Investing in Early-Stage Ventures: The Questions That Everyone Should Ask

By Patrick Westaway

Broadly speaking, there are two schools of thought when it comes to investing in early-stage ventures. There is the “same boat” approach whereby investors’ interests are aligned with those of the controlling shareholder. And, there is the “bells and whistles” approach whereby lengthy and complex documents try to anticipate all future contingencies. The object of this note is to get beyond the auto-pilot, one-size fits all, approach and identify the questions that any investor should ask when presented with an early-stage investment.

As a preliminary aside, investors in early-stage investments may at some point be presented with a SAFE (a Simple Agreement for Future Equity). This is a contract designed to accommodate investment before a meaningful valuation can be made. It says, in essence, “give us your money today and we’ll figure out how many shares it buys you tomorrow, after we have used that money to get us to the stage at which a meaningful valuation is possible”. As compensation for the greater risk inherent at such an early stage, SAFEs generally offer either a straight-up discount or penalize a lower valuation with a proportionately higher share issuance. On the whole, SAFEs represent a practical solution to a prevalent problem. But, by advancing early-stage investment to an even earlier stage, the right questions become even more important.

The starting point is to recognize that investors do not pay for shares per se but for the rights that those shares bring. As banal as that may seem, the point is that investors must look beyond the shares, be they called “Common”, “Preferred”, “Special This” or “Special That”—there is no magic in the name—and even beyond the number of shares and the percentage that they represent. In short, if an investor’s object is a return on investment then it is to the exit that the investor must look and to the possibility of dilution or dissipation beforehand.

The first question, then, is whether investors have the right to participate if the controlling shareholder sells. The main focus here is the need for an effective “tag along” right in a Shareholders’ Agreement. A key related question is how the company’s value would be allocated among shareholders in the event of a share sale, which depends on the comparative attributes of the different share classes under the company’s Articles of Incorporation.

The next question is whether the investors’ interests may be diluted beforehand. Dilution here applies in two different senses. The first and most important is the reduction of share value by the issuance of additional shares at a lower price. The second, somewhat inaccurate, use is a transfer of previously issued shares in a manner that reduces the investor’s influence. In neither situation is an outright prohibition likely to be in the investor’s interest since the company may need to access additional funding, of which equity may be the most favourable source, and the investor will want to protect its own right to sell independently of other shareholders. This balancing of interests is in both circumstances most commonly resolved through the expedient of a “right of first refusal” pursuant to which new share issuances, and transfers of previously issued shares, must first be offered to all shareholders on the same terms and conditions.

The third concern of central importance is dissipation. Can the controlling shareholders—or management, if the controlling shareholders and management are not one and the same—extract the company’s value and so reduce the sale proceeds in which the investors would otherwise share? There are any number of ways in which this could be done, such as by asset sales, pay raises and bonuses, overpaying on related party contracts and so forth. These possibilities are generally covered through a list of “fundamental changes” in the Shareholders’ Agreement for which a certain threshold of shareholder approval must be met. That threshold must be considered in relation to the particular investor’s own shareholdings. 

There then follows a group of questions for which a satisfactory answer may not be available to all investors. How do we know that the money invested will be applied to the intended purposes? How do we know that management will stick to the business plan? What safeguards are there against wasteful expenditures? These questions speak to management oversight for which representation on the Board of Directors would be needed. Such representation is, however, generally afforded only to shareholders who, whether through their percentage ownership interests or for other reasons, are considered sufficiently significant to the company. For all other shareholders, such questions must simply be recognized as risks to be factored into the initial investment decision.

Finally, investors need to ask whether their shares can be converted into those of another class, and whether the documents on which the answers to the above questions rely can be changed, without their consent. There have been situations in which the investment documentation actually authorizes such changes, in which case investors should insist on their removal or consider walking away.

In summary, neither the “same boat” approach nor standard form documents loaded with “bells and whistles” is a reliable substitute for asking the right questions. It is to get the answers to those questions rather than a set of pre-fab documents that one looks to a good lawyer.