In previous postings (here and here), we introduced the topic of raising capital for start-ups in the US and Ukraine and explained the definition of crowdfunding and how it is implemented in Ukraine.
This article focuses on specific instruments for the legal formalization of agreements between investors and start-up and their use in Ukraine.
It should be emphasized that there is no specific and unambiguous contract or agreement that can be used to formalize agreements between investors and start-ups. In order to create a model form of a contract that would be easy to comprehend and thoroughly control the key aspects of the agreement between the parties, startup accelerators and groups of interested investors have taken advantage of this circumstance.
Among the main instruments that are widely used in countries with Common law legal systems, the following can be distinguished:
Convertible Loan (Convertible Note);
SAFE (Simple Agreement for Future Equity);
KISS (Keep It Simple Security).
It is worth starting with the convertible loan, as the other two mechanisms were constructed considering the Convertible Loan’s basic legal concepts.
Although the other two mechanisms were built with consideration for the fundamental legal principles of the convertible loan, it is worthwhile to start with this one.
Convertible Loan is an investment instrument that involves an investor lending money to a start-up under pre-agreed conditions (interest rate, loan repayment term, terms of debt conversion into startup shares), and the start-up has the option to transfer its shares to the investor rather than repaying the loan.
The following crucial terms are included in the standard form of a Convertible Loan (Convertible Note):
Loan amount;
Maturity date;
Interest rate;
Conversion terms;
Most Favored Nation Clause.
The first three terms are typical, even under Ukrainian law. The most interesting relates to the conversion terms.
Typically, the Discount Rate is included in these terms, which is used to calculate the value of the shares for a particular investor at the time of conversion. This provision compensates the risks of the investor who invests significant funds at the riskiest stages of the start-up’s investment life cycle (pre-seed and seed stages), when the start-up idea may not “take off”.
For example, if at the maturity date, the startup shares will be traded at a price of $10 per share, and the convertible loan agreement will include a 20% discount, the investor under the agreement will be able to demand either full loan repayment or convert the loan into shares with a discount applied. The final value of one share for such an investor will be $8.
Also, the conversion terms could set a limit on the estimated start-up valuation when attracting venture capital, at which point the loan is converted into a specific amount of start-up shares (Valuation Cap).
For example, the contract provided for a company valuation of $10 million. Later, the next investor assesses the company at a higher value, let’s say $15 million. In this case, the early-stage investor can use the provisions of the agreement and purchase company shares at a valuation of $10 million.
If the agreement provides for both a Discount Rate and Valuation Cap, the investor is given the right to choose the most attractive conditions for converting his/her loan into shares.
The Convertible Loan agreement may also include Most Favored Nation Clause, which means that if the early-stage investor invested $100,000 in the start-up at a valuation of $2 million, and then the start-up attracted additional investments of $100,000, but at a valuation of $1 million, the early-stage investor has the right to demand the most favorable investment conditions for his/her investment (in this case, a valuation of $1 million).
The Convertible Loan’s primary advantage over other instruments is its high level of investor protection, which gives investors the right to demand repayment of the supplied loan even in the event of a start-up failure.
SAFE (Simple Agreement of Future Equity) is an agreement developed by a famous start-up accelerator Y Combinator in 2013. It is a convertible security, similar to a convertible loan, that is used by start-ups to raise capital from investors. A SAFE is a simpler and quicker alternative to traditional equity financing, as it does not involve the issuance of shares at the time of investment. Instead, it is a promise to issue shares in the future upon the occurrence of certain triggering events, such as a future financing round or an exit event.
The main terms of SAFE are similar to those used in Convertible Loan (Discount Rate, Valuation Cap), but unlike Convertible Loan, investments through SAFE are not loans, so the agreement will not include interest rates or maturity date. Instead of the maturity date, SAFE includes provisions for the most favorable conditions (Most Favored Nation Clause).
Depending on the terms, SAFE can be divided into the following types:
SAFE: Valuation Cap, no Discount;
SAFE: Discount, no Valuation Cap;
SAFE: Valuation Cap and Discount;
SAFE: MFN, no Valuation Cap, no Discount.
The main advantages of SAFE over Convertible Loan are:
the simplicity of the terms, which allows to save valuable time for investors and start-ups;
allows for quick fundraising through crowdfunding platforms;
does not require additional lawyers to develop it. SAFE, developed by YCombinator lawyers, is published on the accelerator’s official website and can be used by anyone;
focused more on protecting the interests of the start-up.
KISS (Keep It Simple Security) is an agreement developed by a well-known American venture capital fund and start-up accelerator 500 Startups in 2014 as a response to YCombinator’s SAFE, and is a combination of certain elements of Convertible Loan and SAFE.
The essential terms of KISS may vary depending on the type chosen.
Currently, KISS comes in two versions:
Debt Version. It is a simplified version of a Convertible Loan with the main essential terms: maturity date and interest rate;
Equity Version. It’s similar to YCombinator’s SAFE in that it doesn’t qualify as a loan and doesn’t have terms regarding the maturity date or the interest rate.
In general, the following essential terms may be included in the KISS:
Loan amount;
Maturity date;
Interest rate;
Conversion terms;
Most Favored Nation Clause;
M&A exit provision, which provides for the terms of investment return in case the start-up is sold before the next round of investment or exit event (usually a multiplier of x2 of the invested amount + interest on the funds used (relevant for Debt Version);
Major investor rights provision, which states that an investor who has invested in a start-up through KISS of not less than $50,000 is considered a major investor and, if the start-up attracts additional investments, has the right to priority additional investment.
Overall, KISS can be considered a “golden mean” between Convertible Loan and SAFE, and depending on the type chosen, it can protect the interests of the investor or the start-up.
So what is the situation with these instruments in Ukraine?
In a previous article, we already mentioned that due to the entry into force of the Law of Ukraine “On Stimulating the Development of the Digital Economy,” some investment instruments for attracting and legally formalizing investments have become available to Ukrainian start-ups: convertible loan, option.
However, national legislation still does not provide for an adapted version of the above-mentioned instruments that could be used, for example, to attract investments into the LLC-resident of Dіya City.
Notwithstanding, Ukraine operates on the principle of freedom of contract, which allows for the conclusion of any agreement, the terms of which do not contradict the current legislation of Ukraine. Yet, it’s still unclear how these contractual instruments would actually be put into practice.
Conclusions:
Without a doubt, the absence of legislative backing for convertible securities like SAFE and KISS in Ukraine significantly complicates the procedure for attracting investments in start-ups and forces founders to seek alternative mechanisms, which complicates the procedure itself and creates additional expenses for the start-up.
Considering the rapid development of the IT industry, we are confident that in the near future, legislative gaps will be eliminated and Ukrainian start-ups will be able to use leading legal instruments to attract investment.