- The concept of venture investment
- Venture investment goals
- Investment stages
- We attract investment in startups. Convertible Notes, SAFE
- Taxation of investments
- How FBS can help
Venture investing (VC) in IT solutions, in contrast to conservative investment methods, for example, shares, ETF, or government bonds, is a high-risk way of investing to obtain multiple returns from innovative solutions in the field of modern technologies. Successful cases in this business amount to rates of x100 or more (in fact, much more) of the invested funds of investors.
For example, one of the most successful venture funds Andreessen Horowitz has the following successful investment examples:
– 2009: $50 million in Skype, which will be acquired by Microsoft in 2011 for $8.5 billion.
– 2011: Investments in Zynga, Groupon and Instagram. Investments in Instagram amounted to 250 thousand US dollars, and income from the acquisition of Facebook in 2012 amounted to 78 million US dollars.
– 2012: $100 million investment in GitHub, generating $1 billion in profit for the fund.
It should be noted that venture capital is not necessarily financial resources – it can represent technical or managerial expertise. Typically, this type of financing is aimed at small companies with exceptional potential or rapidly growing and ready to expand.
Considering the above, we can summarize that the main goals of venture investments are:
1. Investing in Innovation. The goal of venture investors is to invest in promising startups with high growth potential. These are often companies developing new technologies, products, or services that have the potential to change an industry.
2. Obtaining profitability. The main goal of venture capitalists is to earn a return on their investment. They look for opportunities to invest in companies that can achieve significant growth, and their success is tied to the success of startups.
3. Startup support. Venture capitalists often provide not only financial support but also expertise, mentoring, and strategic guidance to entrepreneurs and startup leadership teams. This support helps startups overcome challenges and increase their chances of success.
4. Exit strategy. The main basis of venture investment is the possibility of exiting your investments and making a profit. Common exit strategies include going public with an IPO (initial public offering) or being acquired by large companies.
Before entering an IPO or implementing an Exit by selling a project to “big business,” the company must go through certain stages of raising funds. In the world of venture investments, the following stages of financing are conventionally distinguished, which in turn can be identified with the stages of company development:
Pre-seed. Conventionally considered the earliest stage of raising funds. At this stage of development, the project may not have a legal entity. The startup’s main product is in prototype development mode. The main investors at this stage are the so-called FFFs (friends, family, fools), as well as the founders themselves. In very rare cases, angel investors or venture funds may be involved at this stage.
The search for investment at this stage usually aims to develop an MVP (minimum viable product), study the market, and form a team.
Seed. At this stage, the startup has already moved far from the idea stage and may already have an MVP (minimum viable product). A startup has a basic corporate structure, which is mostly made up of founders. Funds for product development at this stage are already officially raised on behalf of the company, so we advise you already at this stage to consult with your lawyer regarding the most optimal form of company structuring and incorporation.
Investments raised at the Seed Stage are used to develop the product, build a user base and study the market. This funding round actively attracts individual investors and venture capital funds.
Series A. Yes, the first round after the seed stage. At this stage, the startup already has a developed product and a formed team skeleton. Investments are used to scale, expand the team, enter new markets, and increase revenue.
A startup can sell preferred shares (stakes) to venture investors, as well as form a dedicated option pool for the core team. It is very important at this stage to have a business development plan that will generate long-term income. To attract investments and provide information to investors about the market value of a startup, we recommend forming a Cap Table – a capitalization table that can be used to plan and model the ownership structure and conversion from attracting investments in new financial rounds.
According to statistics, in the US, in a Series A round, from 2 to 15 million dollars are raised for the development of a startup, but this figure may depend on various circumstances. As of the first half of 2023, the average amount raised at the Series A stage in the US was $22 million.
Round B, Round C, Round D, etc. Pre-public offering rounds. They are considered one of the most difficult stages of startup development. Aimed at taking business to the next level. At these stages, the startup must show significant achievements after raising funds in previous rounds. Funds can be raised, among other things, for the acquisition of other companies on the market or the takeover of competitors.
There is no limit to the number of rounds a company can raise before an IPO; for example, Stripe announced Round I in May 2023, where it intended to raise $6.5 billion with a company valuation of $50 billion.
There are many ways to raise funds for a startup. One of the most common types of deals that are concluded to attract investments at the Seed stage and later are Convertible Loan and SAFE.
Convertible Loan Agreement
It is a form of raising funds for the development of a startup at a certain percentage with the condition that in the absence or delay in fulfilling the obligation, the debt is converted into shares of the company. The Convertible Loan agreement is a fairly simple tool that can be used in Pre Seed stage or Seed stage. However, it has many risks and its development should be approached with the best interests of the product in mind. If you are a startup and raise funds through a Convertible Loan Agreement, you must assess the risk of non-fulfillment of the obligation, assess what share the investor will receive in the company in the event of negative consequences, and take into account the influence of such an investor on the management of the company.
SAFE Agreement (English: Simple Agreement for Future Equity ) is a type of financial instrument widely used in the Seed line and later. This tool was introduced as an alternative to the more traditional Convertible Loan Agreement. A SAFE agreement allows investors to invest money in a startup to obtain the right to receive shares of the company in the future, usually in the next round of financing, based on the value generated during the Series A round.
The SAFE agreement has the following features and benefits:
1. No interest on the use of funds and no repayment terms. The main difference from Convertible Loan is that SAFE is an equity-centric form of transaction by nature. The main goal is to receive company shares when a certain result is achieved or a trigger agreed upon by the parties is triggered (usually the startup raises a new financial round).
2. Discount from the price per share (Discount) or Valuation Cap (maximum score). Investors favor the use of SAFE because it often includes a discount on the price per share that will be converted in the next round of fundraising (Seed, Series A, B, C, etc.) or sets a maximum price per share at which the investment amount will be converted into startup shares.
3. No voting rights. The provisions of the SAFE agreement are based on the fact that the investor is not interested in managing the company, which in turn makes it more attractive to founders.
There are different types of SAFE deals. They may include a Pre-money provision (receiving a share of the company before attracting investments) or Post-money (receiving a share in the company after attracting investments) containing a discount or a Valuation clause Cap. Therefore, we strongly recommend that if you use such a tool, you involve a lawyer at the stage of agreeing.
Taxation of venture capital depends on numerous factors and varies depending on the country of the chosen jurisdiction.
Typically, venture funds are structured through capital management companies.
CEOs of private equity and venture capital funds—those who manage the fund—usually receive a management fee, a small percentage of the fund’s assets under management, annually or a fixed payment.
Taxation of sales income
A venture fund receives its greatest income from the liquidation of shares in the portfolio through the company’s IPO, sale of shares to another investor, or otherwise (for example, acquisition, or transformation of the company). Interest, dividends, and investment profits are subject to tax in such cases. Some countries may tax gains on shares as part of the general income tax on disposal.
The taxable income in such cases is the income from interest and dividends plus the income received from any disposal of the investment minus the expenses of the venture capital fund.
In most jurisdictions, fund assets are not taxed until the profit is realized.
In the US, the International Revenue Service (IRS) requires fund partners to file individual reports of their respective shares of the fund’s income and losses on the IRS Schedule K-1 form. This form is a means for US partnerships, including venture capital firms, to pass on taxable income to their partners.
The Fund prepares a Schedule K-1 for each partner, which is filed to calculate taxes paid on income received. A copy of each K-1 is also sent to the IRS along with the fund’s tax return (IRS Form 1065). The information reported on the fund’s Schedule K-1 must be consistent with the profits and losses reported on the fund’s tax return.
Venture capital funds must complete and file Schedule K-1 annually, regardless of whether they report taxable income, losses, or no taxable income and losses. The deadline to file foundation tax returns (IRS Form 1065) is March 15, although foundations can apply for a six-month extension.
Some countries may provide special tax regimes for venture investors, such as reduced income tax rates or other incentives to support investment in startups. So, for example, in the USA, if you hold the acquired assets for more than one year from the date of purchase, in the future, when selling investment assets, the tax rate will be reduced.
When building your venture portfolio, we recommend that you contact your lawyer or tax advisor to optimize taxes in a particular jurisdiction. A variety of tax rules and exemptions can have a significant impact on the financial implications of venture capital investments for investors.
Finance Company Business Service has experience in the field of venture investments and understands the specifics of this activity. Here are some aspects in which we can be useful to you:
1. Structuring of transactions.
Assistance in creating and optimizing the structure of transactions with investors, including the use of financial instruments such as Term Sheets, SAFE, Convertible Loans, and so on.
2. Due diligence and documentation.
Researching the startup and its legal structure to ensure it is correct and meets investor requirements. Preparing and documenting required documentation such as Shareholders Agreements deals with investors, deals with founders, SAFE, and others.
3. Contractual relationship.
Conclusion and revision of agreements between the parties, including confidentiality agreements, licensing agreements, etc.
4. Cap table. Option pool.
We will help you create a Cap table to make the project more attractive and transparent for investors. We will form and allocate an option pool for the team.
5. Tax support.
Providing advice on the taxation of venture investments and optimizing the financial consequences for the parties.
6. Transaction support.
Conducting negotiations and representing the client’s interests when concluding transactions with investors.
7. Protection of rights and interests
Conflict resolution and protection of the rights of the company and investors, including legal representation in case of disputes.
Ensuring that all transactions comply with investment laws and other regulatory requirements.