Funding early-stage companies with the goal of earning profits after their intensive growth phase has always been a popular financial tool – backing both the wealthiest and, paradoxically, the poorest individuals on the planet.
What investment mechanisms are used in practice?
There are three primary investment mechanisms.
- Equity Investment
The investor acquires corporate rights in the company. This mechanism provides the investor with the highest level of control over the company’s operations, as they become a shareholder in the startup and can directly influence decision-making. This form of investment gives the investor significant powers, the strongest level of protection and control, and allows them to strengthen their position through a shareholders’ agreement or by incorporating specific rights and guarantees into the startup’s charter.
- Convertible Loans
This tool allows funds to be raised without immediately valuing the company, which is especially useful in conditions of uncertainty. The investor provides a loan that can later be converted into a share in the startup—usually during the next funding round or once a certain valuation is reached.
A typical structure includes an interest rate, a discount for share purchase, and a conversion trigger (the amount of investment or company valuation that activates the conversion).
For example, an investor provides a convertible loan of $100,000 for one year at 10% annual interest. The agreement provides for a 20% discount on conversion. After one year, a new funding round takes place, valuing the company at $1,000,000. With interest, the debt to be converted is $110,000.
With a 20% discount, the effective valuation for this investor is $800,000. Thus, upon conversion: $110,000 ÷ $800,000 = 13.75% ownership in the company.
This method avoids difficult early-stage valuation negotiations by deferring them until more certainty and external valuation exists. However, a drawback is the lack of direct investor involvement in the startup, making it harder to influence internal decision-making.
- SAFE (Simple Agreement for Future Equity)
A contract where the investor receives rights to a share in the startup after a future funding round valuation.
SAFE is not a debt instrument – it has no repayment terms or interest. Instead, it may include a valuation cap (the investor pays no more than a set value regardless of the startup’s eventual valuation), a discount on share purchase, an MFN clause (Most Favored Nation), which guarantees the investor the best deal terms offered to future investors.
SAFE is gaining popularity in Ukraine and is widely used in the U.S. (notably by Y Combinator) as a simpler alternative to convertible loans, especially at the pre-seed and seed stages.
Beyond these mechanisms, there are quasi-investment tools and venture debt, but they remain extremely rare in Ukraine and are essentially modified forms of convertible loans.
Stock option plans (e.g., for employees) also exist, granting the right to buy shares at a fixed price. However, options are not true investment tools—they are designed to attract human capital and reduce the startup’s burn rate in early stages.
Key Risks For Investors
Investors face various risks when funding startups, which should be evaluated and mitigated wherever possible. All risks can be grouped into basic and additional.
Basic Risks – these are inherent to startup investments and cannot be eliminated due to the nature of early-stage ventures. They include failure to develop the core product or technology, lack of market interest, illiquidity or loss of product liquidity.
In short, basic risks are the risk of startup failure. They are unavoidable and explain why early-stage investments offer high potential returns. Once a company has a product and a market share, it’s no longer considered a startup.
Additional risks are factors that can be eliminated or minimised by the investor through a series of actions or the use of special legal instruments.
Additional Risks & How to Avoid Them
- Equity Dilution
Investor shares may be diluted in subsequent funding rounds, either voluntarily, by agreement with the founders to raise more capital, or involuntarily, when founders disregard the investor’s interests.
This problem is very common. A similar incident happened to Eduardo Saverin, one of the co-founders of Facebook, whose stake was diluted from 34.4% to 0.03%.
In order to avoid such issues anti-dilution clauses (provisions that protect investors from dilution in the event of new rounds of financing) must be included in the investment or corporate agreement. Such provisions may also be included in the charter, depending on the chosen investment structure.
- Ineffective Management & Misuse of Funds
By ineffective management, we refer to either the conscious or unconscious withdrawal of investor funds from the company in ways that do not help the startup become a profitable business capable of generating returns for the investor.
Unconscious withdrawal of funds typically happens when investment is misused, often due to a lack of experience, insufficient knowledge, inadequate qualifications of the founders, and the absence of strategic planning.
Conscious withdrawal of funds, however, presents a more concerning scenario. Essentially, these are types of startups created with the intention of “burning out” after securing funding. The goal of such ventures is not to execute an idea but to secure financing for its development and then drain the funds by increasing the company’s burn rate. This can involve inflating salaries, hiring friends and family for key positions, or engaging contractors for services (such as marketing and consulting) with no standardized pricing.
To prevent ineffective management, it is recommended to conduct a thorough legal and financial audit of the startup to assess current expenses and growth plans. The corporate agreement, charter, or investment contract should also include mechanisms that establish clear rules for the use of invested funds and grant investors the ability to block unjustified decisions.
- Deadlocks Due to Founder Conflicts
A frequent issue is the blocking of company activities by one or more founders due to a conflict with an investor or another founder. This can arise from a desire to repurpose the work for another project or from an internal disagreement about the company’s strategic direction.
To minimize such risks, it is essential to develop a joint business strategy during the investment stage. This plan will help determine if the co-founders and investor share the same goals.
Despite the most detailed development strategy, disputes can still arise. To mitigate this risk, corporate documents should include procedures for mediation and arbitration in case of conflicts between founders and/or the investor, exit strategies for the investment, and out-of-court dispute resolution mechanisms. These processes must be swift and effective, as even a brief blockage of decision-making in a startup can lead to its downfall.
- Loss of Intellectual Property, Technology, Brand, Patents
Startups often prioritize developing the founders’ idea while bypassing legal procedures and protections due to limited funds and a focus on product development rather than safeguarding it. While this approach is understandable, it introduces additional risks for both the startup and the investor.
Failure to protect the company’s key assets, whether it be its brand, technology, patents, or other intellectual property, puts those assets at risk of being lost. The loss of such assets will inevitably result in a significant decrease in the company’s value, if not the potential closure of the startup.
To prevent such risks, a comprehensive due diligence process should be conducted. This will involve (1) identifying the company’s key assets (such as software code, art objects, technology, etc.); (2) verifying the origin of these assets and reviewing the original documentation regarding their development (contracts, intellectual property transfer agreements, etc.); (3) developing a framework to document work results and implement mechanisms for protecting key assets, followed by registering the relevant rights.
- Overvaluation or Undefined Valuation at Time of Investment
Startup valuations during the pre-seed stage are often based on subjective factors or, in some cases, there is no valuation at all. This creates a risk of investors overpaying for a stake in the company during the early stages of funding.
To protect the investor’s interests, a SAFE (Simple Agreement for Future Equity) agreement can be used, which sets a cap on the company’s valuation for early investors. This means that regardless of the company’s actual valuation, the amount used for calculating the investment offer cannot exceed a predetermined threshold.
It’s important to note that while this tool offers protection, it introduces other risks. Since the investor does not acquire equity in the company, they have no direct influence on the company’s decisions. This is why equity investment remains the most popular form of investment around the globe.
- Insufficient Funding to Reach Profitability or Attract Further Investment
A common issue arises when founders create overly optimistic forecasts regarding the resources needed to develop a product or achieve profitability after its launch. Unquestioningly accepting the founders’ projections, as outlined in their pitch deck, can lead to a situation where the investor becomes a hostage of the startup – where the product hasn’t been created yet, but the investment has already been spent.
In such situations, trying to reclaim the investment is futile, as the startup no longer has the funds. The investor faces a difficult choice: provide additional funding from their own pocket, or attempt to bring in another investor and hope to recover their initial investment later.
While it’s impossible to entirely eliminate this risk, conducting an independent evaluation of the company’s product, calculating the company’s burn rate, assessing the product’s profitability, and analyzing market conditions, alongside a comprehensive financial and legal audit of the startup, can help minimize this risk.
Conclusions
A proper approach to conducting due diligence, evaluating a startup’s profitability, and structuring the investment transaction does not guarantee the return of the invested funds, but it significantly reduces the risk of losing the investment.
By applying the provided advices and taking a comprehensive approach to investing, most additional risks can be eliminated, and the basic risks can be reduced, thereby protecting the investor from losing their funds.
In conclusion, it’s important to remember that fortune favors the bold, but luck favors the prepared.
Authors:
1. Oleksandr Melnyk, Partner, Head of Corporate Law and M&A Practice at GOLAW, Attorney at Law
2. Nazarii Zeliak, Corporate Law and M&A Practice Associate at GOLAW