company must completed all of the conditions precedent required by the Investors.
- Closing Date — date of the payment made by the Investors and the deliverables by the company and the investors, such as: share certificate, wire receipt, KYC documents, etc.
- Terms of Payment — the payment process made by the Investors, usually include the period of time for the investors to wire the money.
- Confidentiality — both the Investors and the Company must keep all confidential information, and must use their best efforts to not make any unwanted disclosure to the other party.
- Costs and Expenses — who will be responsible for the expenses and costs incurred in relation to this Agreement, such as: legal fees, consultant fees, etc.
- Representatives and Warranties — the current situation of the Company — more like the disclosure of information that the company is aware of such as, the establishment, the authorized person, licenses, litigation matters, debt conditions, business, etc.
- Termination of Agreement
Shareholders Agreement
This Agreement sets out the rights, obligations, as well as the limitation attached to the Shares owned by the Shareholders:
- Board Composition — this clause sets out the number of the Board seat at the company and whether the Shareholder is entitled or not to appoint and maintain a Board seat — also containing the procedure of appointment & removal of the Board.
- General Meeting of Shareholders — the General Meeting of the Shareholders shall be held (at least annually) as per the requirement by the law. This also sets out the minimum quorum and the procedure of the GMS.
- Voting Rights — the Investor need to ensure that the Shares they are in includes the voting rights, so when it comes to the material decision, the Investor can vote on such matters.
- Information Rights — one of the most important things, the Investor usually requires the company to provide them with the progress of the company and all other material information, such as: financial statements (monthly / quarterly / annually)
- Transfer of Shares — sets out the requirement of the Shareholders who intends to transfer / sell / dispose of their shares of the company.
Tag Along Right / Co-Sale Right — a contractual obligation to protect the minority shareholders, if majority shareholders and/or the Founders (no minimum threshold for the Founders) of the company intends to sell or transfer of their shares to a third party (ie: if the transaction made by the Shareholders will result the buyer holding more than 50%), it gives the minority shareholders the right to participate in the transaction (prorate based)
Drag Along Right — if there’s a third party buyer and its resulting ownership is more than (let’s say 50%) this allows majority shareholder to drag the minority shareholders to participate in the transaction, the triggers of drag along rights are:
Change of Control — any change in the ownership of more than 60%
Trade Sale — the sale of all or substantially all the assets of the Company; any merger, acquisition consolidation, or exclusive licensing & Intellectual Property Rights to the third party.
Right of First Refusal — if any Shareholder intends to sell / transfer / dispose of its shares, the shares must be offered to the existing shareholders before offering to the third party.
6. Pre-Emptive Right — if the Company intends to issue new shares, the Company must offer to the existing Shareholders to participate on a prorated based before offering to the third party.
7. Redemption — Redemption is when a company requires shareholders to sell a portion of their shares back to the company, or vice versa. to redeem shares, it must have stipulated up front that those shares are redeemable (example: if Event of Default occurs, or if the Company not be able to secure exit for the next 5 years).
8. Anti-Dilution — to protect the existing shareholders, the right to maintain their ownership at the company. if the company issues shares in the future less than the price per share the Shareholders subscribed (commonly using the broad based weighted average calculation)
9. Confidentiality — both the Investors and the Company must keep all confidential information, and must use their best efforts to not make any unwanted disclosure to the other party.
10. Exclusivity — when the company requires the shareholders and its founders to not, with or without intention, to be the key person or the shareholders at the competitors or similar companies.
11. Board and Shareholders Reserved Matters — this includes all the action made by the Company usually related to material decision, capital expenditure, loan matters, amend the number of board seats, appoint & removal of the board, merger, acquisition, disposal of assets — all the mentioned action sets out on the Reserved Matters must have prior approval from the Board and/or Shareholders.
Tips to Startup Companies!
There are some steps that you might need to consider or prepare to get funding from VC firm.
- You really need to know how the VC funding works. As you may know, VC tends to invest in companies that they find promising because they expect the Return of Investment will be achieved in a couple of years (usually 2–4 years). Not every company can achieve that kind of growth. If you don’t plan on embracing that goal and the strategy to achieve it, don’t waste your time talking to VC. The first step is to analyze the future growth of your company and come up with realistic projections for the coming years. Based on the size of your company in the coming years you can decide whether to go in for VC funding or not.
- Most typical VC’s instrument for investment are Convertible Notes and Equity, but recently VC also use SAFE as its investment instrument, you really need to understand how these instruments work and make sure which one is more suitable for your company, and of course its upside as well as the downside.
- Make sure that the products/services your company provide based on the market demand, not just following the hype to establish Startups company.
- Get your pitch ready! One of the key success for VC funding depends on how good you can pitch to them. So it is absolutely necessary to prepare the “winning-pitch” to get their attention.
- Balanced teams define startup culture, which can make or break your business. Having a reliable team also demonstrates to VCs that their potential investments have management that works like an efficient machine.
- You can jump into the Startups event, or Investors events to directly reach them for “speed-dating” (i.e: Tech in Asia, Echelon, RISE, etc…) and make sure you’re 100% prepared!