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Capital raising by start-ups
In Argentina, many start-ups look 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 undesirable exchange rates and entry and entry problems. currency outflows which unfortunately have to be analyzed when conducting business. in Argentina.
The first step to raising capital when starting a business is through equity financing. At this stage, friends, family and others who choose to invest. Angel investors, incubators and venture capital funds, depending on whether the start-up is in a pre-seed cycle (average investment amount of 25,000 to 200,000 USD) or seed (amount of average 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 business. This financial arrangement is different from debt transactions where lenders are repaid according to the terms they have agreed.
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 opt for Series A funding. Typically, well-known venture capital firms participate in these rounds. Then, if the companies are primed to succeed on a larger scale (i.e. if the companies have potential and after the Series A funding has been successfully completed), Series B funding and even C series are generally used. In these cases, as the venture has proven to be successful and hence the investment becomes less risky, more investors are willing to participate. In Series C, groups such as hedge funds, investment banks, and private equity firms are also involved.
The legal documents to instrument equity financing are as follows.
- Term sheets: they set the framework and the main conditions of the investment, which may or may not be binding depending on the case. They accelerate the entry of funds while negotiating the entry of investors who complete the cycle.
- Subscription agreements: these set the conditions for subscribing to the shares and the methods for disbursing the investment. They repeat, in more detail, the terms already agreed in the term sheet.
- Shareholder pacts: they govern the rights and obligations of the investor (now 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 debt capital. Bridge financing takes place when investors invest in a start-up company with a short-term loan to help it reach the next funding round, on the basis that they will receive their money. Startups use bridge financing or a “relay round” to help them access a large round of funding such as equity financing. In general, they are instrumented by bonds convertible into shares.
The various alternatives that are used when seeking debt financing are discussed below.
i Convertible debt instrument
It is essentially a loan convertible into shares if certain events occur (eg change of control or maturity date). So if the business fails, the investor is in a better position by having a debt security than by having equity in the business.
The convertible debt security makes it possible to postpone the discussion on the valuation of the company at the time of the closing of a new round of investment. Moreover, by having (1) a valuation cap (the maximum valuation of the company at which the investor can convert his loan into shares) and (2) haircut clauses (fixed 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 a dilution of their stake in the company can be avoided.
Some downsides are that it will burden the company with debt, and it’s still unclear if its balance sheet will support it. In addition, to the extent that the conversion is not exercised, interest will accrue. It also does not confer political rights (votes) insofar as the option is not exercised (it can be exercised until maturity); and investors do not participate in the distribution of dividends until the option is exercised. Another disadvantage is the very high transaction cost involved in negotiating the terms of this document.
ii Simple agreement for future fairness
Created by the start-up incubator ‘Y Combinator’ in 2013, the Simple Equity Future Contract (SAFE) is a contract for the subscription of company future shares.
Unlike the convertible debt security, the SAFE has no 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 right to shares, which will be calculated by taking as reference valuation the negotiated ceiling or the actual market valuation by applying the discount (depending on the negotiated value) .
The SAFE does not generate interest and does not pay out capital, so it can be considered equity and not debt. It will be automatically converted into capital in case of investment, it does not confer political rights (votes) if the conversion does not take place and the investors participate in the distribution of the dividends even before the conversion. This document is intended to be short, clear and reduces negotiation and drafting time, as well as the expense of professional fees for the corresponding legal advice.
In any case, it is important that the bridge financing is approved by the board of directors of the company and to check that no special authorization is required (for example, from the shareholders, if there is an agreement of shareholders signed).
iii Keep it simple security
Keep it simple security (KISS) is an alternative to SAFE and was created with the main purpose of allowing an investor to invest money in the company and receive the right to buy shares during a future round table when it occurs.
KISS includes a maturity date, like the convertible note, but does not earn the investor interest. There is also an “equity version” of the KISS, with no maturity date or interest, which is considered a middle ground between the convertible note and the 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. With regard to Argentina, it is advisable to understand the venture capital operation to assess what is the preferred financing structure to try to receive any of the alternatives mentioned above in accordance with local laws.
From a different perspective, with the enactment of Law No. 27,349 on Supporting Entrepreneurial Capital in 2017 (the Entrepreneurship Law) and the creation of the Entrepreneurial Capital Development Fund, great opportunities have opened up for the development of Argentine projects, from tax advantages and credits for venture capital institutions, the granting of loans to companies and the establishment of crowdfunding platforms.
Crowdfunding was born as an alternative to traditional financing methods that do not always take into account the realities experienced by local entrepreneurs. The novelty and the advantage of 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 reimburse not only in money, but also in shares, products or other forms of compensation.
There are three main types of crowdfunding which depend on the type of reward obtained by the investor:
- Rewards crowdfunding: 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 falls under the Ministry of Economy. There is no specific law on crowdfunding, but it is governed 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 without an interest rate to be paid within a maximum period of six years can be requested. However, as these initiatives are relatively new, we will continue to see their impact in the years to come.
