A Guide to Venture Deals

For investors and entrepreneurs to understand early-stage deal structures, valuations, and term sheets.

Ripple Ventures is an early stage venture fund based out of Toronto, with a focus on enterprise software startups in Toronto-Waterloo, Montreal, and Boston. Our goal as a pre-seed to seed stage fund is to help startups grow sustainably and achieve tangible traction for their Series A round.

We are operators first, investors second. What this means is that we work with our entrepreneurs every day, not once a quarter. The Tank is our incubator space where our portfolio companies work with us and see benefits such as monthly Tank Talks, on-the-go strategy sessions, and an environment to thrive with other companies looking to succeed.

As an early stage venture fund, we have seen and invested in companies using various types of deal structures including equity rounds, SAFE’s, and convertible notes. Each of these instruments is fairly different, and it’s important to understand why they are used or preferred by both investors and entrepreneurs.

Equity Rounds

This is the most commonly known method of investing — you give cash and receive shares of a company. For this deal structure, the company is valued (negotiated by the founders and the investors) and corporate structure documents are set-up. From what we’ve seen, around 10–25% of the company is attributable to the new investors after the deal has closed and shares are issued. Equity rounds are a lengthy legal process which can take months to complete, and thousands of dollars in fees. These can get complex with investors rights, voting structures, and liquidation scenarios, which is why it’s important to have a great legal counsel to support you through the process.

Advantages of Equity Financing

• The company has a corporate structure and other documents set up; founders are familiar and comfortable with the legal process
• Reputable investors on the cap table give the company credibility and can open doors to other investors/customers
• No covenants or financial constraints on the company post-raise like debt

Disadvantages of Equity Financing

• Immediate dilution of ownership for top management and employees
• Company and investors may have opposing views on the business
• High expectations for strong growth post-investment; may put too much pressure on the management team and employees
• Risk of pricing the company wrong (over-pricing) and can negatively affect the company in the future (i.e. down-round)

SAFE’s (Simple Agreement for Future Equity)

The SAFE was originally founded by Y Combinator to simplify the investment process between founders and VC’s/angels. The investors put cash into the company, but instead of receiving shares right away, the shares are issued at a later date, in connection with a specific event. A SAFE is not a debt instrument, it is an alternative to convertible notes.

Advantages of SAFE’s

• They are very simple (typically 5 pages long) and standardized by Y Combinator to reduce time and transaction costs for deals to close
• The company is not forced to set a valuation too early, only the valuation cap and discount are negotiated for this deal structure
• No covenants or financial constraints on the company post-raise like debt
• Receive the cash quickly and worry about how you’re going to get to the next round of financing

Disadvantages of SAFE’s

• No maturity date — the investors may never see equity or cash back from their initial investment
• Not a loan — once you invest in the company, they have no obligation to pay you back at a certain date as a convertible note would; it all depends on the next round of financing
• The company could just bootstrap (finance themselves off operating cash flows) and never raise money again, so investors may need to wait until the IPO or acquisition to see shares/liquidation

Convertible Notes

Convertible notes are a short-term debt instrument that converts into equity, typically in connection with a future financing round. Instead of receiving your typical principal + interest at the maturity date, investors hope to receive equity in the company at a much higher value.

A couple of terms to get familiar with:

• Valuation Cap: this effectively caps the share price at which the note principal + interest converts into equity if the share price is favorable to investors after considering the discount rate.
• Discount Rate: this applies to the share price when the valuation of the round is either below the cap or up to the cap * (1 — discount). It rewards investors for taking on additional risk early on in the business.
• Interest Rate: instead of cash, interest accumulated will add onto the principal amount, increasing shares issued upon conversion.
• Maturity Date: if the company has not yet seen an event that triggers the conversion of the note into shares, then the company will be liable to repay note investors if they choose to call it. Sometimes, notes will just get extended to a later maturity date if investors believe in the company (must be mutually agreed upon by the company and investors).

Advantages of Convertible Notes:

• Investors get downside protection as it is a debt instrument
• Not forced to set a valuation too early on in the company
• Simpler than equity arrangements to execute, therefore lower transaction costs and timing needed

Disadvantages of Convertible Notes:

• May never convert into equity if a subsequent round isn’t raised or if the company fails
• Valuation cap and discount can complicate future equity raises by anchoring price expectations (i.e. if the cap is $5M, then the valuation for this round must be higher…?)
• Limited governance rights compared to an equity investment

Valuing Startups

Company Has Revenues

• Leverage Revenue Multiples: EV/ARR, EV/Sales, EV/EBITDA
• This is not the best option as revenues are fairly early and immaterial at this stage of the company (typically below $1–2M in ARR)
• It’s hard to find good comparable companies or precedent transactions (fundraising deals with disclosed valuations/metrics) to benchmark off of, and there may not be many other companies doing similar things

Company Has No Revenues

• Value based on the size of the round and new ownership: as said before, typically seed stage investors (new money in) will receive around 10–25% of the company post-deal. Therefore, the valuation can be derived from dividing the new money in by the expected ownership. For example, if a company raises $1M from VC’s and the expected ownership post-deal for the new money is 20%, then the post-money valuation of the company is $5M.
• This too is not the best option as there is no benchmark or real rationale used to determine the value of a company’s assets.

There is no perfect way to value a pre-seed to seed stage start-up. Precedent fundraises and negotiations dictate and drive the valuation of a company.

Term Sheets

Term sheets are simply a contract that outlines the key terms of a deal between the startup and an investor and does not represent a legal promise to invest in the company.

These documents are fairly lengthy and full of… well, terms. Here are some of the key concepts that are often negotiated between investors and founders that drive the preceding legal documents post-term sheet.

• Board Seats: Formal addition of investor(s) and independent board members in addition to the founder(s) on the board
• ESOP: Usually 10–15% of an option pool created in aggregate to issue to new employees, advisors, etc.
• Vesting: Withholds shares owned by founders and key team members and released back to owners over a period of time to keep personnel committed to the company
• Liquidation Preferences: Upon liquidation (i.e. bankruptcy or acquisition), returns money to preferred shareholders before common shareholders at a 1X rate typically
• Participation: Upon liquidation, investors get their liquidation preference returned first, and the remaining distributions are allocated based on percentage ownership
• Anti-Dilution: Protects investors when a company issues equity at a lower valuation than in previous rounds (full rachet/weighted average)
• Right Of First Refusal: The right to enter into a transaction with a person or company before anyone else can (i.e. sale of shares, assets, or the entire company).
• Drag-Along Rights: Enables a majority shareholder to force a minority shareholder to join in on a deal (i.e. get acquired by a larger company)
• No-Shop: Cannot bring deal terms to other investors to drive up valuation or get more favorable terms

Finally, there are five general documents that follow a term sheet:

• Certificate of Incorporation
• Stock Purchase Agreement
• Investor’s Rights Agreement
• Right of First Refusal & Co-Sale Agreement
• Voting Agreement

Overall, the term sheet is a mechanism that helps investors and founders guide the deal conversation, be a point of reference to create corporate legal documents during the process, and help make decisions after the deal.

Thanks for reading and feel free to give us a clap! Follow us on Medium for anything tech and VC related, updates on our fund, and more.

Written by Dominic Lau, Associate at Ripple Ventures