In the world of fundraising, traditional methods often involve protracted negotiations, extensive legal due diligence, and a time-consuming process that can span weeks or even months. While this approach may be suitable for established corporations with longer planning horizons, startups operate on a different timeline.
For startups, securing timely funding is critical to transforming their visionary ideas into reality.
Consequently, the fundraising journey for startups unfolds through distinct stages, from pre-seed to seed, series A, B, C, and beyond, with each stage representing a milestone in the startup’s growth trajectory.
In contrast to traditional fundraising, where funds are typically sought in a single, lengthy process, startup funding often takes place in multiple stages.
By breaking down the fundraising process into stages, startups can maintain momentum and access resources at crucial junctures in their development.
Pre-Seed
This represents the earliest phase of a startup’s journey, where founders typically rely on personal savings, bootstrap their operations, or seek support from friends and family.
Seed
This stage involves raising capital from angel investors, early-stage venture capital firms, or specialized startup accelerators. This funding round enables startups to refine their product, build a core team, and begin scaling their operations.
Seed funding is often crucial for startups to establish market traction, refine their business model, and demonstrate their potential to generate revenue and attract further investment.
Early and Growth stages
As the startup progresses, series A funding becomes the next milestone. Series A funding involves larger investments from venture capital firms, allowing startups to scale their operations, expand their customer base, and invest in talent acquisition and marketing efforts.
Subsequent funding rounds, such as series B, C, and beyond, represent additional stages of growth and financing. These rounds provide the necessary capital for startups to penetrate new markets, invest in research and development, acquire competitors or complementary businesses, and solidify their position within the industry. Finally, the founders may exit the investment using different routes.
What laws govern raising capital by a private company in Sri Lanka?
The Companies Act No. 07 of 2007 governs any company incorporated in Sri Lanka and sets out all the laws governing the affairs of the company. Accordingly, the Companies Act sets out how a company may raise equity capital in the form of the issuance of shares.
The Act sets out the nature and type of shares that may be issued (Section 49). Section 51 authorizes the Board of Directors to issue shares as it deems appropriate subject to the Articles of Association of the Company. Section 52 provides for the consideration or price of the shares to take any form including cash, promissory notes, future services, property of any kind or other securities of the company. Private companies and the Board of Directors should ensure that they are compliant with the Companies Act when raising capital.
What makes the Seed Stage unique in terms of fundraising?
Raising capital during the seed stage is unique for startups due to several factors that make it challenging to determine a precise valuation at this early stage. Here are some reasons why startups often avoid conducting a formal valuation during the seed stage:
Limited Operational Data: Startups in the seed stage typically have limited operational data and a short track record. They are often in the early phases of product development, customer acquisition, and revenue generation.
Uncertainty and Risk: Startups at the seed stage face high levels of uncertainty and risk. Their business models, product-market fit, and scalability are still being validated. The lack of proven market traction and predictable financial projections further complicates the valuation process. Investors may hesitate to assign a specific value to a startup without sufficient evidence of its potential success.
Evolving Business and Market Landscape: Startups in the seed stage are highly dynamic entities, constantly evolving and adapting to market conditions and customer feedback. Their business models and strategies may undergo significant changes as they gather more information and insights.
Investor Expectations: Seed-stage investors understand the unique nature of early-stage startups and the associated risks. They are often willing to invest based on the startup’s potential, vision, and the capabilities of the founding team, rather than relying solely on financial metrics or a formal valuation.
Given these factors, startups in the seed stage often opt for funding instruments such as convertible notes or SAFEs. These instruments allow startups to secure capital without needing to establish an immediate valuation. Instead, the valuation and conversion into equity occur at a later stage when there is more tangible data, market validation, and a clearer understanding of the startup’s value proposition.
What are the funding instruments used by Startups to raise funding during the seed stage?
Convertible Notes
Definition and Purpose
A convertible note is a debt instrument that allows a startup to raise funds from investors with the understanding that the debt will convert into equity at a later stage. It serves as a short-term debt instrument with the intention of converting the investment into shares upon the occurrence of a specific event, typically a future financing round.
Structure and Terms
When a startup issues a convertible note, the investor lends money to the company with the expectation that the loan will convert into equity under predetermined conditions. Convertible notes typically include the following terms:
Principal Amount: The amount of money being loaned to the company.
Interest Rate: The interest rate at which the loan will accrue interest over time.
Maturity Date: The date at which the loan must be repaid if it has not been converted into equity.
Conversion Terms: The terms and conditions under which the loan converts into equity, such as a future financing round or a specific valuation threshold.
Conversion Discount: A discount applied to the price per share when the note converts into equity, providing the investor with a benefit for investing earlier.
Valuation Cap: A maximum valuation at which the note can convert into equity, protecting the investor from excessive dilution in case of a high valuation in the future.
Conversion into Equity:
When the predetermined conversion event occurs, such as a qualified financing round, the outstanding principal and accrued interest on the convertible note are converted into shares of the startup. The conversion is usually based on the terms defined in the note, which may include a conversion discount or a valuation cap to benefit the investor.
Considerations
Except for the provisions under the Companies Act, there are no specific provisions under the Sri Lankan securities law governing startups, startup funding or issuing convertible notes. In contrast, under the laws of India, only companies recognized as a startup under the Department for Promotion of Industry and Internal Trade can issue Convertible Notes, and the Companies (Acceptance of Deposits) Rules 2014 sets out the prerequisites and conditions to be met by such company when issuing convertible Notes.
In the Sri Lankan context, the applicable contract law will govern the convertible note agreement and therefore, it is essential that the parties ensure that their rights are specifically set out in the convertible note agreement. It is also essential that all procedures required to ensure that the Convertible Note agreement is legally valid and enforceable under contract law are followed.
SAFE
Definition and Purpose:
A SAFE, or Simple Agreement for Future Equity, is an investment instrument used by startups to raise capital. It is a contractual agreement between an investor and a startup, whereby the investor provides funding in exchange for the right to convert their investment into equity at a future financing round or specified triggering event.
Structure and Terms:
When a startup issues a SAFE, it does not involve a loan or debt like convertible notes. Instead, it represents a promise of future equity. SAFEs typically include the following terms:
Conversion Trigger: The specific event or milestone that triggers the conversion of the SAFE into equity, such as a future financing round, or sale of the company etc (termed as “Liquidity events”).
Valuation Cap: a provision that sets a maximum valuation at which the SAFE will convert into equity, ensuring investors receive a predetermined ownership percentage.
Discount Rate: a provision that offers investors a discount on the price per share when converting the SAFE into equity, incentivizing early investment.
Pro-rata Rights: In some cases, SAFEs may grant investors the right to participate in future financing rounds to maintain their ownership percentage.
Conversion into Equity:
When the specified liquidity event occurs, the SAFE converts into equity at the predetermined terms. The conversion is typically based on the valuation cap or discount rate, ensuring the investor receives a favorable conversion price compared to subsequent investors in the financing round.
Considerations:
In the absence of specific regulations for SAFEs in Sri Lanka, the legal treatment and enforceability of SAFEs in Sri Lanka will rely on general principles of contract law and will depend on factors such as the clarity and specificity of the terms, the intention of the parties, and compliance with other applicable legal requirements. Given that there is no maturity for SAFEs unlike Convertible Notes, it is essential that the contract does not leave any room for ambiguities in relation to liquidity events and other provisions to ensure that both founders and Investors are secured.
Convertible Notes and SAFEs offer startups a streamlined and relatively quick approach to raising capital. By understanding the structure, terms, and legal ramifications of these instruments, founders can make informed decisions when selecting funding options that best suit their needs.
