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Tech Investors Academy, powered by SeedBlink, is a hybrid learning program designed for startup investors who want to enhance their venture capital knowledge. Check the wrap-up of lesson one here.

The second learning session of the Tech Investors Academy by SeedBlink focused on the legal conditions influencing various types of investment rounds. This session delved into the details of priced and unpriced rounds, explaining how each can affect an investor's portfolio under different market scenarios.

This session was led by Andrei Hancu, Head of Legal at SeedBlink and one of the hosts of the Tech Academy series. His conversation partner was Nicoleta Cherciu, a Romanian-based lawyer and the Managing Partner of Cherciu & CO. This law firm works with investment funds and technology companies during their financing rounds.

From their discussion, we have unpacked the most important things you should know to learn about different round types and the legal conditions each of them has.

What investment instruments are available?

There are two types of financing rounds: priced rounds and unpriced rounds.

In a priced round, the company has a determined valuation and share price, and investors receive equity in exchange for their investment. It’s known as an equity round. Priced rounds occur when the company has reached a stage where it can be valued, often after achieving key milestones.

In an unpriced round, the company does not have a determined valuation, so investors do not receive equity directly. Instead, they provide a loan to the company, which is later converted into equity at the next priced financing round. These unpriced rounds are often referred to as bridge rounds, as they help the company bridge the gap between financing events.

What you need to know about priced rounds

One of the most important parts of a priced round is the negotiation, where investors sit with the company's founders to discuss over a term sheet document.

The conversation starts with the company's valuation. It includes other important commercial provisions, such as:

• drag-along rights (forcing minority shareholders to join a sale)
• tag-along rights (allowing minority shareholders to participate if a majority shareholder sells)
• liquidation preferences (determining payout order in a sale or liquidation)
• reserve matters (critical decisions requiring investor approval).

"You have these rights as shareholders right after you sign the fundraising documents and shares have been issued. Even if the law doesn’t allow the creation of preferred shares, investors get these rights, which to a certain extent, make these shares preferred."

mentioned Nicoleta Cherciu, Managing Partner of Cherciu & CO.

Investors need this information to understand how the investment round is governed and what rights shareholders will have. In some cases, lawyers often discuss these decisions, but as they directly impact control over the company and future decision-making, you should be involved or aware of what is being decided.

The structure of a priced round

The structure and dynamics of a typical priced round depend on the mix of investors. When VC funds are involved, the lead investor often secures a board seat, possibly allocating another seat if the majority of preferred shareholders can appoint one.

The concept of reserved matters doesn't require unanimous investor decisions but is subject to a threshold and voting majority, often around 60%. This setup resembles a democratic process where, even if you are a minority or retail investor, you don't directly influence decisions.

mentioned Nicoleta Cherciu, Managing Partner of Cherciu & CO.

Holding a small percentage of the company means their voting rights won't sway major decisions. However, private investors can evaluate the lead VC's reputation and track record and align with reputable VCs with significant rights and board memberships.

While private investors might have limited direct power, aligning with experienced and reputable VCs who share the goal of maximizing returns offers security and indirect influence. Angels and private investors might have less power, but organized structures like those we offer at SeedBlink give rights to smaller investors.

How do you protect your ownership in a priced round?

Unlike private equity, venture capital investors often have to balance their investment protection with their non-controlling role in the company. To safeguard their investments, they usually use a liquidation preference clause.

In the event of an exit or liquidation, preferred investors can either get back their initial investment or participate in the proceeds as common shareholders, whichever yields a better return. It’s a 1x non-participatory liquidation preference, providing a safety net even for private investors.

Moreover, there's another, less common, type of liquidation preference, the 1x participatory liquidation preference. This clause offers an even higher level of protection and potential return by allowing investors to "double dip." With this clause, investors return their initial investment (1x) and then participate pro rata in the remaining distribution alongside common shareholders.

It is not a common solution because industry standards consider it too much. I understand that you want your money back in a worst-case scenario, but getting your money back and getting something extra doesn’t look good. The founders worked for that exit, and they deserve something, regardless of how much it is.

mentioned Nicoleta Cherciu, Managing Partner of Cherciu & CO.

Liquidation preferences can be structured in different ways. Investors receive their return simultaneously or on a waterfall basis. Companies have different dynamics as they grow and move to more advanced funding rounds.

Initial investors might find their control decreasing, facing dilution as new capital flows in. It’s especially true in Series C or D rounds, where the likelihood of early-stage investors still holding significant ownership is low.

New investors, whether VCs or private equity funds, often aim to buy out earlier investors, seeking as much equity as possible at each funding round. This strategy labels early investments as "dead equity," meaning the initial investors have already made a return and are seen as no longer contributing actively to the company's growth.

If you’d like to learn more about exit power plays, check this out.

What do you need to know about unpriced rounds?

Convertible instruments, like convertible notes or Simple Agreements for Future Equity (SAFEs), are common in unpriced rounds.

Investors are generally familiar with convertible rounds, a debt and equity financing hybrid. A convertible round is a contract where investors lend money to a company with the agreement that the loan will convert into shares during a future equity financing event.

Convertibles allow investors to provide funding without setting a fixed price per share. Instead, they agree on terms like a valuation cap, discount rate, and maturity date, which define how their investment will convert into equity in the future. Instruments like convertible notes or SAFEs are particularly useful for early-stage startups where determining an accurate valuation can be challenging or premature.

The structure of convertible-driven rounds.

Since convertible loans are often used when it's difficult to determine a precise company valuation, these agreements usually include a valuation cap. A valuation cap sets an upper limit on the company’s valuation for conversion, protecting investors by ensuring they don't convert at an excessively high valuation.

The valuation cap is generally an estimate based on the company’s current status, projected growth, and the amount of convertible loans expected before the equity round. While some investors may push for a lower valuation cap to maximize their shareholding upon conversion, this approach can backfire.

Investors often negotiate a lower valuation cap in convertible rounds to maximize their potential returns. For example, if the cap is set at $2M and the next round's valuation is $6M, investors can triple their money, which seems ideal.

However, this can lead to significant dilution of the founders' ownership, causing potential problems in future financing rounds. To avoid such scenarios, keep a balance by setting the valuation cap around realistic future expectations.

If founders are overly diluted, it might deter future investors or lead to difficult negotiations. Setting the cap too low can raise questions from subsequent investors while setting it too high can make the company seem out of touch with reality.

mentioned Nicoleta Cherciu, Managing Partner of Cherciu & CO.

Convertible rounds also feature variations like discounts and sometimes even interest provisions. A standard discount is around 20%, allowing early investors to convert at a price 20% lower than the next round's valuation. Occasionally, an additional interest might be included, especially in bridge financing scenarios, to incentivize the company to secure the next round quickly.

However, the primary purpose of these instruments is equity, not interest income. The discount and valuation cap can generate substantial returns for early investors, sometimes producing 3x or 4x gains.

How do you protect your ownership in unpriced rounds?

Convertible rounds need a well-defined maturity date to avoid the loan's indefinite hanging.

If no equity round occurs by the maturity date, the loan typically converts based on the valuation cap or the company's current capitalization. A conversion mechanism ensures investors are not left without a return.

Additionally, a floor valuation can be a safety net when an equity round is delayed or the company underperforms. The floor valuation is the minimum value at which conversion can occur, often based on the last financing round, ensuring investors do not convert at an unreasonably high valuation.

When an exit occurs instead of a subsequent equity round, convertible instruments typically convert right before the exit. It allows investors to participate in the sale on equal footing with other shareholders.

However, some investors might prefer to get their money back instead of converting in cases of a "fire exit" or a less favorable sale. While this could benefit individual investors, it often doesn't align with the interests of all stakeholders, especially if the company's remaining funds are limited.

When you negotiate the transaction documentation, remember that you need to keep the founders happy. Otherwise, they will not be so incentivized and feel they work as employees.

It’s not what you want to do because they started the business and want to change the world. So, let them do that, while sure, find a way to protect your interests!

mentioned Andrei Hancu, Head of Legal at SeedBlink.

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