Introduction to venture capital deals in IT

So, a potential investor has been found and the first negotiations on the deal are about to start. Where to start?

Term Sheet

The first document you will encounter. It is traditionally drawn up after negotiations with the investor and records the top-level agreements of the parties.

Term Sheet is a non-binding document, in which the parties fix the very first and basic terms of the future transaction: the amount and terms of investment, the company's management procedure, confidentiality, etc. In essence, it is a kind of "gentleman's agreement", by signing it, the parties demonstrate their intention to co-operate and fix its basic conditions.

It is important to remember that although the terms of the term sheet are used by the parties when concluding the transaction, they can be, and often are, changed in the course of the transaction (with the mutual consent of the parties, of course).

Let's understand what a convertible loan and equity financing are

There are two main ways to provide investment to a company: convertible loan and equity financing.

A convertible loan agreement (CLA) is the easiest, quickest and cheapest (in terms of transaction document preparation costs) way to invest. - is the simplest, fastest and cheapest (in terms of transaction document preparation costs) method of investment. It is used in initial (seed) rounds, for small amounts (up to 1M) and involves providing a startup with investment in the form of a loan with the investor's right to either get the loan amount back or convert the loan into shares in the company in the future upon the occurrence of certain events.

Such "certain events" may be the raising of the next (larger) round of investment, sale of the company, expiry of the loan, and others.

Thus, at the start, the investor lends money and does not become a co-owner of the company. In this case, only one document is signed - the CLA itself.

Another very similar instrument is SAFE (simple agreement for future equity). Under SAFE, the investor also provides the investment now, but the right to receive a share in the company arises in the future and only upon the occurrence of events agreed upon by the parties. But unlike a convertible loan, SAFE does not allow the investor to claim back the loan amount.

SAFE was developed by startup accelerator Y Combinator, and you can see the standard forms of this agreement on their website.

The second option is equity financing

In essence, it is a transaction to acquire an equity stake in a startup, whereby the investor immediately becomes one of the owners, unlike a convertible loan. This investment instrument is carried out at later rounds of financing and, as a rule, at an investment amount of 1M or more.

There are two main options for equity financing: cash-in and cash-out.

With cash-in, the investor buys a stake in the startup and becomes its participant (i.e. co-owner of the business) on an equal footing with the founders, while the funds received from the sale go into the capital of the company itself.

In this case, the company issues additional shares to which the investor subscribes on terms defined in the transaction documents.

In a cash-out purchase of a stake in a business, the investment does not go into the capital of the company, but goes directly to the founders, i.e. the investor buys their stake (all or part of it). This option is less common.

In our practice we have also encountered mixed variants of investment (cash-in + cash-out), when part of the stake was bought from the company and part from the founders.
In the case of the option of investing through the acquisition of a stake in a start-up company, it is assumed that the parties will have to agree on a much larger number of rules of "living together", a larger package of documents will be required and a mandatory due diligence procedure will be required.
The number of documents in equity financing depends on the particular jurisdiction, usually a minimum of two:

  • Share Purchase Agreement

  1. Share subscription agreement (SSA), where shares are purchased on a cash-in or
  2. Share purchase agreement (SPA), when shares are acquired on a cash-out basis.

These documents record such key terms of the transaction as the number of shares to be purchased by the investor, the transaction price, the order and timing of the investment, the terms of closing, the representations and warranties of the funders, and the liability of the parties for breach of terms.

  • Shareholders' agreement (SHA) - an agreement between shareholders containing the rules for the management of a company. Depending on the jurisdiction, such an agreement may be split into several separate documents.

    For example, in the USA, these are Voting agreement, Right of first refusal and co-sale agreement, Investor rights agreement. These documents define the procedure for decision-making, i.e. business management, the procedure for alienation of shares to third parties, as well as mechanisms aimed at protecting the interests of the parties.

We will tell you about the content of the transaction documents and the work of individual mechanisms aimed at protecting the interests of the parties in the following articles.

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