In a previous article, I wrote about the problem of the principal-agent and how the American model of building startups solves this problem or at least reduces the conflict between the principal and the agent – investors and founders of startups. I still don't give advice on taking care of your "pet unicorn". In this article, I will write about the sources of financing for startups and about the most common contractual instruments for raising capital at early stages to achieve that cherished goal – to grow a unicorn. 

A startup or tech crowd knows that the most common way to raise capital is venture capital investments. But according to the unwritten laws of the Valley, it is not so easy to knock on the door of venture capital companies and get financing from them. If you are not Sam Bankman-Fried or Adam Neumann, to whom the Andreessen Horowitz company agreed to give $ 350 million for his new project even after he almost bankrupted his previous WeWork project, then you will have to go through several stages to have a chance to present your project to venture investors.

Sources of financing:

1. Budstrapping

There are many successful startups that have achieved tangible financial results without any investments. In addition, almost all founders, up to a certain point in the startup's life, finance the project out of their own pocket or from funds received from customers. This practice is called bootstrapping - the development of a startup without attracting third-party investments. The advantages of developing a startup in this way are maintaining a 100% stake in the company and absolute control in decision-making by the founders. The most famous examples of startups whose founders bootstrapped to the very last are Shopify, Mailchimp, GoFundMe, GoPro and Atlassian. The founders of these companies owned a significant part, if not all, of the shares of their companies at the time of the IPO or takeover. For comparison, the three founders of Doordash, whom I wrote about in a previous article, owned no more than 10 percent of the shares jointly at the time of the IPO. 

Of course, not all business models are suitable for development using only internal resources. Sometimes startups require tangible financial investments to purchase licenses, permits or expensive equipment from the very beginning. 

2. Attachments from family and friends

The next most obvious source of financing is investments from relatives and friends. If you watched the movie Social Network about the history of Facebook, then you remember the moment when Mark Zuckerberg went to a party with his friend Eduardo Saverin to propose a partnership in a new company. Saverin invested the first 19 thousand dollars in the Facebook project and became the financial director of the company.

So, investments from relatives and friends can be part of a partnership where your investor will play an active role in the company or, as often happens, your friends or relatives become passive investors who get the opportunity to buy your shares when they are very cheap. On the one hand, friend investors benefit from such a deal in the form of a price difference for your company's shares. On the other hand, investing in early-stage startups is a huge risk, given that according to statistics, 9 out of 10 startups do not achieve the expected results. It is precisely because of the inherent risk of securities that government securities authorities in almost all countries limit the possibility of selling securities without registration with such authorities. In the United States, for example, startups cannot offer to invest in their shares to an unlimited number of unqualified investors. I will write about the intricacies of raising capital by issuing shares without registration with the Securities Commission in the following articles.

3. Angel investors

The next category of investors who invest in the early stages of a startup is angel investors. Angel investors are people with entrepreneurial or financial experience who invest their own funds. Angel investors are almost always qualified investors according to the requirements of the securities regulations. Elon Musk and Peter Thiel are prime examples of angel investors. After the successful sale of PayPal, where Thiel was the founder and Musk was an early investor, both received significant funds, which they began to invest in new startups. Peter Thiel was an angel investor in Facebook, Linkedin, DeepMind, Change.org and Asana. Famous angel investments of Elon Musk are Asana, DeepMind, Flux and OpenAI. 

4. Accelerators and incubators

The next category of investors in seed and pre-seed rounds consists of accelerators and incubators. Accelerators and incubators are organizations that provide resources and support to help startups grow and succeed. They usually provide a combination of seed funding, mentoring, and access to a network of investors, consultants, and other resources. The most popular and largest in terms of the number of startups and investments are Y Combinator, Techstars, 500 Startups and Seedcamp. For example, the founders of companies such as Airbnb, Dropbox, Stripe and Doordash went through the Y Combinator program. 

Contractual instruments:

Limiting the description of the sources of financing to the above three categories of investors, I will tell you about the most common contractual instruments for attracting investments. As I described above, at the initial stages of startups, the risk that investments will not pay off is very huge. No one can guarantee, for example, that the founder of a startup will not leave the project if he receives a job offer from Google or Facebook. From the point of view of the founders, selling shares of the company at the initial stage may be an unattractive way for several reasons. Firstly, it will increase the number of shares in the company and reduce the share of the founders. Secondly, the company's shares are accompanied by voting rights, and the founders may be limited in their actions at a time when the company needs speed and flexibility. Thirdly, the procedure for issuing shares can be an expensive and long procedure for a startup, which is very important for resources – time and money. In order to reduce the above risks on the part of investors and eliminate unnecessary bureaucratic procedures at early stages, investors and startups use a convertible loan mechanism.

A convertible loan is a type of debt instrument that is commonly used by startups to raise capital. This type of loan usually has a fixed repayment date and may include a percentage for the use of funds. They are called "convertible" because they can be converted into shares, usually when a startup attracts the next evaluated round (Usually Series A, B, C and so on, in which investors receive preferred shares at set prices. Usually, at the first such round, the loan is converted). If the startup proves successful and attracts a larger round of financing or goes public, investors can convert the loan into shares of the company. The conversion price is usually based on the company's valuation at the time of conversion. Otherwise, the startup will have to pay the loan back to the investors.

A convertible loan can be drawn up and agreed upon relatively quickly due to its relative ease of understanding and negotiation. Most startups (read: almost all) There are no resources to negotiate more complex financing agreements. Meanwhile, a convertible loan can be made with various conditions, including the conversion price, interest rate and repayment date. This flexibility allows both investors and startups to adapt financing conditions to their specific needs. In addition, a convertible loan allows startups to raise capital without agreeing on a company valuation. This can be useful for startups in the early stages of development without significant revenues and clarity on future cash flows. In this case, a convertible loan usually includes a discount at which the investor will be entitled to buy shares of the startup in a future estimated financing round.

Despite its simplicity and ease of drafting, a convertible loan still remains a relatively complex contractual instrument that requires consultation with qualified legal consultants. It happens that investors, taking advantage of the founders' ignorance of the legal intricacies of the signed document, add conditions that are obviously unfavorable to startups to the convertible loan agreement. In order to avoid such cases, reduce costs and speed up the approval procedure, well-known accelerators such as Y Combinator, Techstars and 500 Startups have developed standard forms of convertible loan agreements. The Y Combinator form is called SAFE (simple agreement for future equity), and the 500 Startups form is called KISS (keep it simple security).

The Y Combinator SAFE form of convertible loan is the most common and is used to attract financing from relatives and friends, accelerators, angel investors and even large venture and corporate investors. Introducing the SAFE form in 2013, Y Combinator founder Paul Graham wrote that "SAFE is similar to a convertible loan in the sense that the investor does not buy the share itself, but the right to buy the share in the next round. SAFE can have a limit amount of evaluation (valuation cap) or without any limit amount. But, what an investor buys is not debt and there is no need to set a deadline or decide on an interest rate."

Today, SAFE is the industry standard for investing in early-stage startups. We will learn about the legal and practical subtleties of SAFE and KISS in the following articles. The SAFE Y Combinator form can be found and downloaded here, and the 500 Startups KISS form can be compiled, viewed and downloaded here.

This material was prepared within the framework of the Project "Stimulating productive Innovations" with the support of the International Bank for Reconstruction and Development and the Ministry of Digital Development, Innovation and Aerospace Industry of the Republic of Kazakhstan.