This blog is part 2 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.
In the first part, we explored what happens after you’ve decided to take the leap, focusing on the online angel investment process and using the Leapfunder convertible as a specific example. Now that we’ve seen the fundamentals of angel investing we will look into topics such as ‘caveat emptor’, the Leapfunder ‘SPV phase’ and the ‘exit phase’. We will also share some extra tips on how to avoid making basic angel investing mistakes.
Expectations when investing in a Startup: Part 2
Caveat Emptor is a financial term that should be interpreted as: Buyer beware! Essentially, it means “read the small print”. When dealing with investments, an investor always needs to carefully review the fine print because one small sentence can mean a world of difference.
I will give you an example. Some convertibles have an opt-out option built in, which means that at the end date of the convertible the investor and/or the startup have the option to decide whether the investment is converted into shares, or paid back in cash. As we know from Part I of this blog post, an investor usually invests with the desire to get shares eventually. So it is interesting to know that sometimes there is a clause in a convertible that states that at the end date of the convertible either party can decide whether the convertible transforms into shares, or is paid back in cash with interest (in essence, making it a loan). It is important to look carefully at this part of the contract: Will there potentially be repayment in cash? Will it happen if either party wants it or only if both want it?
If at the maturity date the startup has the option to repay in cash, investors will not get the shares they wanted. That could be a serious disappointment. The investors have endured the risk of investing in a startup but are only compensated by a return which he would get by investing in a loan. This is not how the risk/return mechanism should work.
If, however, an investor has the option to claim cash + interest back, then the startup may get into trouble if it does not have the funds available. If a majority of investors have the right to call back their money and opt to do so, this can result in an important debt burden for the startup. The startup would then need to start paying interest and repay the full funding amount within a few years, or even immediately, which would likely decrease its chances of success. Clearly, this would have negative repercussions for the startup (significantly increase their burn rate), and also for the investors who hold the remaining shares.
In the event that the convertible states that both parties have to agree on a cash repayment, then the repayment would only happen because both parties believe they benefit from it. In general, this seems to be the fairest for both parties and perhaps this should be an industry standard. So: dear investors and startups, always be aware of what it says about this matter in any convertible contract you sign. Leapfunder convertibles always convert to shares, unless both parties mutually agree that settlement should be handled otherwise.
Let us assume you have received shares and you can now proudly call yourself a shareholder. What exactly does this mean? With Leapfunder, the next phase is the Special Purpose Vehicle phase.
Special Purpose Vehicle (SPV) Phase
A special purpose vehicle is an entity which makes it possible to unify multiple investors into one. They are bundled together in order to make the process of holding shareholder meetings and gaining consensus easier. Let’s say a startup collects investment from 20 Angels. If an SPV were not used, the startup would have 20 investors on their cap table. In this case, a startup with 2 co-founders would have to invite all 20+2 investors to shareholders meetings, they would have to collect 20+2 signatures for official documents, and likely negotiate with 20 separate investors whenever something special needed to be agreed, etc… This will make the life of the startup and investors complex and it will consume much time.
If the startup has an SPV containing the 20 investors, there will be just 3 parties present at the shareholders meeting: the 2 co-founders and the SPV. This is why Leapfunder investment rounds almost always use an SPV. The Leapfunder SPV allows the SPV to be represented by one of the investors pooled inside it. This representative is generally one of the larger investors, chosen through a vote amongst the whole group. We have seen that typically most of the smaller investors are ‘passive’, meaning that not all 20 will want to be the elected representative. Since the representative has voting power the formal board positions within the SPV are predominantly just for administrative functions, and usually carried out by the startup itself.
Though investing in a startup can be done in about 5 minutes nowadays – especially with a system like Leapfunder – startup investment is still a long-term game. Waiting for a return on investment – or ‘exit’ – is usually a process that can take between 5 to 7 years. It is more likely that a startup will contact the investor for new funding, perhaps several times, before announcing that they have sold the business and the investor has made 10X their initial investment.
What possible exits can you have when you have come into an SPV with your fellow investors?
- You can sell your shares to other investors. The market for startup investments is not as liquid as for example shares of multinationals which are listed on the general stock exchanges. However, the market for startup investment is growing. Usually, the first interest is shown amongst the other investors in the same company, who may want to increase their position. Remember: there may be rules for offering shares which are startup-specific. Most startups have a first-refusal rule that requires you to offer any shares to other existing investors first.
- A larger company decides to buy the whole startup. In this case, the entire SPV will typically get an offer. Because of a possible drag-along in the shareholders’ agreement, you may be required to sell along with the other investors. Find out more on this in my shareholders’ agreement blog post.
- There could an IPO. That means that the company becomes listed on an exchange. In Europe this is rare, but it obviously means it will become much easier to sell any shares that you may hold.
- The startup can become a normal cash-generating company! A startup can decide not to be acquired or have an IPO. Of course, these two options lead to a direct return for the investors. However, if the startup is profitable it can use its own money to grow and can decide to pay out any remaining profit as dividend to investors. This will not create an immediate high return, like selling the shares would, but it can lead to nice a stable yearly income for the investors. In the long-term, this can actually work out better for everyone.
Let us imagine we have been through all of the phases and the startup has exited successfully, leaving you, the investor, an X amount richer than when you started. This is not the time to buy a house on an exotic tropical island, it’s the time to start all over again! Startup investing is something you can learn from only through experience, not textbooks. I always advocate that investors need to diversify their portfolio between 5 to 10 startups – or as many as your minds can handle! Most startups will fail, but investors need to count on the 1 to 3 that will generate a return greater than 10X the initial investment. When you are starting out, it is wise to invest smaller amounts until you gain valuable experience.
When you have finally exited from some of your investments: maybe it’s time to review new startups seeking funding. In doing so you not only increase the chance of becoming a better startup investor, but you also contribute to the health and success of the whole startup scene… and it’s good fun.
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