Startup Equity Financing: Investor Perspectives

You may be someone interested in investing in startup shares. Alternatively, you may be a startup founder who wants to gain insights into investors’ considerations when making startup investment decisions. The general goal of investing in startup equity is to get an early foothold in a successful venture. At the same time, startup equity investors should minimise the risk that comes with investing in startups, which are inherently risky. This article will consider investor perspectives in startup equity financing. 

Maximising Upside Potential and Minimising Downside Risk 

Startup investors commonly speak in terms of upside potential/downside risk when it comes to equity financing.

Upside refers to the potential to share in a profitable business’s future growth. This commonly means obtaining shares for a discount price relative to future equity financings. You as an investor may then sell your shares if the business is purchased or goes public. If you are a successful startup investor, you can turn £1m to £100m. This is provided you invest in the right startup. 

However, the vast majority of startups fail to achieve their growth targets. This either leads to massive devaluations in price or the outright failure of the business. Should this occur, in the absence of downside protection, you are likely to lose some or all of your investment. 

Case Study 

Consider the following scenario. 

WeCo Ltd: Different Perspectives 

You have identified WeCo Ltd as an investment opportunity. WeCo intends to raise £1m in seed funding. The company plans to conduct three more financing rounds before it goes public in seven years. 

Based on your modelling, you determine that if WeCo hits its growth targets, your investment will be worth £50m at the point of an IPO. 

However, a more pragmatic model suggests that the company may not hit its valuation targets. Instead, its pre-IPO valuation may be closer to £25m. 

More cynical models suggest that if WeCo fails to develop its product within the next three years, it will struggle to achieve more than £10m in valuation. In this case, it is unlikely to go public. Accordingly, you would write down the value of the company as £8m. 

The most negative forecasts would be where it fails to develop the product at all. This would essentially write off the value of investments to less than £1m. 

Downside Exposure

If you exchange £1m for just ordinary shares, you obviously stand to grow your capital considerably if the business meets its targets. But the pessimistic forecasts would either see your investment grow at sub-par rates or be written off entirely. 

In all cases, achieving a return on your investment requires the startup to achieve a measure of success up to seven years in the future. You are unlikely to unlock any value in your investment until then. This is because startups rarely pay dividends to ordinary shareholders. Nor are you likely to find a willing buyer of your existing shares at a competitive price until the IPO. 

As you can hopefully see, your downside exposure is intolerably high, at least at an initial investment of £1m. In an ideal world, you should be able to achieve some combination of the following objectives:

• receive some return on your investment before the IPO in seven years; 
• minimise the risk of your investment being written off; and 
• participate more fully in the success of the business when it becomes clearer in the future if this is likely to happen. 

If you have a competent investment adviser, they can help you achieve those objectives through bespoke transaction structuring.

Structuring Your Investment 

Convertible Loan Notes

The earlier the company is in its growth cycle, the less likely it is to succeed in meeting its end goal, which is typically an IPO or buyout. Therefore, your downside exposure is at its highest in the earlier stage. Accordingly, you may wish to initially structure the terms of your investment as a loan rather than a strict equity investment. 

This is because financial creditors like banks and loan noteholders obtain stronger rights of repayment than shareholders. As you may know, obligations contained in a loan agreement to make interest payments or repay the capital sum are legally binding. Shareholders have no similar right to demand payment under an ordinary share issuance. 

Notably, well-managed startups with stable cash flows and expense management can typically service regular interest payments ranging between 5-15% on the value of the loan. 

Additionally, you can structure the terms of the loan note so that you obtain the right to convert all or some of the loan notes in the future. This gives you automatic rights to acquire shares either for free or at a deep discount when the company’s future growth is more assured. 

Example of Convertible Loan Notes

To illustrate, suppose you loan a company £1m structured through convertible loan notes due to mature in five years. 

You negotiate a term that allows you to convert up to 50% of the outstanding debt at the time of the next fundraising round into ordinary shares. Otherwise, the loan notes mature in five years’ time or the next fundraising round — whichever comes first. 

Assuming the notes paid 5% in interest, over the course of five years, you would receive £250,000 in interest payments. 

If, in three years, the company manages to raise a strong fundraising round, odds are its performance will have continued to improve. You may therefore choose to convert £500,000 into shares before the fundraising. Due to receiving a discount on the price you pay, you effectively acquire the equivalent of £650,000 worth of shares at a 30% discount. 

However, if the company does not secure another fundraising round in five years, you can demand the startup repay the £1m when the loan notes mature. This ensures you protect your downside exposure. 

Preference Shares 

Structuring startup financing with strong investor upside historically meant startups would issue investors preference shares. Assuming the startup makes a profit, you would be given priority as opposed to ordinary shareholders when it comes to dividend payments. 

However, the company has to pay tax on dividends. Likewise, investor protections are not as strong for preference shareholders as creditors. 

Therefore, convertible loan notes are more commonly used as opposed to equity financing when it comes to startup investing. 

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Key Takeaways 

Investing in startup equity involves balancing upside potential with downside risk. Startups have high failure rates, which can lead to significant devaluations or total loss of investment. To mitigate risk, investors can structure their investments using convertible loan notes. This is advantageous as you have right to repayment as a financial creditor. Additionally, you may convert the debt you loaned to the startup into shares at a future date. Further, this approach allows for regular interest payments and potential discounted share acquisition. In contrast, preference shares, while offering dividend priority, are less common due to tax implications and weaker investor protections. Customised transaction structuring can ensure investors can benefit from upside potential while minimising downside exposure.

If you need help with your startup, contact our experienced startup lawyers as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page. 

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