Investment is pivotal for realising the success of any business. With 75% of startups failing, it is clear that even when investment is found, we must bear in mind an exit strategy to safeguard our hard-earned capital. The following article discusses what investment means, why it is important for the growth of a business, different types of investment common in fast-growing tech startups and finally, the advised documentation for investing in businesses.
What is Investment?
An investment is the purchase of an asset, with the view it will at some point increase in value.
There is an important distinction to be made between saving and investing. Saving is associated with realising your short-term goals, paying for a holiday for example. Whilst investing is associated with actualising long-term goals, buying multiple houses for instance. You can ultimately either work or have your capital work for you. Investment is ultimately a way to increase your business’s, or personal, financial security.
Returns can be realised by:
- Exiting when the company is bought for more than you originally paid.
- If the shares increase in value and are subsequently sold.
- A portion of the dividends, if the company makes substantial gains in profit. This is often uncommon in startups as the capital is re-invested.
What do Investors look for?
- Momentum: They want to see real growth. Whether that be through profit margins, amount of employees being hired, or speed of product development. Thus, it is important to see investors early, and manage their expectations, as then the momentum is not only realistic, but also may surpass their expectations.
- Management: This is absolutely indispensable, in meetings it is advisable to lead with experience. Investors will think your presentation, and thoughts, are legitimate from beginning to end.
- Market Size: A quantitative assessment of the market, with timing and a plan of growth emphasised. Investors will use this to compare you with competitors.
- Money: Minimum ownership of the business by investors must be discussed.
What are the common types of investment for fast-growing start-ups?
The following four types of investment fall under the equity funding umbrella, which refers to the exchange of money for stock:
Different equity funding venture rounds include:
- Seed: This refers to the small amount of funding necessary to get a company off the ground, and is usually based just on the value of the concept stage. It generally comes from friends, family, or angel investors ( a term used to describe an investor, who provide capital for startups).
- Series A: This denotes the first round of stock offering to prospective investors and generally falls within the 2 – 5 million range in exchange for a 20 – 40% share. This round is intended to give a startup longevity of a few years, with investment of angel and boutique venture capitalist firms being the most likely.
- Series B: This denotes the second round of funding and is often based on whether the company has exhibited proven viability.
- Series C: Any successful venture round is given the subsequent letter in the series (D, E, F, G)
The following four types of investment fall under the debt funding umbrella, which refers to the borrowing of money to be paid back, regardless of a company’s profit margin when the debt is called in:
- Venture Debt: One of the differences between this and equity investment is that it must be paid back. It is usually used for companies that do not have the cash flow to fund capital expenses.
- Accounts Receivable Financing: an asset-financing arrangement where a company uses money owed by companies as collateral in an investment agreement.
- Asset Based Lending: a loan secured by collateral, whether that be inventory, accounts receivable or other balance sheet assets
The New Investment Crowd:
With the development of technology, one of the favoured new ways of gaining investment is the utilisation of Crowdfunding. Ultimately any individual can now invest in start-ups, only having to look on Crowdsourcing.org to access 3,000 crowdfunding platforms listed in its directory, and an endless number of startups looking for investors.
What is the necessary investment documentation for all parties?
Each investor and company should begin with asking for a timesheet from the other party. Although timesheets are not a legal promise to invest, it does:
- Stipulate confidentiality.
- Prevent company from looking for other suitors.
- Help negotiate the documents that follow.
A Timesheet supplies you with the means to calculate the economics of both parties (Pre-valuation, Post-valuation, type of financial security, dividend provisions, liquidation preferences, participation, and the option pool).
Following an assessment of the timesheets, the documents to follow are fundamental in creating a legally binding investor relationship:
- Stock purchase agreement: This sets an agreement that finalises terms/conditions, and tends to include the following:
- The definition of all major terms.
- The processes for purchase and sale of stock (itemises purchase price, allocation of tax between seller and buyer and dispute resolution procedures.)
- The representations and warranties of the seller and buyer.
- The matters relating to employees
- Provides details on indemnities for any costs that may arise due to a pre-transaction condition.
- The tax matters ( specifies special tax treatment either party may be entitled to).
- Investors’ rights agreement:
- Right to elect one or more individuals to the board of directors.
- Right to receive various financial and information reports.
- Right to have stock registered for sale in a public offering.
- Right to maintain percentage of share ownership by participating in future stock sales.
- Right to participate in sale of any shares made by founders.
- Certificate of incorporation: Legal document relating to the formation of a company or its corporation. In the UK, it typically includes:
- The full name.
- The registration number.
- The date of incorporation.
- The registered office location.
- The legal business structure of the company.
- Co-sale agreement and Right of First Refusal: usually refers to a right of other investors to make the preliminary decision to purchase shares being sold. Items typically negotiated include:
- Common holders. Generally investors will want large holders of stock to be party to a co-sale agreement.
- Exception to the co-sale agreement, usually specific share transfers to family members or for estate planning purposes.
- Minimum investor shareholding, company may want to limit the rights to investors who hold a minimum number of shares.
- Voting agreement: An agreement, or plan, under which tw or more, shareholders agree to pool their voting shares for a common purpose.
Overall investors are extremely inventive as they have to stay ahead of the curve. Therefore, new terms, and types of funding, continually emerge. Do contact Linkilaw for a free assessment. We would be happy to ensure that either; the type of investment is correct for your business strategy, or the business you wish to invest will likely provide a return.