Attracting investments for startups: What tools are available and commonly used

Enthralled by the idea and the desire to bring their startup to life, founders often overlook legal matters. Focused on product development, they may miss important aspects of legal regulation that can have consequences in the future. Non-compliance with these requirements can lead to disputes and conflicts with partners, investors, or clients. How should startups choose a legal structure? How should ownership shares be allocated? And what documents are needed to attract funding? Petro Bilyk, Chief Innovation Officer at Juscutum law firm, shared insights on these and many other topics at the recent IT Ukraine Legal Conference 2023. Mind took note of the most interesting points from his presentation.

Choice of the legal structure

To attract investment, it is necessary to create an appropriate legal structure. Many startups choose the Delaware structure, but it is not always suitable. It may also entail certain obligations, especially in the European market. However, if you create an LLC (Limited Liability Company), particularly in the United States, no investor will provide funding because LLCs are generally not suitable for investment in that country.

When it comes to investments in Ukraine, despite the existence of the Diya.City regime, Ukraine is currently not an attractive jurisdiction for startups. Issues related to law enforcement agencies and courts have not been resolved. Investors do not see sufficient protection. However, it can be a good option for establishing an R&D centre within the startup structure.

When building the structure, it is worth considering the following:

• Incorporation documents – the necessary documents for establishing the startup.
• Stock options – an employee option plan: what portion of the company will be allocated to employees in the form of options? What is the volume of these options?
• Vesting agreement – the possibility of partial transfer of the company's shares to the founders. For example, if there are four founders, after a year, two of them exit and do not receive their shares or only receive a portion. The other two founders continue to invest their time, effort, and money in the startup's development. Therefore, it would be fair if their share in the company is reduced.
• Shareholders' agreement – it regulates the contribution of each founder, responsibilities, ownership stake, etc. An important tool is also the cap table (a table showing the distribution of shares) – it determines the portion of the company owned by the founders, as well as the portion allocated for investors and options.
• Ownership structure and share distribution – it is important to distribute shares equally among the startup founders and consider vesting. Typically, around 10% of options from the company are allocated to the first employees. If we are talking about pre-seed and seed stages, investors usually reserve their share until the exit round, and funds are raised during the pre-seed and seed stages. In other words, investors do not receive specific parts at such early project stages.

Raising funding at different stages

In Ukraine, investors often prefer to immediately acquire a stake in the company, whereas abroad, the majority of deals at early stages are done through convertible loans. Therefore, it is important to determine which mechanism is better suited for your startup. If we are talking about raising investment through the sale of equity or shares, two mechanisms can be applied:

1. Selling existing shares in the company, which is more commonly used when the company's form is a limited company.
2. Issuing shares during the next equity sale round.

Another process of fundraising occurs at the pre-seed and seed stages. Here, instruments such as convertible loans or safes are typically used.

Although these instruments are similar, they have their differences. Convertible loans involve a specified date by which the loan must be repaid or converted into shares, whereas safes involve conversion during the occurrence of a certain event.

However, safe is a rather specific instrument that may not be available in all jurisdictions and may not be suitable for all purposes.

At the pre-seed and seed stages, the main goal of a startup is to quickly obtain funds without the need for extensive legal work or complex legal processes. Such agreements allow for rapid funding and agreement on key terms without the need to alter ownership stakes or enter into corporate contracts.

It is important to note that the due diligence of a startup largely depends on the investors. For example, some startups that received funding from major funds in Silicon Valley did not undergo detailed due diligence at early stages. A presentation was sufficient for them. They made their initial investment based on a safe agreement.

However, in Europe, certain forms of due diligence are more commonly practised to ensure that the startup's presentation meets the investor's requirements. In such cases, it is necessary to consider:

• current legal structure;
• ownership of the company by the founders;
• existence of agreements with employees;
• proper establishment of all relationships;
• ownership of all intellectual property by the company.

These questions may arise during due diligence in one way or another. It is better to have everything prepared in advance.