What to Expect When Investing in a Startup: Part I

Dear Investor,

This blog is part 1 of a step-by-step description of what you should expect when investing in a startup. We talk about investing via Leapfunder but many of the points made here are generally applicable.

The first of the two-part series explains what happens after you’ve decided to take the leap, focusing on the online angel investment process and using the Leapfunder convertible as an investment example.

My previous blog, 7 tips for first time startup investors, gives an overview of what to look out for when making your first startup investment decision and is a useful read for novice startup investors.

What to Expect when Investing in a Startup by Leapfunder

Expectations when investing in a Startup

The First Step: The Execution Phase

Congratulations! You have chosen which startup to invest in and have entered the exciting world of angel investing. Now you first need to make the investment; this is the execution phase.

To invest online, you will go online and follow the simple steps such as filling in the total investment amount, basic personal information and confirming you have read and accept all required information. Remember that the investment will have to be personalized, as only a single person/entity can be the formal owner of one convertible.

Your investment is anonymous to the general public. Only the startup will be able to know who/how much has been invested. After you have completed the investment process a chartered accountant will check all the records before you receive your convertible.

You are now a convertible holder! The real fun is about to begin.

What’s Next: The Convertible Holder Phase

So now you’re a convertible holder, what does this mean?

You have just signed an agreement with a startup: you have committed capital to the startup, which they will use for all activities mentioned in their information memorandum. They can spend it on whatever they need to make the startup as successful as possible.

What do you get?

A convertible is in principle a security which has the potential to become equity. With your money you have bought a convertible: it’s a thing that you own and can even sell again to another party, though this is rare.

What happens for you next?

Firstly, you have the right to receive a monthly update summing up the startup’s progress. Information sharing is vital to the relationship between investor and startup. You can sit back, relax and read these newsletters or you can get more involved. In practice, when angels invest in a startup they often start working for the company in one way or another; becoming a mentor, lecturing on a specialty of their field and opening their network of people of interest.

For instance, accountants or financial specialists will guide the startup with budget or pricing mechanisms, marketing experts explain traditional marketing and growth hacking, HR specialists help the startups hire new staff. Remember, Angel Investor, this is your investment and your crucial involvement can directly make or break the success of the startup.

What more can you do?

An investor can sell the convertible at any time by finding a buyer, obtaining approval from the startup and settling upon a price. You may use the nominal amount or the nominal amount + interest, or another amount you agree upon with the buyer – at your discretion.

…But let us assume you do not want to sell your convertible just yet and the startup you invested in is successful! Then, a ‘qualifying event’ will happen.

Business Angel Networks in Europe

And then: the Qualifying Event Phase

The ‘qualifying event’, ‘conversion event’ or ‘trigger event’ is the event that causes the convertible to be transformed into shares. What conversion means: the convertible will cease to exist and the Angel Investors will receive shares in return. These shares will be placed into a Special Purpose Vehicle (SPV).

The valuation of the startup is not set from the start. Rather, the convertible postpones the final valuation to this qualifying event. The qualifying event is chosen so that at this point a reasonable valuation can be made. It is nearly impossible to establish an accurate valuation in the early stages of a startup. The qualifying event, which generally occurs between 1,5 to 3 years after the convertible has been issued, enables a more sensible valuation of the startup and will ultimately determine the number of shares the convertible translates into.

As seen previously a convertible is a contract between an investor and a startup, formalized as they wish. Therefore, the qualifying events can be defined according to the desire of both parties, but there are some typical definitions that are used.

The Leapfunder convertible uses the three most standard qualifying events, which are:

1. The next funding round

When a startup attracts an investor investing cash for equity, it is considered a qualifying event. Not every equity investment round will count: the size of the round has to be large enough. The convertible contract must state what the minimum size of a round is that can trigger a conversion. The size of a trigger investment can differ, though a commonly used minimum investment size for early stage startups in Europe is around 100K-500K.

As most startups are cash-flow negative in their first couple of years, they will eventually seek fresh funding. If a startup is cash-flow positive but still wants to boost growth, it can also do another round of funding.

When the startup accepts an investor’s terms and the size of investment is enough to be a qualifying event, the valuation occurs. A valuation happens because a shares-for-equity deal is taking place. For instance, if a startup wishes to sell 10% of the company for 100K, the implied valuation is of 1 million. With this same share valuation the convertibles will be transformed into shares. Of course the convertible investors get some additional benefits like a Discount, Interest and Cap, but these are explained elsewhere.

To avoid confusion: the qualifying event is a sufficiently large cash-for-equity transaction, from one single investor. Thus, when a new round of convertibles is used as funding it is not a qualifying event. When the funding amount comes from multiple small investors it is not a qualifying event.

2. Acquisition

When another company or large investor purchases the startup, a majority of the shares, or its key assets, it is considered a qualifying event. This is sometimes called a ‘change of control’. Of course the startup may accept or decline an offer. If the startup accepts, a valuation of the shares occurs because you can see what price is being offered for the shares. Based on this share price the conversion will happen.

3. Final conversion date

If there is no qualifying event because of an equity investment or a change of control, then another type of qualifying event is usually built in the convertible for safety. After all: if the mentioned qualifying events never happen the convertible will simply increase in value with the interest indefinitely, without converting into shares. As an investor this is clearly not what you want.

Your goal is to one day own shares. It could possibly happen that a startup does not need extra funding because they are doing well and decide to bootstrap, and perhaps there is no sale to a third party either. For this reason, a convertible will often contain a final conversion date, at which point the convertible is automatically converted into shares. Of course at this point there is no acquisition or funding round from which a valuation can be taken. This is commonly solved by hiring an external professional party to establish an independent valuation. With Leapfunder there is also the opportunity to negotiate the share price with the Leapfunder investors as a group first.

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We’ve just seen the fundamentals of Angel Investing, particularly on Leapfunder. In the second part of the blog we will explore topics such as what happens in the ‘SPV phase’, the ‘exit phase’ and we will give some extra tips on how to avoid basic mistakes. With all that you will be on your way to being an expert investor!

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