Once you have found a startup you’d like to invest in, it’s time to understand the deal. Therefore, it’s useful to know the different types of deals and what they entail.
Once a startup has successfully raised funds, they need to make a deal between them and the investors. Roughly put, the deal marks down the amount invested and what the investor gets in return.
The main goal for the investor is to get their investment back with a return. In the deal, both parties will agree on how that should happen. Depending on the deal type, the investor may get an equity stake in the company or their investment will be used as a loan which will be paid back with interest over time or something completely different.
There are many different deal types with nuances that can be very detailed and specific but the three most common deal types regarding startup investing are equity, convertible note, a fund and a bond.
In short: equity is about obtaining company’s shares, convertible note is a loan converting to either cash or shares, a fund is a collection of equity investments and a bond is a tradable loan.
We will explain each instrument more in depth below.
An equity deal means that in exchange for the investment, the investor gets a part of the company’s equity. The investor now owns some of the company in the form of shares — they are now a shareholder.
The number of shares or in other words the amount of equity the investor gets depends on the size of the investment and the valuation of the company. The bigger the investment the bigger share of the company you’ll get.
How the valuation of the company is calculated, is a more complex topic. Though, an investor should be familiar with the terms pre-money valuation and post-money valuation.
Pre-money valuation is the valuation of the startup before the investor’s money is received or the last round’s valuation. Post-money valuation counts in the financing received in the latest round. This plays a role for the investor because the amount of equity they will receive will depend on the valuation of the startup, which can depend on whether pre- or post-money valuation is used.
Another thing to consider about an equity deal is the risk of dilution. If the startup wants to raise other equity rounds in the future, then new shares will be issued. The new shares will dilute existing investors’ shares and the new investors’ deals might have better conditions like preferential rights to dividends etc. Read more about risk here.
A convertible note is structured as a loan but will be converted into cash or a certain number of shares later on during a conversion event, which is agreed on by both parties. The conversion event could, for example, be the next financing round, the date when the loan is repaid (maturity date), an exit or even something else.
By investing through a convertible note, the investor is basically lending money intending to help the business to become successful and then later share the profits with other shareholders if things go well.
Convertible notes are often used in the early stage, or in-between funding rounds because the startup does not have to negotiate a valuation at the time. Most often the convertible note gets turned into equity during the next funding round when a new valuation is set.
When investing via a convertible note, you will run into terms like “discount rate” and “cap”. The discount rate is a percentage that will allow the note to convert to shares at a cheaper rate than other shares at the next valuation round. The cap marks the maximum valuation at which the convertible note can be turned into shares.
A fund means that the investor can invest in a number of companies all at once through a fund manager.
The fund manager picks out the startups they think have potential and provides them with advice, mentoring or funding or all of it combined. Fund managers are for example startup accelerators or venture capitalists.
The key to investing into a fund is diversification. Instead of putting the money into one company, through a fund you will give each company a portion of it in exchange for shares. This is a good way to lower the risks of investing because the portfolio becomes more diverse with a fund investment.
A bond is a type of debt investment that has to be repaid in after a certain period of time passes. Bonds have a fixed interest rate called a coupon and the funds have to be repaid after a fixed time limit passes — it’s called the maturity date.
Each bond deal has a schedule for the repayments, so have a look at the terms of the bond before investing. The more frequent the repayments, the more liquid the investment. Higher liquidity means lower risk but also lower returns compared to the riskier investment instruments.
Bonds are issued by the borrowers, usually corporations or governments, who now owe money to the lenders, who can be any person. What differentiates a bond from a loan is that bonds are tradable.
Bonds can be secured or not secured. Secured bonds are backed up by (or collateralised) by an asset for example real estate, equipment or some other income stream. In the case of a default, the assets can be sold in order to pay the lenders their money back.
Secured bond are less risky but in case of a default, there is no guarantee that the sale of the assets that back up the bond will cover the initial investment. Since they are less risky, the returns are also generally lower.
Which type of deal to go for?
As an investor, think about which deal types are most suitable for you. Different deals come with different risks, for example, equity deals are riskier than bonds because equity deals don’t have fixed payment dates and interest.
Also, think about how long your investment could be tied down. For fund campaigns, you have to wait for a potential exit to happen before you will get your finances back but bond payments have a maturity date by which they have to return the loan, so you know when you will see your money again.
Each deal between an investor and the startup will include specific details and nuances, so read the terms carefully before you decide to invest.
Regardless of the deal type you go for, nothing can guarantee that you will get your investment back. Therefore, only invest money you can afford to lose.
On Funderbeam the deal negotiations are between the lead investor and the startup. Other investors don’t have to take that responsibility and can easily choose the most suitable deal for them. All the aforementioned instruments are available on the Funderbeam platform.
The Funderbeam Guide for New Investors
In case you missed the previous chapters in our series and want to know more, check them out here:
- Investing in Startups: 10 Checks Before Your First Deal
- 1) The Problem — Analysing Your First Investment
- 2) The Solution — Does It Solve The Problem And Can We Make Money Doing So?
- 3) The Market — Who Is Going to Buy The Solution?
- 4) The Competition — How Does the Startup Stand Out from the Crowd?
- 5) The Team — Who Are the People Behind the Scenes?
- 6) The Traction —Is the Startup Gaining Momentum?
- 7) The Use of Funds — What Will They Do With Your Money?
- 8) Exit Strategy — How Will You Get Your Money Back?
- 9) The Risk — What are the risks you are taking?
Funderbeam consists of three parts:
- Free data intelligence on investors and startups
- Tools for startups to raise funds and for investors to co-invest
- A marketplace for investors to buy and sell their investments
Our vision is to provide everyone in the world with equal opportunities, whether you are building a company, or looking to fund the next big thing. What if the next Silicon Valley is not a place, but a platform?
LEARN MORE ON FUNDERBEAM.COM, OR WATCH THE VIDEO BELOW: