A syndicate is an investment vehicle that allows investors (backers) to co-invest with relevant and reputable investors (leaders) in the best startups in the market.
Syndicate leaders are business angels with vast experience in selecting investment opportunities and investing in then, in various technology sectors and with dealflow that most investors don’t have access to. They tend to be angels -or successful startup founders- who have been part of the industry for many years and know its ins and outs.
There are three characteristics a syndicate leader should meet:
- Access to capital: business angels with a good track record or successful startup founders that have the capital necessary to invest in startups.
- Propietary dealflow: dealflow refers to the to the rate at which investors receive business proposals or investment offers. If this dealflow is propietary -as in, exclusive to the investor- the chances of scoring good deals increases.
- Good judgement: knowledge and market experience that might result key in making the right investments
It’s worth noting that the fact that an investor meets this requirements doesn’t guarantee his or her success. Investing in startups is hard and risky, but co-investing might decrease the risk associated to it.
A backer is an investor that either does not have a lot of experience in startup investing or, even if he or she does, he’d rather allow someone else -the leader- manage the investments and choose the startups in which to invest.
Syndicates offer great advantages to both leaders and backers.
- They can invest more money per deal.
- They can reach startups that might have high minimum commitments they couldn’t match on their own.
- By investing more capital per deal they might have access to better investor rights.
- They also get paid a carry (capital gains generated by an exit or dividends paid) in return for their ‘leadership’ on a project they would invested in anyway.
- Better dealflow by having access to investment opportunities they might not be able to find by themselves.
- Transparent negotiation process.
- Aligned interest with the leader
- Less paperwork than if they were investing on their own.
- Less risk: leaders have vast experience in investing and thus can differentiate good from bad deals.
- Access to higher sums of capital.
- Not having to deal with numerous and different investors.
- Leaders take advantage of the fundraising process and they are responsible for managing their relationship with backers.
- There’s only one investor in the startup’s cap table as the investment is done through a vehicle.
Lead investors invest their own capital into the startups and they charge backers 10% of the capital gains generated by an exit or dividends. A carry is only paid in the case of a successful investment.
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Convertible debt is a type of security frequently issued by startups when raising seed capital. With convertible debt, the startup issues the seed investor a promissory note, for the investment amount, that contains a conversion feature. The conversion feature is the mechanism by which the debt (the promissory note) will convert to equity(new shares for the investor) upon a future event.
The Qualified Financing
Most (if not all) convertible promissory notes contain an Automatic Conversion clause that dictates the automatic conversion of the convertible debt upon a “Qualified Financing.” The Qualified Financing is typically defined as anequity financing by the startup, for the purpose of raising capital, in which the aggregate of $1,000,000 (this amount can vary per deal) is purchased by investors. Thus, the Qualified Financing event is the trigger by which the convertible debt will automatically convert to equity. The conversion is considered “automatic” because it does not require the vote of either the startup or the investor.
The Qualified Securities
The equity raised in the Qualified Financing (the $1,000,000 above) is typically termed “Qualified Securities.” Think of this as the Series A round. The convertible debt held by the investor will convert to the Qualified Securities. The amount of shares of the Qualified Securities issued to the convertible debt investor is dependent on the conversion discount per the terms of the convertible promissory note.
The Conversion Discount
As a sweetener to the convertible debt investor, convertible promissory notes have a conversion discount feature by which the convertible debt holder will exchange the debt for Qualified Securities at a price per share equal to 80% (this amount can very per deal) of the price per share paid by the Qualified Financing investors (the investors with the new $1,000,000 above).
Here’s the basic outline of how convertible debt works:
(1) Joe Angel invests $100,000 in Startup.
(2) Startup issues Joe Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 (the “Qualified Financing”) with a conversion discount equal to 20%.
(3) Startup closes $1,000,000 Series A Preferred Stock round (the “Qualified Securities”) by a VC at a Series A Preferred Stock price of $1.00 per share.
(4) Since the Automatic Conversion feature in Joe Angel’s convertible promissory note is triggered by the Series A round, Joe Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.
(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is cancelled.
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