We are launching a series of publications dedicated to reviewing the legal aspects of venture capital financing. In the first issue, we will talk about the logic behind round financing and the economics of venture capital investments.
Logic behind venture capital investments
Round financing is a distinctive feature of this model, which distinguishes venture capital investments from other models such as bank financing or private equity (including private equity funds).Round financing means that the company raises new funds at each stage of its development. Each new round implies a new inflow of capital for the development of the company at the new stage. The average development cycle of a technology company can be divided into the following stages:
- Pre-seed: at this stage there is no ready product or business solution yet, and investments are aimed at its development and hypothesis testing.
- Seed: the product already exists and the raised funds are used for its market testing and marketing.
- A round: at this stage, the company has already confirmed product-market fit and applies the raised funds to its own growth and scaling up.
- Further rounds (B, C, D, E, etc.): usually do not have a specific goal and are most often focused on international expansion, entering new markets or developing new products.
Referring to rounds using letters is well-settled, so they are also reflected in legal documents. The logic is as follows: as a rule, a new round investor receives preferred shares of the company of a new class, and it is customary to designate each new class of shares by a separate letter in legal documents. Therefore, for example, a round B investor receives B class shares.
Stage-by-stage fundraising under the venture model is explained by the economic specifics of startup development. First, the creation of a new technology company always involves a fairly high risk level. It often happens that a company goes bankrupt between rounds before it has had time to raise new funds. In order to reduce risks for investors, the next round of financing usually comes only after the company has successfully met the challenges it faces at a particular stage of its development. Second, investors differ from round to round. While early rounds are characterised by the participation of small private investors, small funds, syndicates of small investors, later rounds are invested by large funds, institutional investors and corporations.
Company valuation and investor shares
The key point in raising funds is the valuation of the company, as it determines the size of the investor’s stake and, accordingly, the level of control over the company’s operations. This issue will be the focus of negotiations between the investor and the company. The negotiations result in a term sheet that usually reflects the so-called pre-money and post-money valuations, i.e. valuations before and after the investor’s funds are invested.The mathematical calculation of the investor’s share is quite simple: if a company raises USD 2 million with an initial (pre-money) valuation of USD 8 million, then after the investment (post-money) its valuation will be USD 10 million, the investor’s share is, respectively, 20%, as the amount invested by it is 20% of the company’s post-money value.
The challenge in valuating a company consists in balancing the interests of the founders and investors:
- If the company is valuated too low during negotiations, the investor’s contribution relative to the value of the company will be higher, hence the investor’s stake in the company will be larger and the founders’ stake will be diluted.
- If the valuation is too high, it may be difficult to raise the next funding round, because to do so, the company will have to increase its valuation further during negotiations.
If a company fails to raise funding at a valuation higher than at the previous round, which is often the case, it will have to raise investment at a lower valuation (eg, during the first round it is valuated at the level of USD 8 million and at the second round it is valuated at the level of financing 6 million, in light of the economic environment). These rounds are referred to as down rounds.
To protect the interests of current investors (anti-dilution protection), down rounds provide for a number of special arrangements in the development of legal documentation. We will provide more details on the specifics of down rounds and such arrangements in one of the next issues.
On average in venture capital investing, the size of the stake an investor receives is around 15-25% (the median value often tends towards 20%). During later rounds, the investor’s stake may be even lower, around 12-15%. These values are lower than in other investment formats, such as joint ventures or private equity deals. We note however that the abovementioned figures are approximate, as they are highly dependent on the geography of deals and macroeconomic conditions.
Legal documents structure
The stages of investment and related legal arrangements play a key role in determining the future of a company. Early stages often involve greater risks, but also have greater potential. Late rounds, while involving less risk, require more complex and layered legal structures. Legal documents that accompany the venture financing process vary from round to round and become more complex as it moves into later stages:- Simple forms of contracts are usually used in the pre-seed round. First, this is due to the fact that at this stage a substantial part of startups cease to exist. Second, investors at this stage are usually private investors and their syndicates, so the development of complex documentation at this stage is cumbersome.
- For example, the US market at the pre-seed stage is characterised by the use of the SAFE (Simple Agreement for Future Equity) contract model. This model was developed by market players to simplify first investments in business to the maximum. This form is publicly available. Usually, SAFE does not provide for the stage of negotiations, save for agreeing upon the size of investments and valuation cap.
The SAFE model is not similar to classical contracts used in transactions. SAFE provides that an investor contributes a certain sum of money in a company in exchange for the right to receive shares in that company if certain conditions are met. In a simplified form, in the SAFE model, the investor transfers money to a company, assuming that in the future this company will be able to attract a full round of equity financing, which will allow the investor to convert its investment into shares in the company. Therefore, SAFE is a risky model, as the investor does not become a shareholder of the company until the time of conversion (swap), which may or may not occur in the future. The lack of repayment distinguishes the SAFE model from a convertible loan, as discussed below. - At the early stages of venture financing, a convertible loan agreement is also commonly used. What distinguishes it from a conventional loan agreement is that it provides for a mechanism to convert the debt (i.e., the amount that the company should return to the investor who financed it) into shares in the company if certain conditions are met. Therefore, unlike the SAFE model, it is initially assumed that the investment will be returned to the investor.
Typically, debt/equity swap is tied to a further qualifying round of financing. The standard terms of a convertible loan in venture capital financing are the conversion floor and conversion ceiling, which are limits on the valuation of a company that are used to calculate the number of shares an investor will receive in the next round of financing. - In Russian practice, a simple investment agreement and a corporate agreement (often also quite simple) or a convertible loan agreement are used at pre-seed stages.
Often at the first stage of financing the participants consider it inexpedient to develop even these documents. In this case, investments are made simply by making a contribution to the company’s authorised capital and amending its articles to provide at least minimal guarantees for investors. - At the seed and subsequent rounds, full-fledged legal documentation is already being developed. The structure of such documentation is usually different in the US, Europe and Russia:
- In Europe, there is a fairly straightforward documentation structure consisting of a subscription agreement and a shareholders agreement. Sometimes the provisions of these agreements are combined into one investment agreement.
- In Russia, the structure is similar to that in Europe. Typically, an investment agreement is concluded that regulates the mechanics of making a contribution to the company’s authorised capital and contains appropriate representations and other rights and guarantees for the investor. A corporate agreement regulating the management of the company is also concluded. Separately, a new version of the company’s charter and corporate resolutions approving the additional contribution to the company’s authorised capital are negotiated separately.
- In the US, the structure of legal documentation may be vastly different. In early rounds, transaction documentation usually includes (i) an investors’ rights agreement, (ii) a share purchase agreement (SPA) between the company itself and the investor, and (iii) an amended and restated certificate of incorporation.
At later rounds, the documentation structure may become more complex and may include the following documents, which we will cover in more detail in our next issues:
- voting agreement;
- investors’ rights agreement;
- right of first refusal and co-sale agreement;
- share purchase agreement, SPA;
- amended and restated certificate of incorporation.
The structure of documentation in the US is so complicated compared to European and Russian transactions for a number of reasons. Documents in American transactions are more sophisticated in principle, the structure of transactions is usually more complex, so if you combine all of the abovementioned documents into one or two, you will have too massive a document, which will then be difficult to edit and negotiate. That said, each document serves a different function, and the parties to these documents may differ. For example, small and early investors may lose some of their rights in subsequent rounds, so they are not always a party to the right of first refusal or co-sale agreement.
The industry has developed templates of these documents, which are often used in practice. These templates are available at the website of the National Venture Capital Association.
Exits
Venture financing most often involves the return of investment through the sale of the company to a strategic investor, its going public (IPO) or other forms of investor exit from the project, especially if the investor is a venture capital fund. This is due to the fact that venture capital funds have an investment cycle and a horizon for investment return. For example, for the first few years the fund actively invests, then for a few years it actively grows companies and helps them with attracting new investments, and then there comes a period when the funds withdraw from the projects in which they invested (exit). At the same time, there are also so-called evergreen funds, which do not have such a distinct cycle.Since the fund has a goal of exiting the project after a certain number of years, exit is an integral part of the venture cycle. The methods of exit vary. Sometimes the fund sells its stake entirely at a later round to other investors. Sometimes the management of the company buys out the investor’s (fund’s) stake at some stage (management buy-out, MBO), but this method of exit is the exception rather than the rule for venture capital financing. This usually happens when a company transitions from a venture capital business model (i.e., one that provides for active growth) to a dividend business model (i.e., one that provides for low growth but constant profit generation).
If we go back to the well-known venture-backed companies that we talked about at the beginning, almost all of them have either gone public, been sold to a strategic investor, or are still in the venture cycle and will be sold or go public sooner or later. For example, Apple, Google and Zoom went public and are now public, while What’sApp and Slack were sold to strategic investors. Accordingly, investors in these companies received their returns by selling the shares in these companies acquired in the investment rounds.
Sometimes investors, on the contrary, increase their stake in subsequent rounds in order to obtain more shares in the company before exiting, which happens when the company is growing rapidly and shows good financial results. The right to participate in further rounds is called a pro rata right (or a pre-emptive right). There is a distinction between the American pro rata right model and the European mode:
- the American model provides that the current investor can buy all the shares of a new round and essentially lock it in. This model is considered to be quite aggressive;
- the European model provides that the current investor’s right to participate in the next round is pro rata to the percentage of shares it owns in the company (i.e. if an investor owns 4% of the shares, it can acquire up to 4% of shares in the new round).
In addition, to ensure investor exit, transaction documentation usually contains provisions on the right of investors to demand the sale of the company or its assets (drag-along), i.e. to require minority participants to join the transaction. In addition, US transactions often include a provision on the investor’s rights to register its shares to participate in the IPO (registration rights).
Our next issue will be dedicated to an overview of such contractual tool in venture capital investing as the liquidation preference, a clause that determines how funds will be distributed in the event of a company sale or other exit scenarios. We will explain how these terms work and why they are so important in negotiations between companies and investors.
