Wednesday, November 9, 2016

FundersClub book: Understanding Startup Investments

Just recently, FundersClub, an online venture capital portal open to accredited investors, published a guide on startup investments. The guide is available online at their education center.  It's a great quick read for first time investors and startup founders who are raising capital for the first time.  The guide focuses on common vs preferred equity, SAFEs and convertible notes, - the instruments used to invest into early-stage startups.  To me (and many other lawyers, I am sure) FundersClub is best known as the author of a famous SEC no-action letter  from March 2013 that clarified the SEC's position on activities that did not require broker-dealer registration.

The guide is written in an easy-to-read language and is divided into five chapters. Below are several valuable lessons (but I encourage to read the entire guide):
  • Typically, seed and early-stage investors invest into SAFEs or convertible debt, and investors into later-stage startups (Series A or later) invest into preferred stock in priced rounds.
  • VC investments are not just about the money; they are also about the much needed connections and advice.
  • Convertible debt investors are not really giving a loan to the company, - they are effectively buying a percentage of the company's equity.
  • The concept of "total outstanding equity" of the company also includes shares issuable upon conversion of all convertible securities issued by the company, as well as outstanding options given to employees.
  • Founders typically hold common stock, investors - preferred stock, and employees - options that give them the right to purchase shares of common stock.
  • Preferred stock has a liquidation preference, - i.e., these investors get paid first if a liquidation event occurs (such as acquisition or bankruptcy). Preferred stock holders also typically get pro rata and anti-dilution rights.
  • Founders and investors nowadays typically agree on a broad or narrow-based-weighted-average anti-dilution rights rather than the full ratchet anti-dilution formula because they protect the investors while not excessively diluting common shareholders.
  • Convertible securities used in startup investing can be either convertible debt or convertible equity (SAFE - invention of Y Combinator, or KISS - invention of 500 Startups).
  • Startups prefer to issue convertible securities if they are not ready to establish a valuation.  Also, convertible securities deals are cheaper to execute.  
  • SAFEs differ from convertible debt in that there is no maturity date or interest rate, but caps, discounts, and conversion upon next qualified financing are still there (although caps and discounts are optional).
While FundersClub guide is a great read for the first timers, for an in-depth study of these topics, I recommend checking out the following two sources: the blog Startup Company Lawyer  and the book titled "Venture Deals" (note that a new edition of this book is coming out soon).

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law. 

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