What should you focus on during investments? What types of investment rounds and investors are there? Find the answers below. At the same time, you will find out about the stages of a typical VC investment and some practical advice for negotiating with an investor.
When trying to get an investment, it is very important to prepare for the whole process to conclude it as soon as possible, and to lay a good foundation for the relationship between the founders and investors.
When negotiating with an investor, a startup should definitely not be in a subordinate position – just as a startup needs an investor, investors need startups.An investor’s purpose is to invest. If a startup has attracted one investor, it is highly likely that it will also attract others and investors will compete for the best startups.
Therefore, the startup should not jump after the first investment, but choose the investor carefully. The ideal investor should, in addition to money, also bring know-how, experience and contacts (smart money). Conversely, an investor who is just trying to micromanage the startup can do more harm than good.
Before investing, startups often participate in one or two acceleration programs, in which they have the space to validate the idea, build MVP, training, get feedback from mentors and potential investors. Accelerators are often focused on startups either within some industries (e.g. healthtech, urban innovation) or startup stages (e.g. idea validation, post-market-launch phase). Well-known accelerators include Perry Talents, Future Now, Uplift, Startup Wise Guys, Healthcare Lab, Civitta’s Challenger, Startupyard and ReactorX.
1. Investment Rounds
Investments are often discussed in the context of various investment rounds, which we refer to as Angel (Pre-Seed), Seed, Series A, Series B (C, D, etc.). Their name, on the one hand, reflects the stage of the startup (idea phase, MVP, paying customers, etc.) and, on the other hand, the amount of investment and the type of investors who will invest in each stage. There may be a bridge round, between the investment rounds, to help the startup reach a higher stage and sometimes compensate for external factors (e.g. the corona crisis). You can read more about it in our blog on Investment Rounds.
2. Types of Investors and the Differences between Them
We divide investors into seven categories, which determine the size of the investment, investor expectations, the process of negotiations and the scope of investment documentation:
- Founders – the first investors who, in addition to their time and energy, also invest their savings into lower startup expenses.
- Family and friends (FFF – friends, family and fools) – investors in the early stages of a startup, from whom the startup has the greatest chance to easily get an investment, however, it is necessary to consider the impact on personal relationships. In this case, it is appropriate to write a simple donation agreement or a loan agreement and also think about the tax implications.
- Accelerator – some accelerators invest in their graduates from tens to hundreds of thousands of euros. This investment may be more beneficial than an investment from an angel investor who has nothing, other than financing, to offer. There are several programs on the market that already require equity for participation in the program – participation in them needs to be carefully considered, as this is not a market standard.
- Angel investor – expects a sophisticated business plan and standard investment documentation. They can enter together with a VC fund or another angel investor, within one investment round. Compared to a VC fund, negotiations can be quick and flexible, as the decision-making process is in the hands of one person. The amount of investment from an angel investor is usually in tens of thousands of euros.
- VC fund – a typical player in a startup environment, which, in addition to financing, also brings other benefits such as a network (contacts) and experience from other startups. It pays to monitor VC fund portfolios and choose one that has experience with your business. A complex multi-month investment process, including an audit, more extensive investment documentation and sometimes regulatory requirements, is associated with the fact that VC funds often have public funding at their disposal. The amount of investment from a VC fund is usually around several hundred thousand euros.
- Corporate (strategic investor) – some larger companies such as banks have their innovation sections which invest in startups. The investment of a strategic investor is considered “smart money“, as in addition to financing, it can bring specific know-how from its field, clients and also the cooperation of the corporation with the startup. On the other hand, the process of negotiating and preparing documents tends to be lengthy and inflexible.
- Private Equity Fund – a conservative investor that focuses on longer-running companies that generate profits and therefore startups are not their typical target group.
3. How Does the Investment Process Work (Stages of the Investment Process)?
The course and duration of the process depend on the requirements of the investor, but also on how the startup is prepared. Especially with a VC fund and a corporate, it is necessary to expect a process of several months, so start building relationships with investors in advance before the end of the runway. Don’t be afraid to contact investors before launching the product. Investor consultations can speed up the investment process.
The investment process at a VC fund and a corporate consists of successive stages, some of which may take place in parallel:
- Pitch – the startup will appeal to selected investors with a pitch deck, in which it will present its traction and potential. This may be followed by a video call or a face-to-face meeting to discuss the business plan in more detail.
- Beginning of negotiations – the startup and investor will determine the basic parameters of the investment such as the valuation of the startup, the amount invested (ticket), the position of the founders and possibly the relationship with other investors who invest in this round.
- Term Sheet – although not fully legally binding, it is used in further negotiations and is rarely changed. Therefore, be careful about what you sign at this stage. The term sheet contains an agreement on the following points in particular: the amount invested, the investor’s share in the startup and the startup’s valuation, the form of investment, the rights associated with investor’s share and the share reserved for members of the startup team (so called equity pool or ESOP).
- Audit – the investor will check the situation in the startup from a legal, financial and sometimes technological point of view. The startup will make available the relevant documents that are reviewed by the investor. The process is faster if the startup is ready, i.e. the documents are scanned (in the final signed version), saved and sorted. The main areas of legal due diligence are intellectual property rights, corporate structure and contracts with key suppliers and customers.
- Drafting of investment documentation – This step varies according to the form of investment (see below – Investment methods). The costs of preparation are usually borne by the startup, which then pays for them from the investment provided.
- The signing of documentation – the documentation must be signed by executives of the investor and the startup (managers or members of the board of directors) and usually also by the founders themselves as natural persons, if the documentation regulates their position. Some documents need to be written in the form of a notarial record. After signing the documentation, the investment amount will be sent to the startup account.
- Provision of investment – very often, and especially for higher amounts, the investment is not provided at once, but is linked to the achievement of certain milestones defined in the investment documentation and released gradually. It can therefore take several months or years to invest the full amount.
4. Methods of Investment
The earlier the startup stage, the simpler the method and the investment documentation. The method also depends on the type of investor – a VC fund or corporate will certainly have higher requirements for the complexity of documents than family and friends. The basic ways are:
- Contribution by a shareholder (founder) – a shareholder can invest in the startup when incorporating in the form of a contribution to the registered capital, which is entered in the commercial register or (even later after the incorporation) in the form of a contribution into the capital fund. For this purpose, simple documentation is signed between the startup and the founder. In a Slovak company the contribution is approved by the general meeting, while in a Czech company, consent of the company’s director is sufficient. Loans are also available, although they may be impractical depending on the startup.
- Convertible loan – is a loan that is converted into the investor’s share in the startup under certain conditions agreed in a convertible loan agreement (CLA). It is most suitable for the early stages of a startup, or for bridge financing. The aim is not to repay it, but to convert it into a share in the startup in the next investment round on favourable terms to future investors. A convertible loan is presented as an easier way to invest, but even here it is necessary to think about several parameters (see below). More information can be found in our separate blog Convertible loan vs. equity round.
- Share buyout – this is not a common method, it is used especially in early-stage startups when an investor buys a share off of inactive founders. The investor repurchases the share on the basis of a share transfer agreement, so that their share in the registered capital corresponds to the share that the investor is to hold after the investment. The rest of the investment amount will usually be provided by the investor as a contribution into the capital fund.
In addition to the documentation above, shareholders and the investor often sign a shareholders’ agreement, which regulates their relationships and obligations beyond the statutory partnership agreement, which is public and is stored in a collection of deeds. In this case, the documentation is relatively extensive and more difficult to prepare. More information in our article Founders’ Relations.
5. Negotiations between an Investor and a Startup
Practical advice on finding investment and negotiating with an investor:
- Suitable investor: they are a long-term partner, so it is important that the startup and the investor have the same “blood type”. They should be aligned on basic priorities, mutual expectations and the way they work on a day-to-day basis. At the same time, assess the level of the smart money that the investor brings to the startup.
- Audit: do not hide anything and prepare all documentation related to the startup, during due diligence, so that it is clear and comprehensive (have signed versions, not working versions). In most cases, digital versions of documents will suffice.
- Negotiation: set priorities for negotiation (startup valuation, the position of founders, investor control powers, etc.) and be prepared to compromise in less important areas when negotiating.
- Supervisory Board: Unlike in the US, the Supervisory Board is also established for convertible loans before conversion. When negotiating a term sheet, bargain for (i) maintaining your control over the entry of new investors, and (ii) maintaining autonomy in day-to-day operations, i.e. do not allow the investor to micromanage you. Founders’ control over the entry of new investors and the autonomy of founders in day-to-day operations is standard in the US. This is not the case in the EU yet, but it is gradually changing.
- Share value: the value of the share that the investor acquires during the investment depends on the stage and situation of the startup, while the founders should retain a sufficient share (especially in the first stages). Beware of significant dilution of the founders’ share too soon, it could prevent further investments, because, in the eyes of investors, the founders would be less motivated. Here is an overview of the optimal share for investors by round: Seed 10-20 %, Series A 15-25 %, Series B and C 15-30 %
- Anti-dilution: both the investor and the founders can protect themselves against future dilution of shares, i.e. in the case of a new investment round, by equalizing the share of the founder or investor to their original value. However, some dilution is expected, so these rules must be set in a balanced way.
- Liquidation preference: determines the method of distribution of the proceeds from the sale of the startup (or share of the profit), on a basis other than pro-rata (i.e. according to the ratio of share/number of shares). In the first place, the investor can get a multiple of his investment (typically 1x, but sometimes 2x depending on the situation of the startup). If a “non-participating” liquidation preference has been agreed, this investor no longer participates in the distribution of profits (or, if the share of profits is higher in the pro-rata distribution, the liquidation preference will not apply). If a “participating” preference has been agreed, the investor, after the preference is paid out, also participates in the part of the profit that remains undistributed (double dipping) – this option is not very common and should be avoided if possible.
- Legal services: the cost of legal services typically ranges from 1 % to 8 % of the amount invested, with the percentage decreasing with its amount. The costs are covered by the startup.
- Standard conditions of a convertible loan:
- Interest – 5 to 10 %
- Maturity – 18 to 24 months
- Conditions that trigger the conversion – (i) another investment round from another investor in a certain amount (qualified financing), (ii) change of control over the startup, and (iii) maturity of the loan
- The calculation of the valuation of the startup during the conversion works with (i) a valuation cap, which represents the minimum amount of the share that the investor can acquire, and (ii) a valuation discount on the share compared to the price paid by the investor in the next investment round.
Download the list of investors in CEE HERE.