Formalizing investment in startups, drafting an investment agreement or convertible note agreement

Seeking out funds is the easiest part of launching a startup - it’s getting there that’s tricky. Forming a team and keeping it together, developing your product, bringing it to the market, making sales, surviving competition - that’s the hard part. Without proper experience and a clear plan of action, attracting investment is all but impossible, and even if it happens, neither the founders nor the investors would benefit from this.

For an experienced lawyer, legal support of investment is no rocket science but still a complex and demanding task, since such projects and the structure of such arrangements are often unique.

 

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Options for agreements on investment in a startup

Convertible note (or convertible loan) agreement

The startup receives a loan from the investor and can pay him back in cash with interest or in company shares. The formula for converting the debt into shares is determined in the agreement. Company valuation is done in accordance with the procedure agreed on by the parties.

Buying a stake in a company under the cash-in principle (the money goes to the company)

Under the cash-in principle, the investor buys from the project a stake under a stock purchase agreement, with the money transferred to the company’s account.

Loan agreement

Classic loan to a legal entity. The startup receives a loan from the investor or a loan provider.

Joint venture agreement

 

Best jurisdictions for a startup from an investor’s perspective

The countries below have the most convenient legislation (mentioned in the order of priority, since every country has its pros and cons):

  • USA (Delaware, California);
  • UK;
  • Cyprus;
  • Netherlands;
  • Switzerland;
  • Hong Kong.

Stake valuation

It can be done two ways — the parties can do it themselves in the course of negotiations, or they can use the services of an appropriate firm.

Stake valuation methods

  1. Based on incurred expenses.
  2. Based on the total value of all assets. The key asset in IT business is the IP, which is why valuation based on assets is not particularly accurate.
  3. Based on revenue projections which may or may not come true.
  4. Based on comparable companies. There might not be any, of course. Even if you have already developed a Facebook killer, it won’t get the same valuation as Facebook would without an appropriately large user base.


 It’s best to use the vanishing optimum method, which involves the use of several valuation methods at once.

The wrong way to formalize investment in a project

  • Verbal arrangements.
  • Without an agreement just because "we trust each other".
  • In a jurisdiction that does not offer appropriate legal guarantees.
  • Without a lawyer that has at least 5-10 startup investment deals under his or her belt.

Most frequent screw ups

  • Constant postponing of the project’s release date.
  • Unfeasible or absent marketing strategy.
  • Improperly calculated key metrics — LTV, MOM, Retention.
  • Weak legal structure.
  • 50/50 arrangement with the investor.
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