A Crucial Strategic Playbook For Early-Stage Tech Founders
Raising investment is often time-consuming and daunting, especially for early-stage founders managing the process alone while scouting for the correct set of investors, communicating their startup’s unique selling proposition, establishing their startup’s product market fit, determining the sweet spot of funding requirements, negotiating with potential investors their desired valuation, managing the expectations of their existing stakeholders and amidst all this manage the overall timelines for the fundraising. Fund raisings also become a significant distraction from a founder’s job of running and growing his business and dealing with more pressing issues – mounting cash burns and contending with the fierce market competition while striving to carve out a niche for their tech companies.
For tech startup founders, many of whom lack a legal background, navigating the complexities of financing – from debt options like venture debt financing to various forms of equity financing – adds another layer of complexity. However, if, as a founder, you have chosen to pursue equity funding in a priced round – where shares are issued to investors at a predetermined valuation – rather than opting for convertible notes, here are essential pointers to help you navigate your fundraising process effectively:
- Establishing Your Priorities: It’s essential for founders to take the reins and establish their round’s priorities. This strategic move allows you to execute a successful priced equity round, maintain control over the process, and ensure a smooth closing. Here are some critical steps to consider:
(a) Define Objectives: Determine the primary objective of your equity fundraising round. If the goal is to secure cash for business growth, focus on efficiently closing the round without reopening terms agreed upon in previous transactions. Timely closure ensures the timely availability of funds for immediate business requirements. Alternatively, if the objective is to establish or increase your startup’s valuation, mainly if the previous round involved a convertible note and was unpriced, early engagement with advisors is crucial. Therefore, plan before the fundraising round to optimize priorities while raising equity financing.
(b) Review Previous Documents: Evaluate the shortcomings of your previous deal documents and identify areas for improvement. Planning how to address these shortcomings in the new round is essential for streamlining the process and mitigating potential issues.
(c) Engaging with advisors early in the fundraising process is not just beneficial; it’s crucial. This proactive approach allows you to establish clear priorities, strategically plan for the next round, and maximize the effectiveness of your equity fundraising efforts. It’s about being prepared and taking control of your startup’s future.
2. Estimating your startup’s valuation: Estimating your startup’s valuation is not just a step; it’s a crucial one. This strategic move is key to attracting investors and determining the equity allocation to incoming investors on your cap table. While valuations are subjective and hence subject to negotiation, here are some steps to ensure a credible valuation determination strategy to gain investor confidence with your numbers:
(a) Financial Forecasts: Base your valuation on realistic financial projections, providing a solid foundation for negotiating with investors based on the business’s potential.
(b) Market Benchmarking: Compare your startup to similar businesses in your sector, especially those at a similar stage of development. Recent funding rounds can serve as valuable benchmarks for assessing market sentiment.
(c) Avoid Unrealistic Valuations: While aiming for a higher valuation is tempting, starting negotiations with an inflated figure can deter investors. Be realistic and open to negotiation to foster investor interest. Setting an unrealistic valuation may also lead to future down rounds, where the company’s valuation decreases compared to previous rounds. These issues can be detrimental to investor confidence and the overall health of the startup. By maintaining a realistic approach to valuation, you can increase investor confidence and facilitate successful fundraising efforts for your startup.
(d) Pre-money Valuation: Ensure your startup’s valuation is based on pre-money rather than post-money to minimize dilution for the founder and preserve equity.
By following these steps and maintaining a realistic approach to valuation, you can increase investor confidence and facilitate successful fundraising efforts for your startup.
3. Research Your Potential Investors: Conducting thorough research on potential investors is critical for evaluating compatibility and making informed decisions about who joins your cap table. Here are some essential steps to consider:
(a) Track Record: Investigate the historical track record of your potential investors in backing startups. Look for evidence of their successful investments, level of involvement in portfolio companies, exit timelines, and any notable exits or failures. All this helps you gauge the overall investor’s experience and expertise and enables you to draw boundaries of what aspects you may be unwilling to accommodate as a founder. Illustratively, certain investors may have elaborate internal reporting requirements that necessitate frequent information requests from startups. You may need to hire a corporate management team to meet such requests, which would hamper your expectations of maintaining a lean team early in your startup stage.
(b) Autonomy of Portfolio Companies: Assess the level of independence enjoyed by portfolio companies of your prospective investor. Understanding the investor’s level of engagement in day-to-day operations can provide insights into their management style and potential impact on your startup.
(c) Reputation in the Ecosystem: Consider the investor’s overall goodwill and reputation within the startup ecosystem. Seek other founders, industry professionals, and advisors’ feedback to gauge the investor’s standing and credibility. A reputed investor will help you appropriately design your marketing strategy and attract more capital. That explains why offering equity to shark tank investors is so popular among tech startups.
(d) Alignment of Values: It’s crucial to ensure alignment between your startup’s mission and values and those of the potential investor. Look for investors who have demonstrated interest in founders with similar backgrounds, missions, and industry focus. Evaluate whether the investor’s existing portfolio aligns with your strategic goals and market positioning. This alignment will reassure you about your startup’s future and attract investors who share your vision.
(e) Potential Conflicts of Interest: Be cautious if an investor has also invested in your competitors, as this may create conflicts of interest. Indian startups are replete with examples of investor bias when confronted with the dilemma of choosing between one portfolio company and another operating in the same space.
By dedicating time to researching potential investors and considering these factors, you can make informed decisions about who to invite into your startup’s journey and ensure investor alignment with your vision for growth.
4. Avoiding Over-Dilution: Founders must maintain control over their startups and safeguard their influence on their startup’s business decisions. Here are some strategies to mitigate over-dilution:
(a) Evaluate Adequate Funding Needs: When determining the size of your fundraising round, carefully assess your funding requirements. The key is to balance raising sufficient capital for growth and minimizing dilution.
(b) Retain Significant Ownership: Successful founders often aim to retain at least 50% ownership by the time the startup reaches its Series B round of equity funding. This approach ensures that founders maintain a substantial stake in the company and retain influence over its direction.
(c) Implement Control Mechanisms: Even if your ownership falls below the 50% threshold, founders can maintain control through various mechanisms. For example, establishing control through founders-controlled board nominees or implementing a founder’s affirmative voting structure can help safeguard your influence on critical decisions.
By carefully managing fundraising rounds and implementing control mechanisms, founders can navigate the challenge of dilution while preserving their ability to steer the direction of their startups.
5. Evaluate Your Control: Founders must assess and protect their control over critical operational and strategic decisions within their startups. Here’s how founders can evaluate and maintain control:
(a) Define Strategic Matters: Collaborate with investors to establish clear guidelines on strategic, operational, and protective matters that require mutual agreement or solely be determined by founders. While there’s no universal standard for determining matters falling within operational and strategic decision-making, founders can leverage established market practices to guide their evaluation. Understanding industry norms can help founders identify areas where they should assert control. For example, it would be wise of a founder to insist that any merger of his startup with a competitor should also require the founder’s consent.
(b) Protective Provisions: Ensure that founders have veto rights or significant influence over critical matters, especially in the later stages of startup financing when founders’ shareholding may have significantly diluted. Founders holding a controlling stake also safeguard founders against unwanted outcomes such as forced founder removals.
(c) Differential Class Shares: Consider issuing differential class shares for founders with enhanced voting rights. This strategy, seen in global tech giants like Facebook and Snapchat, can give founders greater control over decision-making processes. However, it is still not common in Indian startups.
(d) Learn from Past Cases: Study past successes and failures to glean insights into effective control mechanisms and potential pitfalls. By learning from the experiences of others, founders can better navigate challenges and protect their interests. Accordingly, by proactively evaluating control measures and implementing appropriate protections, founders can significantly influence their startups’ operational and strategic direction, ensuring alignment with their vision and goals.
6. Investor Dominance: Founders must resist dominance by one or a group of investors holding a significant stake. Here are some strategies to mitigate the risk of investor control:
(a) Statutory Veto Rights: Be mindful that investors holding more than a 25% stake in your startup would enjoy statutory veto rights under the Companies Act, 2013. Understanding the implications of these statutory rights is imperative in striving to prevent investor dominance.
(b) Prevent Cartelization: Take measures to prevent investor cartelization, where multiple investors join forces to exert undue influence. Ensure that critical decisions requiring investor approval are subject to the majority consensus of investors by number or stake. Furthermore, it limits governance rights to significant investors with a substantial stake in the company and hence’ skin in the game’ in the startup’s success.
(c) Threshold-Based Rights: Grant investor rights based on specific shareholding thresholds rather than individual investors. This approach provides clarity and consistency in decision-making processes and prevents disproportionate influence from individual investors with minuscule stakes.
By implementing these measures, founders can maintain control over their startups and ensure that decision-making processes are fair, transparent, and aligned with the company’s and its stakeholders’ best interests.
7. Resist Issuing Participating Preferred Instruments: Resisting the issuance of participating preferred convertible shares can be beneficial for founders, as these instruments can potentially disadvantage founders and lead to increased dilution. Participating in preferred shares entitles investors to participate twice in the distribution of proceeds. First, they receive their entitlement to dividends and liquidation proceeds, and then they also receive a share of any remaining proceeds granted to equity holders. This can significantly reduce the returns for founders and other equity holders. From a founder’s perspective, non-participating preferred shares are preferable as they limit the investors’ participation to only their initial investment and any accrued dividends. This ensures that founders retain a larger share of the proceeds during a liquidation event. Non-participating preferred shares are more common in today’s equity funding deals and align with industry standards.
8. Resisting atypical Rights: Resisting the granting of atypical rights, such as super pro-rata rights, to investors can help founders maintain control over future funding rounds and prevent excessive dilution. Here’s why founders should carefully consider such rights:
(a) Super Pro Rata Rights: Super pro-rata rights give investors the first right to subscribe for shares beyond their pro-rata entitlement in future fundraising rounds. This can lead to disproportionate dilution for existing shareholders, including founders, by reducing the stake available for incoming investors. Granting super pro-rata rights can impede the ability to offer attractive stakes to new investors, potentially hindering future fundraising efforts. If super pro-rata rights are deemed necessary for commercial reasons, consider imposing expiration dates for investors to exercise these rights. This helps maintain flexibility when introducing new investors to the cap table without being unduly constrained by existing shareholders’ rights.
(b) MFN Terms: When negotiating investment terms, founders should carefully consider the implications of granting the most favoured clauses to investors. It’s essential to strike a balance that protects the interests of both founders and investors while preserving flexibility for future fundraising activities.
9. Exits: Designing a robust exit strategy is crucial for founders to ensure a smooth transition and maximize returns for all stakeholders. Here are some critical considerations for crafting an effective exit plan:
(a) Exit Mechanisms: While IPOs and strategic sales are standard exit mechanisms in India, founders must negotiate reasonable exit timelines to accommodate market conditions and ensure flexible exit timelines are workable for all parties involved.
(b) Avoiding Onerous Exit Mechanisms: Exits through put options or buyback mechanisms can create an inappropriate risk-reward framework for founders and, hence, best avoided. These exit mechanisms may also not provide sufficient liquidity to investors to afford a complete exit from startups or align with the startup’s long-term goals.
(c) Control over Exit: Carefully evaluate who has the right to force an exit. Ensure that exit decisions are made collaboratively through an investor majority structure, with input from founders at the board and shareholder levels.
(d) Lock-up Undertakings and Warranties: Consider the nature of lock-up undertakings and warranties that founders are expected to provide. Evaluate whether founders can participate in the IPO process to realize liquidity, especially considering liquidity may be restricted after an IPO.
(e) Housekeeping Drag Rights: Introduce housekeeping drag rights to prevent a collective sale of the company from being held up by dissenting minority shareholders. This ensures that major decisions, such as consolidation efforts, can proceed smoothly with the approval of majority of the shareholders.
10. ‘Pay to Play’ Anti-dilution: When negotiating anti-dilution provisions, it’s crucial to balance protecting investors’ economic interests and maintaining fairness for founders. Here are some considerations:
(a) Avoid Full Ratchet Protection: Full ratchet protection, which offers investors complete protection from dilution regardless of the price of the new issuance, should be avoided. These protections are non-market as they disproportionately penalize existing shareholders and discourage future investment.
(b) Weighted Average Anti-Dilution: Weighted average anti-dilution protections are reasonable and commonly accepted mechanisms to protect investors in the event of a down round. A broad-based weighted average anti-dilution protection ensures investors’ economic interests are safeguarded without unfairly diluting founders and existing investors.
(c) ‘Pay to Play’ Structures: Prioritize ‘pay to play’ structures over automatic conversion-based anti-dilution mechanisms. Conversion-based anti-dilution provisions can be complex and may need to align with the interests of all stakeholders. Conversely, ‘pay to play’ structures protect investors from dilution only if they participate in subsequent funding rounds, thereby incentivizing continued investor support.
(d) Exclusions from Dilution Triggers: Certain aspects, such as limited advisor equity, should be excluded from dilution triggers to avoid unintended consequences and ensure fairness in the anti-dilution provisions.
By carefully considering these factors and negotiating anti-dilution provisions that balance investor protection and fairness, startups can maintain investor confidence and support while preserving the integrity of their capital structure.
11. Leaver Provisions and Reverse Vesting Alternatives: When it comes to leaver provisions and reverse vesting arrangements, it’s essential to strike a balance between protecting the interests of both founders and investors. Here are some considerations and alternatives:
(a) Reverse Vesting Alternatives: Consider alternative arrangements such as reverse vesting agreements instead of traditional leaver provisions. These agreements can protect investors in the event of a founder’s departure while incentivizing founders to remain committed to the company’s success. Engage with investors to find mutually beneficial solutions that preserve founder incentives without overly penalizing the founding team in case of a leaver event. Such approaches involve customizing leaver provisions or exploring creative arrangements that address the concerns of both parties.
(b) Customization: Tailor leaver provisions and reverse vesting agreements to the startup’s specific circumstances and stakeholders’ expectations. This involves defining different categories of leavers and applying provisions accordingly to fairness and alignment with the company’s goals. For example, the implications of a bad leaver cannot be assigned to a founder who is incapacitated or asked to resign from the startup voluntarily.
12. Liquidation Preference: When considering liquidation preferences, founders should carefully define a “Liquidation Event” to ensure fairness and alignment with the company’s goals. Here are some key points to consider:
(a) Definition of Liquidation Event: It is essential to define a Liquidation Event to include only material cash-generating events where money can be distributed to shareholders. Be cautious about including events such as an IPO, which may not align with the purpose of liquidation preferences and could disadvantage founders.
(b) 1X LP Rule: “1X” liquidation preference is the norm, indicating that preferred shareholders are entitled to receive an amount equal to their original investment before any distributions are made to the equity shareholders. Amounts exceeding 1X should be commercially negotiated as it would decrease the distribution of returns to founders, which may need to be more equitable.
(c) Tax Implications: Consider the regulatory implications of preferential payments to investors in the event of a liquidation. Ensure that the structure of liquidation preferences complies with tax regulations and does not create unintended tax liabilities for the company or its stakeholders.
13. Managing the Process: Managing the funding process is a crucial aspect of startup growth, and the approach can vary depending on the founder’s preferences, team dynamics, and the complexity of the fundraising round. Here are some considerations:
(a) Founder’s Role: As a founder, you may manage the funding process directly, especially if you have experience and expertise in negotiations and investor relations. This hands-on approach allows for direct communication and alignment with the startup’s goals.
(b) Team Dynamics: Consider the capabilities and availability of your team members when deciding who will manage the funding process. In some cases, a dedicated team member with financial or negotiation skills may be more equipped to take the lead, allowing the founder to focus on other aspects of the business.
(c) Complexity of the Round: If the fundraising round involves multiple existing investors, new investors, and advisors, the process may become more complex and time-consuming. In such cases, founders may opt to appoint an investment banker or external advisor to manage the process, leveraging their expertise and network.
(d) Internal Point of Contact: The decision to appoint an investment banker or manage the process internally is founder-specific and should align with the founder’s preferences, strengths, and resources. Some founders prefer a hands-on approach, while others benefit from external expertise and support. However, regardless of who manages the process, it’s essential to designate an internal point of contact within the startup to coordinate communication and facilitate collaboration between existing investors, incoming investors, advisors, and other stakeholders.
14. Remembering the opportunity cost: Managing the fundraising process involves understanding the opportunity costs of stretching the round and delaying cash receipt and business needs. Accordingly, founders must adapt strategies to navigate this significant challenge appropriately:
(a) Realistic Timelines: Recognize that raising a funding round often takes longer than anticipated, especially for growth or late-stage equity financing. Early-stage rounds, such as seed rounds, typically have shorter timelines. However, regulatory approvals, investor interest, and market conditions can influence overall timelines, which often range between three and four months.
(b) Engage Advisors: Work closely with advisors to ensure that negotiation efforts focus on critical points of concern without over-negotiating less immediate risks. Avoiding excessive negotiations helps streamline the negotiation process and speeds up fundraising efforts.
(c) Flexibility and Adaptability: Understand the opportunity cost of prolonged fundraising efforts and remain flexible to adjust strategies as needed. It’s essential to prioritize fundraising efficiency while balancing the need to address potential risks and concerns.
(d) Future Rounds: Remember that fundraising is an iterative process. When more investors join the cap table, you’ll have opportunities to revisit and refine your shareholder agreements in future rounds. Feel free to reopen discussions when the right timing and stage are set.
Before raising your next equity investment, watch out for these themes to streamline your funding process. Hopefully, this note offers you valuable insights, practical tips, and answers some of your pressing questions about your startup next fundraising.