An excerpt from The Venture Capital Law Review, 1st edition
Capital raising by start-ups
In Argentina, many start-ups are looking for funding abroad (after friends and family have invested in the project). It is very common for them to do this through a company incorporated in a foreign jurisdiction (usually Delaware) to facilitate the investment of their foreign investors and avoid unwanted exchange rates and entry problems and outflow of currencies which unfortunately must be analyzed when conducting business. in Argentina.
The first steps in raising capital when starting a business are equity financing. At this point, friends, family – and those who trust the project that are often called “fools” – dare to invest. Angel investors, incubators and venture capital funds, depending on whether the start-up is in the pre-seed stage (average investment amount of US $ 25,000 to US $ 200,000) or seed stage (average amount investment of $ 200,000 to $ 1 million) are also key players at this stage. When an equity investor agrees to invest in a start-up, they are investing in exchange for ownership of that company. This financial arrangement is different from debt transactions where the lenders are repaid on the terms they have agreed to.
Once a business has developed a track record and understands how to monetize the business by having a concrete business plan, consistent revenue numbers, and long term profit expectations, that business can go for Series A financing. As a rule, well-known venture capital firms participate in these rounds. Subsequently, if the companies are prepared to succeed on a larger scale (i.e. if the companies have potential and after the Series A funding is successfully completed), the Series B funding and even from the C series are generally used. In these cases, as the business has turned out to be successful and therefore the investment becomes less risky, more investors are ready to enter. In Series C, groups such as hedge funds, investment banks, and private equity firms are also involved.
The legal documents for instrumenting equity financing are as follows:
- Termsheets: set the framework and the main conditions of the investment, which may or may not be binding depending on the case. They speed up the entry of funds while negotiating the entry of investors who complete the round.
- Subscription agreements: specify the conditions for subscribing to shares and the terms for disbursing the investment. They repeat, in more detail, the terms already agreed in the term sheet.
- Shareholder pacts: regulate the rights and obligations of the investor (now a shareholder) in the decision-making process in order to take care of his investment and the relationship with other investors and sponsors or founders.
There are also other ways to raise capital through debt. Bridge financing takes place when investors invest in a start-up company with a short-term loan to help it reach the next round of financing, on the basis that they will receive their money. Start-ups use bridge financing or a “relay round” to help them secure a large round of financing such as equity financing. In general, they are instrumented by loans convertible into shares.
The various alternatives that are used when looking for debt financing are discussed below.
i Convertible debt instrument
It is basically a loan convertible into shares if certain events occur (for example, a change of control or a maturity date). So, if the business fails, the investor is in a better position by having a debt obligation than by having equity in the business.
The convertible debt instrument allows the discussion of the valuation of the company to be postponed until the closing of a new investment round. In addition, by having (1) a valuation ceiling (the maximum valuation of the company to which the investor can convert his loan into shares) and (2) discount clauses (set to be applied on the valuation reached by the company at the time of converting the investment in cases where the start-up does not reach the cap), founders or early investors suffering from a dilution of their stake in the company can be avoided.
Some downsides are that it will burden the business with debt, and it is still unclear whether its balance sheet will support it. Also, insofar as the conversion is not exercised, interest will accrue. It also does not grant political rights (votes) insofar as the option is not exercised (it can be exercised until expiry); and investors do not participate in the distribution of dividends until the option is exercised. Another drawback is the very high transaction cost involved in negotiating the clauses of this document.
ii Simple Agreement for Future Equity (SAFE)
Created by the start-up incubator ‘Y Combinator’ in 2013, the SAFE is a contract for the subscription of future shares of the company.
Unlike convertible debt securities, SAFE does not have a maturity date and only triggers its conversion into shares if certain events occur.
Thus, in the event of conversion, it is capitalized in the company and will give the right to shares, which will be calculated by taking as reference valuation the negotiated ceiling or the actual stock market valuation by applying the discount (depending on the negotiated value).
SAFE does not earn interest or pay capital, so it can be equated with equity and not debt. It will be automatically converted into equity in the event of an investment, it does not confer political rights (votes) if the conversion does not take place, and investors participate in the distribution of dividends even before the conversion. This document is intended to be short, clear and to reduce negotiation and drafting time, as well as the expenses for professional fees of the corresponding legal advisers.
In any case, it is important that the bridge financing is approved by the board of directors of the company, and to verify that no special authorization is required (for example, from shareholders, if there is a pact shareholders signed).
iii Keep it simple security (KISS)
KISS is an alternative to SAFE and was created for the primary purpose of enabling an investor to invest money in the company and to receive the right to buy shares in a future equity round when It happens.
KISS includes a maturity date, like the convertible note, but does not accrue interest for the investor. There is also an “equity version” of KISS, with no maturity date or interest, which is considered a happy medium between convertible note and SAFE.
Different from SAFE, KISS contains a “most favored nation” clause, which allows the investor to obtain better securities in the future if they are issued by the company.
As mentioned, these modes of financing are commonly used abroad. As far as Argentina is concerned, it is advisable to understand the venture capital operation to assess which is the preferred financing structure to try to receive any of the aforementioned alternatives in accordance with local laws.
From a different perspective, with the promulgation of Law No. 27.349 on Support for Entrepreneurial Capital in 2017 (the Entrepreneurship Law) and the creation of the Entrepreneurial Capital Development Fund, great opportunities have opened up for development. of Argentinian projects, from tax advantages. and loans for venture capital institutions, the granting of business loans and the establishment of crowdfunding platforms.
Crowdfunding was born as an alternative to traditional financing methods which do not always take into account the realities experienced by local entrepreneurs. What is new and advantageous about this method of financing for entrepreneurs is that, on the one hand, the interest rates are generally lower than in traditional financing and, on the other hand, it allows investors to be reimbursed not only in money, but also in shares, products or other forms of remuneration.
There are three main types of crowdfunding which depend on the type of reward obtained by the investor:
- Crowdfunding rewards: Investors will receive a product or service in exchange for the money invested.
- Crowdfunding by donation: the investor does not expect a return in exchange for the money (often linked to non-profit companies or social actions).
- Equity Crowdfunding (also called “equity”): Investors receive shares of the company in exchange for their funding.
Crowdfunding platforms in Argentina are regulated by the National Securities Commission, which reports to the Ministry of the Economy. There is no specific law on crowdfunding, but it is regulated by the law on entrepreneurship.
The Entrepreneurship Law also established the FONDCE – a trust fund for the development of entrepreneurial capital to facilitate the financing of entrepreneurs in Argentina. A loan of up to 250,000 pesos with no interest rate payable for up to six years can be requested. However, as these initiatives are relatively new, we will continue to see their impact over the next few years.