The foundation of any startup is an idea to create something new. To create something, you need someone that can do it. To find that someone, you have to pay them. The problem is, startups often don’t have the money for that, which is why they either have to look for investment to pay their specialists or to seek out those willing to work under certain conditions or for a lower salary, or even, initially, for free. Traditional Ukrainian legislation on structuring such relations is rather clumsy and archaic, which makes it a challenge to build stable partnerships.

Diia City makes it possible for its residents to use elements of English law that have been implemented in our legislation. There are at least two interesting instruments for startups to help them raise finances: options and convertible loan notes. Maksym Nosarev, attorney and Tretten Lawyers CEO, explains how to make use of these instruments.

Published on ain.ua

Is it possible to attract investment successfully without joining Diia City

Of course, Ukrainian startups have been finding investment under pre-Diia City legislation as well. However, nothing can stop an idea when its time has come.

When I talk about investment, I mean it in the broadest sense of the word. When specialists contribute their time and expertise to a project for a lower salary than usual – this also is a way of investing in a startup.

Good specialists can’t work for long on enthusiasm alone, without decent pay. This is why Ukrainian business has long been interested in the ​​options instrument. An option is an arrangement with an employee, under which he agrees to work on a project for a more modest remuneration in exchange for getting a stake in the company after a certain period of time or upon achieving specific results.

Traditional Ukrainian legislation has no direct mechanism for specifically signing a document which would pledge a stake in a business to someone under certain conditions. That is to say, a Ukrainian company that isn’t a resident of Diia City is unable to grant options to its employees. All it can do is sign an agreement with employees in which to promise to sell them stock after, say, 4 years. However, there is no reliable mechanism to ensure that the company would make good on that promise. Even with a complex system of penalties, should something go wrong, there’s no telling whose side the courts will take if it comes to litigation.

That’s why some IT companies have turned to so-called phantom stock options. This is when you pay the employee a bonus in the form of a pre-agreed sum or the equivalent percentage of the company’s value at the time of paying the bonus (phantom stock option) after a certain time working on the project and for achieving specific KPIs. 

But it still doesn’t quite cut it, does it? Just like with financial investment, you offer a partnership to the investor, but unless you two know each other, he’ll find it difficult to trust, let’s say, three sole proprietorships with nothing but an idea behind them. Even if you’re a legal entity – LLC or JSC – a serious investor would first want to see how capable you are, offer unfavorable terms, or simply say no. After all, giving away money for a stake in a business that may never take off is risky.

Outside Diia City, startups can:

  1. Take the investor’s money and give him stock right away. This would mean his involvement in both revenue distribution and business management.
  2. Borrow money. When it’s time pay it back, offer the investor a stake in the company instead. Or, if all finances are tied up, drag things out as long as you can instead of making that offer. That’s because traditional Ukrainian legislation offers less protection to investors, which is why they are often so reluctant to invest in startups in the first place.

Diia City enables startups to attract investments using convertible loans: when borrowing money, you immediately state in the agreement that you will be returning the debt either as funds with interest or as stock – whatever the investor chooses after a period specified in the agreement.

It’s not Ukrainian reformers that came up with these two ways of shaping relations between the company and its employees or investors. These are elements of English law that have stood the test of time.

How to issue options as a startup in Diia City

Options are attractive for startups as they get you the specialist’s labor and expertise right away and on the cheap in exchange for a stake in the business that will be granted if certain conditions are met.

Of course, you could hire a great developer for little money and immediately give him the stock. However, who’s to say that in half a year he won’t leave you for some other project?

Instead, we tell him: you work for us for, say, 3 years, and during this time you must complete the following tasks to help our business grow. After 3 years, you will be able to buy for 1 dollar stock that may cost $1,000 by that time. It’s no secret that when employees are personally invested in their company’s success, they produce better results. After all, this is to their benefit as well.

It’s worth mentioning that Diia City companies that no longer are startups can also issue options to employees to motivate them. In countries with more established business traditions, this instrument has already proven its effectiveness.

Let’s take a look at how to launch the mechanism for issuing options in your startup.

  1. Decide who you will be offering options to. It can be all employees involved in the startup, key specialists, or just a select a few of those.

It’s important to strike the right balance here because, once the options are due, the owners’ equity will decrease (so-called dilution of stock). If the new co-owners don’t agree to sell their stake to you, it’s not just the profits that you’ll have to share. So if you miscalculate – give major stakes to several people at once, or smaller stakes to multiple people – you risk eroding your control over the company.

That is why, whether your options are 5% or 0.01%, it’s important to consider these things, perhaps with the help of finance experts, business analysts, lawyers, or simply more experienced colleagues.

  1. Determine the term after which the specialist receives the right to a stake in the company. It’s usually set at 3-4 years. Less than 2 years is not enough to achieve appreciable results while 4+ years is too long – many would just get tired of waiting and abandon the project.
  2. Choose the mechanism via which the specialist obtains the rights under the option (vesting schedule). For instance, you can make it so the person gets a 1% stake after 4 years, or 0.25% in a year and every 3 years afterwards. It’s up to you to set the terms and any additional requirements for the employee. Just remember that if you want this to work out, the terms should be enticing enough for the specialists that you consider vital to the project.
  3. Draft the options agreement. It can be either an additional agreement to a gig or employment agreement, or a separate one. Aside from the aforementioned points, it should have provisions for terminating the agreement. This way you will be protected if an employee grossly violates company rules or harms your business. At the same time, the text should contain provisions with guarantees for employees in case the options agreement falters because of the company.
  4. Offer the agreement to your employees. Be prepared to explain things at length and answer tons of questions about how it all works. Always keep in mind that it’s essentially a partnership agreement, so it should be beneficial to all parties.

The options mechanism is interesting to startups because it’s useful right away. It allows you to retain key specialists and can even motivate lower-level specialists to up their game – and all this without direct expenses on the startup’s part. At the same time, mass issue of options may scare off investors with the prospect of diluting their stake.

Well-thought-out option terms encourage everyone to stay focused on getting results, and that focus is the only way for a startup to grow into a successful business.

How convertible loans work

Another mechanism for attracting resources that Diia City offers startups is convertible loans. With these, a company can repay its investor by giving away stock if the investor asks for it at a certain point in the company’s development (in accordance with the terms of the loan agreement).

Benefits for investors:

– even if they have no confidence in the startup’s success, they don’t risk losing their money;

– they are able to take a closer look at the business and its owners and make an informed decision: whether to take away the funds or leave them and allow the startup to grow;

– after a certain period, they will be able to participate in profit distribution if the company is successful.

Benefits for the startup:

– it’s easier to persuade investors to fund your idea;

– investors get the stock following a certain period, not right away, so they won’t be interfering if they don’t like the way you do things;

– the company won’t necessarily lose the invested funds as with conventional loans, although it would mean having to share profits eventually.

In short, Diia City residents get a new instrument for attracting investment while investors no longer have to buy a pig in a poke.

To start using the convertible loan instrument, the company needs to:

  1. Calculate and determine how much stock it’s willing to give up in the future for a specific amount of investment right now.
  2. Assess whether it will be able to pay back the debt with interest if the investor doesn’t choose the stock.
  3. Consider currency-related risks. If the investment/loan is in foreign currency at the exchange rate of 29 UAH to 1 USD and that rate could go up significantly by the time the loan is due, it’s important to anticipate this when planning expenses.
  4. Draft the agreement, finalize it with the investor, and get the funds.

As in the previous point, I must stress how important it is to find the right balance in calculations to protect the founders’ interests. If you choose the above mechanism, you should understand that, for instance, if there are three of you right now with a stake of 33% each, in a few years there may be four of you, each with 25%. While crunching the numbers, it would be prudent to consult finance and other experts that can help with this, because an insider’s perspective, coupled with insufficient experience and a state of euphoria from starting your business, could cause you to overlook a lot of important details.

Is Diia City worth it for startups today?

If your startup needs additional resources to keep growing and raising finances isn’t working out, you could consider joining Diia City. The mechanisms described above are essentially more flexible ways of attracting investment. They get you the needed resources right away without letting outsiders interfere in the business as co-owners from the get-go.

Of course, these mechanisms entail transparent business practices, reporting all your income, and conscientious paying of taxes. Nevertheless, as experience shows, it’s worth it in the long run.