The following article is a guest post by Dejan Aleksov, lawyer from the Aleksov-Memishi Law Office, which specializes in providing legal expertise for the IT sector.
The last several years mark a substantial increase of investments for early-stage startup companies. Macedonian startup companies have seen early stage investments that range between 30,000 and 500,000 euros. These funds are the initial capital for startups that are either in the idea phase of the project or have already built an initial product.
Startup products such as: Hey Reach, Coach Microlearning, Air Port Briefing, Earth Care and many others have already received initial investments. Now they continue with the development of the company, the product, and foreign market entry strategies.
Investments come from different sources. The domestic or foreign sources can then involve state, mixed or private funding. Finances come from angel investors, programs and accelerators, etc. Part of the domestic access to capital, with investment in exchange for a share are: 700 Accelerator, Seavus Accelerator, CEED – Business Angels Club, X-Factor Accelerator, Ukim Business Accelerator and others. When it comes to foreign capital, we’re looking at investments such as: Keiretsu Forum, South Central Ventures, Techstars, Day One Capital, Vitosha Ventures, FilRouge Capital and others.
When all the steps for securing an investment have been completed, such as program, presentation, negotiations, and so on, we come to the legal aspects of the process. This means providing appropriate documentation for the process, keeping in mind the legal procedure. One of the biggest challenges is setting up a good legal framework through mutual agreements, in which both founders and investors are equally protected.
During investor and startup meetings a specific terminology is being used, such as:
- SAFE Agreement,
- pre-money/post-money valuation,
- convertibles,
- term sheet
- equity
- investment,
- tag along/drag along,
- pre-emptive rights,
- liquidation preference clause,
- shares vesting for founders
- and other similar terms.
However, considering that the Macedonian Law on Commercial Companies was adopted about 20 years ago, it is challenging to integrate these concepts into appropriate contracts and legal procedure, even though some of the above-mentioned terminology is present in the Laws. In the case of a dispute, you can easily finds yourself in a dead-end.
What is a Term Sheet, can it be considered as an adequate offer?
Term Sheet is a document resulting from the negotiations between the investor and the founder of the startup. This document sets out the key elements of the main investment agreement. These key elements include: the amount of financial assets, the share that the investor will receive, the method of investment and other conditions, rights and obligations.
Pursuant to Article 24 paragraph 1 of the Law on Obligations, it is stated that: “The offer is a proposal for the conclusion of an agreement made for a specific person which contains all the essential elements of the agreement“.
Additionally, according to Article 28 paragraph 1 of the same law: “The offeror is bound by the offer unless he excludes his obligation to maintain the offer, or if this exclusion arises from the circumstances of the work“.
Therefore, if we identify this document in our legislation, it would constitute an “Investment Offer”. The offer is with the exclusion of the obligation to maintain that offer, that is, even if the exclusion arises from the circumstances of the work (for example, the necessary funds are not collected in the projection of the investment round).
For example:
Startup company X aims to raise 50,000 euros in the initial phase for 10% of its company. The funds are collected from several private investors. During several months of negotiations with different private investors, the startup company receives several Term Sheets (non-binding offers) from different investors who want to invest a total of 36,000 euros. If the startup company fails to find an additional 14,000 euros, it means that the conditions for the investment are not met and the financing round fails.
Is Term Sheet a mandatory document for every investment?
Most often, when the startup company receives financing from one or several investors acting together , this kind of document is not needed. The reason is that, if the parties agree on the essential elements, the main investment agreement is concluded immediately.
This document is not mandatory, but is used and recommended when dealing with several different and independent investors.
What is an Investment Agreement?
The investment agreement is a basic but key document that regulates the legal relationship between the investor and the startup company. This agreement defines all important elements and conditions under which the investment will take place. It contains the agreed obligations and rights of both parties, the method of investing the funds, and the management of the acquired share in the company.
Key elements of the Investment Agreement:
Amount of the investment: Determining the precise amount that the investor invests in the startup and the conditions under which that investment will be made.
Method of acquiring a share: The investor receives a share in the company, which is determined based on the estimated value of the startup (pre-money/post-money valuation). The share can be acquired immediately by taking a new stake and increasing the share capital or as a loan that can be transformed into a stake under certain conditions.
Rights and obligations: The rights of the investor and the founders are determined, including voting rights, the right to participate in management, and restrictions on share transfer (tag along/drag along, pre-emptive rights). For more details about these rights, see the “My First Investor” brochure.
Shares vesting for the founders: This mechanism determines how long the founders have to stay in the company to acquire the entire share. It ensures that the founders remain committed to the development of the company. However, this mechanism is not possible in North Macedonia, since the shares are received in full at the moment of taking the stake, at the very establishment of the company. Instead, a contractual provision – reverse vesting – can be used . With this provision, the founders undertake to remain in the company for a certain period, and if they do not fulfill this obligation, they agree to transfer their share or part of it back to the company, without compensation.
Participation in future stages of financing: These provisions determine the same or favorable conditions for initial investors who would invest in subsequent stages.
Significance of the Investment Agreement and its record in the Central Register?
The investment agreement not only regulates the relationship between the startup and the investor, but also plays an important role in the long-term management of the company. It represents the basis for future development phases, new investments, and possible exits from the company.
The Law on Commercial Companies or the Law on One-Stop Shop System and Keeping the Commercial Register and Register of Other Legal Entities does not provide for registration of this Agreement in the CRM. This means that the Investment Agreement is kept in the company’s archive.
Pre-money / post-money valuation (value of the company before and after the investment)?
The value of the company is one of the most important aspects when determining the terms of investment in a startup. Pre-money and post-money valuation are two key terms that indicate this value before and after the investment.
Pre-money valuation
Pre-money valuation represents the estimated value of the startup company before the new investment is made. It is important to note that there are several methodologies for determining the value of a company. However, in the initial stages of development and investments, this value is determined “arbitrarily” by the founders themselves. For example, if the founders arbitrarily determine the value of the company as a pre-money valuation of 500,000 euros and the investor invests 100,000 euros, then the estimated value of the startup before the investment is 500,000 euros.
Post-money valuation
Post-money valuation, on the other hand, represents the value of the company after the new investment is taken into account. It is the total value of the company after the investment and includes both the pre-money value and the new invested funds. In the same example, if the startup has a pre-money valuation of 500,000 euros and the investor invests 100,000 euros, then the post-money valuation will be 600,000 euros.
Example of calculation of shares:
- Pre-money valuation: 500,000 euros
- Investment amount: 100,000 euros
- Post-money valuation: 600,000 euros
In this case, the investor will receive a share in the company which is calculated as part of the post-money valuation:
- Share percentage = (Investment amount / Post-money valuation) × 100
- Share percentage = (100,000 euros / 600,000 euros) × 100 = 16.67%
So, the investor will get 16.67% of the company, while the remaining 83.33% remains with the existing founders of the startup.
Meaning of Pre-money and Post-money valuation
These values are crucial in negotiations between investors and startup companies. Pre-money valuation determines the initial position of the startup, while post-money valuation determines the final ownership structure after the investment. Founders typically aim for a higher pre-money valuation to retain more ownership, while investors seek a fair value that will provide them with a fair share of their investment.
Value relative to the stakes?
Pursuant to Article 193 paragraph 1 of the Law on Commercial Companies:” The partner’s share is determined according to the size of the stake taken by the partner, unless otherwise determined by the partnership agreement “
This article allows founders and investors to contractually determine their shares. This means that although the investor’s stake is 100,000 euros, and the founders’ stake is 5,000 euros, with a final amount of the basic capital of 105,000 euros, still contractually the investor can get a 16.67% share, and the founders 83.33%. Since the value of the company is different from the stake, and the same value is not subject to registration in the CRM, but arbitrarily determined by the founders, the negotiation process is very important. By receiving such an investment, the arbitrary value receives some kind of “confirmation” from the investor, as a real value.
Cap Table (table of capital), or book of shares?
Cap Table is an important document that shows the ownership structure in a startup company. This document provides a detailed overview of all the partners in the company, their shares, and how the capital is distributed among them.
Cap Table is especially important for startups because it provides a clear overview of who has control in the company and what is the value of each partner’s shares at different stages of financing.
In our country, according to the ZTD, this document is defined as a book of shares. In Article 195 paragraph 1 of the ZTD it is determined that: “The manager of the company is responsible for keeping the book of shares in which, after the registration of the establishment of the company in the commercial register, data for each partner is entered for:
- The first and last name,
- Citizen identification number (EMBG)
- the passport number, i.e. the number of the identity card if the partner is a foreigner or a number of another identity document valid in his country, as well as the place of residence
- the company (name), headquarters, EMBS if the partner is a legal entity,
- the date on which he became a partner,
- the amount of the investment that the partner paid or is obligated to pay,
- the method and time of the payments, as well as the additional payments he paid,
- description and statement of the agreed value of the non-monetary contribution that has been entered or undertaken to enter in the future,
- all obligations that come with the share,
- the number of votes it has when making the decisions of the partners,
- special rights and duties arising from the share.
Need for legal changes
The Macedonian startup ecosystem is developing significantly, with increasing access to finance and early-stage investments. However, this progress is accompanied by numerous legal and regulatory challenges.
The Companies Act was enacted more than two decades ago and does not address the specificities of today’s startups and their funding needs. This situation requires a careful and innovative approach in drafting contracts, as well as excellent communication and understanding between founders and investors. Founders often need to be willing to negotiate the terms of the investment, especially regarding the value of the company and the allocation of shares. The negotiation process not only defines the rights and obligations of both parties, but also affects the long-term success of the company.
The absence of case law in this area further complicates the situation, making it necessary for investors and founders to carefully draft their legal agreements. It is essential to ensure that written agreements are clear and precise to avoid potential disputes in the future.
Because of this, initiatives for legal changes, such as the initiative to introduce a new type of trading company – a company with variable capital, are of great importance.
The future development of the startup ecosystem will greatly depend on the ability of legal regulation to adapt to new challenges and the adoption of best international practices, in order to create legal certainty and trust between investors and startups.
Note: This piece is of informative nature, involving extracts from the current laws in North Macedonia as well as personal opinion of the author. The content should in no way be considered as a professional advice.
