What are the different kinds of financial instruments available to angel investors and VCs for investing in startups?

Author: Partha Chakraborty Published on: January 4, 2023 Published in: Uncategorized

There are several financial instruments that angel investors and venture capital firms can use to invest in start-ups.

Some of the most common instruments include:

Equity: This is the most common type of investment in start-ups. The investor receives ownership in the company in exchange for their investment.
Convertible notes: These are short-term loans that convert into equity at a later date, usually when the company raises a priced round of financing.
SAFEs (Simple Agreement for Future Equity): SAFEs are similar to convertible notes, but do not accrue interest or have a maturity date. They convert into equity at a later date, usually when the company raises a priced round of financing.
Debt financing: In this case, the investor provides a loan to the company, which must be repaid with interest.
Royalty financing: In this case, the investor provides funding to the company in exchange for a percentage of future revenues.
Crowdfunding: This is a way for start-ups to raise capital by soliciting small investments from a large number of people, typically through an online platform.

There are also a number of specialized financial instruments that may be used in certain situations, such as options, warrants, and phantom stock.

What are options and warrants?

Options and warrants are financial instruments that give the holder the right, but not the obligation, to buy or sell a security at a predetermined price within a certain time period.

They are similar in many ways, but there are some key differences between the two.

Options:

Options are contracts that give the holder the right to buy or sell a specific number of shares of a particular stock at a predetermined price (called the “strike price”) within a certain time period.
There are two types of options: call options, which give the holder the right to buy the underlying stock, and put options, which give the holder the right to sell the underlying stock.
They can be traded on exchanges or over the counter.
They are often used as a way to hedge against price movements in the underlying stock or to speculate on the direction of the stock’s price.

Warrants:

Warrants are similar to options, but they are issued by a company rather than being traded on an exchange.
They may be issued as a standalone security or as part of a bond or other debt instrument.
They give the holder the right to purchase shares of the issuing company’s stock at a predetermined price within a certain time period.
They are often used as a way for a company to raise capital or to provide additional incentives to investors.

Options and warrants are both considered to be derivatives, meaning that their value is derived from the value of an underlying asset.

They can be used to hedge against price movements or to speculate on the direction of the underlying asset’s price.

What about preferred equity?

Preferred equity is a type of investment in a company that provides the investor with certain preferential rights compared to the holders of common equity. Preferred equity holders typically have a higher claim on the company’s assets and earnings than common shareholders, and their dividends are typically paid before dividends are paid to common shareholders.

There are a few key features of preferred equity:

Priority: Preferred equity holders have a higher claim on the company’s assets and earnings than common shareholders. This means that in the event that the company is liquidated, preferred equity holders will be paid before common shareholders.
Dividends: Preferred equity holders typically receive fixed dividends that are paid before dividends are paid to common shareholders. The dividends may be cumulative, meaning that if the company misses a dividend payment, it must be paid before any future dividends are paid.
Conversion: Preferred equity may be convertible into common stock at a later date, at the option of the preferred equity holder or the company.
Voting rights: Preferred equity holders may have limited voting rights or no voting rights at all.

Preferred equity is often used as a way for a company to raise capital without diluting the ownership of the common shareholders. It can also be used to provide investors with a higher level of security compared to common equity.

What’s a SAFE, CSOP, CCPS, and CCD and how are they different from each other?

SAFE, CSOP, CCPS, and CCD are all types of employee equity plans. They are different in the way that they are structured and the rights that they provide to employees.

SAFE (Simple Agreement for Future Equity) is a financing instrument used by start-ups to raise capital from investors. It is similar to a convertible note, but does not accrue interest or have a maturity date. Instead, SAFEs convert into equity at a later date, usually when the company raises a priced round of financing.

CSOP (Company Share Option Plan) is a type of employee share plan that is used primarily in the UK. It allows employees to purchase company shares at a discounted price.

CCPS (Company Contributed Pension Scheme) is a type of pension plan in which the company makes contributions to the pension fund on behalf of the employee.

CCD (Collateralized Convertible Debt) is a type of debt instrument that is backed by collateral, such as company assets or securities. It is similar to a convertible bond, in that it can be converted into equity at a later date.

In summary, SAFEs and CCDs are financial instruments used for raising capital, while CSOPs and CCPS are employee benefit plans.

What is phantom stock?

Phantom stock is a type of equity compensation that is used to reward employees or executives of a company. It is called “phantom” because it does not involve the issuance of actual shares of stock. Instead, the recipient of phantom stock is given the right to receive a cash payment in the future that is based on the value of a specified number of shares of the company’s stock.

There are a few key features of phantom stock:

Value: The value of the phantom stock is based on the value of the underlying shares of the company’s stock.
Dividends: The recipient of phantom stock may also be entitled to receive dividends on the underlying shares as if they were a shareholder.
Vesting: Phantom stock may vest over time, meaning that the recipient must remain employed with the company for a certain period of time before they are entitled to receive the cash payment.
Termination: Upon termination of employment, the recipient may be entitled to receive the cash payment based on the value of the underlying shares at that time.

Phantom stock is often used as a way to align the interests of employees with those of the company and its shareholders.

It can also be a tax-efficient way to compensate employees, as the recipient may not have to pay taxes on the phantom stock until they receive the cash payment.

What about investing through tokens?

Investing through tokens refers to the use of cryptographic tokens as a way to represent ownership or a financial interest in a company or project. There are several different types of tokens that may be used for this purpose, including:

Security tokens: Security tokens represent a financial interest in an underlying asset, such as a company’s stock or real estate. They are subject to federal securities laws and may provide the holder with rights such as ownership, voting, and dividends.
Utility tokens: Utility tokens are intended to be used as a means of accessing a product or service. They do not provide the holder with any ownership rights in the company or project, but may be required to use the product or service.
Asset-backed tokens: Asset-backed tokens represent ownership of a physical asset, such as gold or real estate. They may be backed by the underlying asset or by a claim on the asset.
Tokenized securities: Tokenized securities are securities that have been converted into a digital form and represented on a blockchain. They may provide the holder with the same rights as traditional securities, such as ownership, voting, and dividends.

Investing through tokens can offer a number of benefits, such as increased liquidity and the ability to easily transfer ownership.

However, it is important to carefully consider the risks associated with token investments, as they are often highly speculative and may be subject to regulatory uncertainty.

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