Co-authored by Kaustubh Rastogi and Rohan Parikh
Climate-tech investments in India have taken off, yet funding remains relatively scarce. For early-stage founders building products and solutions in capital-deprived, unproven markets, it is important to raise money smartly. Understanding the implications of using certain investment instruments over others can help them maximise their growth while keeping their dilution to a minimum.
India’s climate-tech moment has arrived. Despite receiving a paltry portion of the total global climate-tech fundraises from 2020-21, India has ranked among the top ten global locations for VC-funded climate-tech companies from 2016-21. The numbers are projected to increase dramatically over the course of this decade. The climate crisis is propelling several mission-driven entrepreneurs to develop products and solutions for the greatest challenge of the 21st century.
Despite the excitement, there exist several issues around investing in climate-tech in India. Lack of patient capital, long product-gestation periods, and unproven markets are deterrents to rapid funding. Early-stage climate-tech founders find themselves competing for a relatively limited pool of capital while also remaining frugal lest they raise too much at low valuations, and as a result, dilute their stake significantly.
While the quantum of funding and the valuation is to be kept in mind during fundraising, it is equally important to think about what instrument best serves a climate-tech founder’s interest as they scale. Different investment instruments offer varying advantages and disadvantages. Being cognizant of this is imperative in countering founder dilution. SAFE Notes, Convertible Notes and Compulsorily Convertible Preference Shares are some of the most common instruments for early-stage investments in climate-tech start-ups.
SAFE (Simple Agreement for Future Equity) Notes
SAFE Notes are agreements that require the issuer (company) to issue equity shares to the contracting party, on the terms and upon occurrence of certain pre-decided events.
Climate-tech start-ups are usually at the proof of concept (POC) stage while raising their first round. Valuing them at this stage can be difficult. Therefore, issuing SAFE Notes can seem like a viable option. Founders not only avoid a priced round but can also delay onboarding investors on their cap-table and on their board. Investors too, can guarantee themselves a pre-determined share of the pie, by putting in a small amount and carving out an upside through variations in the SAFE Notes.
The most common variants of the SAFE note are those with a valuation cap (guaranteeing the highest price per share at which the SAFE Note will convert), those with a discount (on the pre-money valuation of first priced investment round) and those with a hybrid of the valuation cap and discount rate (ensuring that the founder raises the next round at a valuation higher than the cap). Essentially, the lower the valuation cap and the higher the discount, the lower the price per share for the investors and the higher the dilution for the founder. SAFE Notes with a Most Favoured Nation (MFN) clause that allow seed stage investors to mimic the preferential rights and terms of a future round, are less common.
All in all, if SAFE Notes seem like a good bet for both the investors and the founders, then why is everyone not using them? From an investor’s perspective it’s obvious – you have risked your money in an extremely early-stage company but are blocked from all decision making at the board and shareholders’ meetings. Further, your power to negotiate rights in the SHA (shareholders’ agreement when the company is first priced) is significantly low. These investors must live with the rights negotiated by the next priced-round investor.
For a founder, on the other hand, there is a hidden dilution in SAFE Notes that could, often, slip under the radar. The median value of seed rounds for climate-tech start-ups in 2020 was approximately USD 500,000 – not a large sum to develop cutting edge technology. High R&D costs in the climate-tech space and long-gestation period in the lab often leads to founders raising multiple smaller SAFE Note rounds before they are ready for a priced round from institutional funds. The round specific dilution (with each round having a different valuation cap, discount rate or both) and its impact on the cap table is often overlooked and founders can lose significant stake in the company when they finally go for a priced round. But, when a future investor decides to invest in such a start-up, they will do the dilution math and may not like the numbers. They may not be keen to invest in a start-up where founders have already diluted over 25-30% of their stake in the company at the early stages.
Convertible Notes (CN)
A CN is a debt instrument that allows founders to raise debt-capital at a nominal interest rate without diluting equity to the investor at the present date. Like SAFE notes, CNs convert to equity in the company at pre-defined time-periods, or upon the occurrence of a priced round. For climate-tech founders building out their products or in the early stages of monetization, a CN is an effective instrument to raise capital without diluting equity or parting with rights when the CN is issued. CN can also allow for business milestone-based valuations. However, (like a SAFE Note) the founders will negotiate a valuation cap, a discount, or both, with the investors at the time of the fundraise to determine the investor’s percentage holding when the company raises a priced round.
Of course, the downside of a CN is evident when the instrument’s tenure comes to an end, thus allowing the investor (at their sole discretion) to convert their capital (and the compounded interest) to equity at a previously negotiated valuation cap/FMV, or to seek a repayment of the principal amount with a compounding interest rate. For pre-revenue companies, especially those building deep-tech products, the latter scenario can slow down the company’s growth – diverting funds from product development to servicing the debt.
A CN is an attractive instrument for investors because of the ease of execution, sole rights over treatment of the CN post maturity date, and a liquidation preference over any other equity/preference shareholder. The downside, however, is that the investor’s rights in the company, should they choose to convert onto the company’s cap table after the company raises a subsequent round, will likely be determined by the next investor. Future investors may block a CN holder from decision making in the SHA, by providing for a fall-away threshold just above the CN holder’s stake post-conversion.
Early-stage climate-companies building long-lead technologies should assess their product roadmap to ensure the CN conversion timeline does not occur sooner than they can raise a subsequent round of funding, or at least be in a position to repay the principal and interest rate if they are unsuccessful in raising the next round of funding.
Compulsorily Convertible Preference Shares (CCPS)
A CCPS is an instrument convertible to equity upon passage of a pre-decided time or occurrence of triggering events. A CCPS holder has preference over equity shareholder, during liquidation.
CCPS is popular with both investors and founders. The company is priced, and founders have clarity on their dilution and cap-table math, especially for CAPEX/R&D heavy climate-tech companies that must raise a few smaller rounds from angels or micro-VCs before ramping up to larger cheques from funds. CCPS also provides the additional flexibility of a base and cap valuation, typically contingent on product or revenue milestones. Essentially, CCPS offers founders the flexibility of accepting an investment at a certain valuation, and having it bumped up to a higher number basis mutually agreed upon performance metrics, prior to the next fundraise. Investors may also set a base/ cap and/ or discount basis the next qualified funding round. This means that investors will convert their CCPS at a higher valuation, and therefore to a lower percentage stake in the company. This model makes sense for climate-tech companies that require capital to nudge them from POC to commercialisation but can demonstrate tangible growth within 12-15 months of having received the investment.
Investors, on the other hand, prefer CCPS as it offers them pre-determined rights as negotiated with founders. Unlike SAFE and CN, where rights are determined at the occurrence of a priced round, CCPS provides clarity to investors from the get-go. While this is great for the investor, the founder has to part with sole decision-making rights in the company and provide information rights and reserved matter rights to the investor. The elongated negotiations of these agreements can make the investment process tedious. In time-bound or fund-crunched transactions, it is imperative to close out the deal sooner than later.
There is also the flipside to pricing the round. It can be challenging for climate-tech companies that are operating in untested markets with fewer peers to benchmark their value against. This can create friction for founders whose IP may one day be worth millions, but today is limited to a number derived basis the investor’s percentage stake holding preferences.
Conclusion
While all three instruments are recognized and used in India’s early-stage ecosystem, CCPS is by far the more popularly used instrument. Incubators/ accelerators, on the other hand, commonly invest funds through CNs. SAFE Notes, though not as common, have been gaining popularity among micro-VCs and angel investors.
Climate investments are a heady space in India, but it is important to think about the long-term ramifications of parting with substantial stake in favour of investors in the early stages of company building. Irrespective of the instrument used, founders must always raise from true partners, whether they are angels, family offices, or funds, who can help the company grow quickly and meaningfully. As the climate-tech market matures and capital becomes readily available, founders building frugally and in tandem with strategic partners will see outsized climate impact and personal wealth creation in the years to come.