ARTICLE
9 October 2024

Investment In Early Stages Of A Startup: Alternatives To Document The Investment

In the landscape of early-stage investment in a startup, it becomes particularly relevant to the proper legal documentation of such investment to ensure that the rights and obligations...
Mexico Corporate/Commercial Law

In the landscape of early-stage investment in a startup, it becomes particularly relevant to the proper legal documentation of such investment to ensure that the rights and obligations acquired by the investor are well-established. This is especially crucial given that early-stage investments by its nature and due to the startup grade of development, generally involve a high degree of risk. The documents described below are commonly used in seed stage investments or in the early rounds of investment in a startup.

Simple Agreement for Future Equity (SAFE) (Simple Agreement for Future Equity o "SAFE")

These agreements govern the rights of investors to receive equity in the company upon the occurrence of certain conditions or events. Typically, these agreements do not have a set maturity date, and their enforceability depends on the occurrence of an event, usually an investment round or a liquidity event such as an acquisition, merger, initial public offering, or dissolution. Once such an event occurs, the investment will convert into shares of the company at the valuation determined by the event. This flexibility allows founders to access early-stage capital, while investors gain the opportunity to receive equity based on a valuation determined by such an event.

It is common for SAFEs to include a valuation cap or a discount on the valuation determined at the event that triggers their enforceability, or a combination of both mechanisms to reward the investor for assuming early-stage risk. Another clause frequently included in SAFEs is the "Most Favored Nation" clause, which grants the investor the right to enjoy any more favorable investment terms offered in any subsequent SAFEs entered into by the company.

Convertible Notes

Convertible notes originate as debt instruments with a specific maturity date and interest, which then convert into equity of the company upon the occurrence of certain conditions or events before the maturity date. Similar to SAFEs, these notes automatically convert into shares when an investment round or liquidity event takes place, according to the valuation used for that event. It is also common to include in the document a valuation cap, a discount, a combination of both, or either of these mechanisms at the investor's discretion. The interest accrued by the debt up to the point of conversion is added to the capital for the purpose of calculating the number of shares into which the instrument will convert.

Warrants

Warrants provide the holder with the right, but not the obligation, to purchase shares of the company at a set price, within a specified timeframe that is usually not short, especially in early-stage investments (warrants with terms of 5 to 10 years are common). Warrants are typically issued in connection with larger investments than those described above and give investors certainty regarding the amount of their investment if they exercise their rights. If subsequent valuations are higher, investors benefit from this gain; if valuations are lower, they may choose not to exercise their rights. For founders, warrants offer the advantage of delaying the dilution of their ownership in the company. In this regard, it is possible to include mechanisms within these instruments that protect the investor from future dilution of their equity stake. It is also common for warrants to be issued alongside a financing agreement or other form of debt investment in the startup.

While issuing shares directly to early-stage investors (typically preferred shares) is another option, this is less frequently used in practice, as it is often difficult to establish quantitative criteria for valuation at such early stages.

The documents described above are not the only ones that can be used to document early-stage investments in a company, but they are commonly employed in this context.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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