From negotiating equity rights to avoiding first rights of refusal, here are tips for founders to get the best deal they can in today's tough venture financing market.
Every business needs money, but money is never free. Each funding round will have its conditions and stipulations, which are first laid out in a term sheet.
The market has, of course, changed drastically in the past year. Investors want to see higher annual recurring revenue, higher net dollar retention – especially for software-as-a-service businesses – and expect a stronger focus on profitability earlier on.
“In this downturn in the financial capital markets right now I’ve seen investors saying we want to see a 400% year-on-year growth, whereas two years ago if you showed them 200% year-on-year growth, that was fine,” says Soren Nielsen, senior manager at advisory firm Thursday Consulting.
Investors also want to pay less for bigger stakes in companies.
Valuations have come down across the board and the size of investments are generally smaller. This has led to more more aggressive terms and an environment in which investors hold most of the cards.
“If I’m being honest – I’m a bit of a cynic – I think the investors know that there are not many companies where they’re going to be in a highly competitive process with multiple other offers, and so they can be a bit more robust and a bit more bolshy in their negotiating stance,” says Chris Keen, partner at law firm Mishcon de Reya.
Some terms are more important than others, but generally speaking, stringent terms that make a deal fall apart are few and far between, and there is a degree of malleability to terms depending on the value assigned to them by each party.
“I would say none of [the terms] can be real deal breakers as long as you accept that each of them is kind of a bargaining chip. They have different values, and you just need to be open to make the right compromises,” says Frederick Michna, principal at investment firm MIG Capital.
Here are seven tips for startups seeking to raise money from investors:
1. Prioritise terms over valuation
The first thing anyone will be looking at – startup and investor – is the valuation. Everything else revolves around that central question: how much is this company worth? Being too far apart here can kill a deal in the cradle. If the counterparties are not in the same ballpark during introductory calls, there’s not much point in continuing the engagement.
Founders will push valuations up and investors will push down; but, in the early stages, founders would do well to focus more on the terms than on the valuation, says Gauthier Van Malderen, CEO of digital online library company Perlego.
“I feel very passionate about this, because what I see for a lot of my fellow founder friends right now is, they might raise $150 million pre-money, but then they have a 2x liquidation preference stack on there, so that means, actually, at a liquidity event or a down round, the founders get completely screwed,” he says.
“Valuation is important, but I would discount maybe 10% to 15% of the valuation for better terms [at earlier stages].”
2. Make sure you get paid something back when the company exits
Liquidation preferences – the proportion of the original commitment that is guaranteed to be returned to an investor in an exit – have always been a part of term sheets. Since the downturn, however, investors have seen their risks increase, and with them, their focus on downside protection. This has led liquidation preferences to rise in frequency and size.
For example, in the past an investor may have been looking for 1x liquidation preference or less – just guaranteeing they would make their initial investment back in an exit. It’s not uncommon today to see 1.5 to 2x preferences. Another thing to keep an eye on is whether or not the liquidation preferences are participating, which determine if the investor can participate in the distribution of the remaining proceeds, on a pro-rata basis, after their liquidation preference has been paid out.
For founders, this presents a problem as you don’t want to agree to something that would leave you nothing at the end of a sale.
3. Negotiate equity rights early on
In the early stages, the team is the company, and keeping staff committed is crucial. Investors don’t want see a founder leave 18 months after a round, taking with them a large chunk of equity that will sit passively and is difficult to activate.
Founder vesting provisions lay out time-based milestones for founders to keep the equity they already have. A simple example would be a founder keeping 25% of their equity after each year following a fund raise, fully vesting after year four. If a founder says before going into a round that they want their shares vested after two years, it might raise questions about their long-term commitment.
Keen advises negotiating founder vesting provisions in the term sheet phase – which is non-binding – rather than leaving it until the “long-form” binding documents are drawn up.
“I’ve seen some founders receive terrible advice from people on their board saying, ‘Just figure it out in the long-form documents’. Whereas in reality, of course, it’s too important to leave until you are running on fumes, and you can smell the money, to be negotiating the terms that create a bit of carrot and stick around your own equity as a founder,” says Keen.
After around series B, when the survival of the business is no longer dependent on the founders individually, vesting terms tend to disappear.
4. Keep the board small and don’t give out seats willy-nilly
For more mature startups, provisions around governance become more relevant. Things like who gets a board seat and what decisions would require board approval come into focus at later stages.
The impact of a board seat shouldn’t be underestimated, and founders shouldn’t be handing them out lightly.
“I see too often that some of these investors, they just, by default, want to be part of the board. But can you actually deliver something in that board?” says Nielsen. Founders should be particularly careful about giving corporate investors a board seat, because they may at times want it as a form of control to assure the mothership that its money isn’t going into something the corporate parent doesn’t approve of.
The role of personal ego can’t be discounted here, either. A new investor coming in can spark discussions of how deserving existing board members are of their seats. If someone’s shares represent less than 5%, for example, and they don’t have plans to contribute to future rounds, should they cede their seat to someone with more skin in the game? This is partly the reason that many investors often consider existing investors more challenging counterparties in term sheet negotiations than the startup itself.
“It’s really important as a founder to ensure that [a prospective board member] is good talent and not just someone who wants to use this as a stepping stone to accelerate their own career in the big corporate,” says Van Malderen, whose own company didn’t have a board until series B. He warns against having bulky boards that may waste too much of a founder’s time.
“The worst is when you have a board of 15 people and they all talk, so try and keep it as small as possible, as long as possible.”
5. Beware of giving information rights to corporate investors
Information rights are also crucial to think about. Who gets to know what, and when, will always be a big sticking point, especially when dealing with corporate investors.
If the corporate is a potential customer or future acquirer of the company, certain information may, for example, give them insight into when is a good time to make an offer. Complicating matters is if the startup has the corporate’s potential rivals as customers and may therefore glean insight into their operations.
“I would say we usually counsel our client companies that they need to be very cautious agreeing to the same kind of information sharing and information rights protocols with corporates that they would with VCs,” says Keen.
6. Accept anti-dilute but avoid rights of first refusal
Investors want to know their money is protected against being wiped out in future rounds, so anti-dilution provisions have also become more prevalent in the today’s environment.
“Most VC investors used to put [anti-dilute] in the term sheet in the first draft, but you could push back on it and it would go away. Whereas now it’s just, ‘Sorry, we need that protection in there.,’” says Keen.
Separately, any de facto veto rights such as rights of first refusal should be kept an eye on and, from the startup’s perspective, avoided at all costs.
7. Get a good lawyer
Independent of how hot the deal is, investors always have a built-in advantage in that the financials are their full-time job, while founders have to deal with the day-to-day operations of the business. The importance of getting a good lawyer in your corner as a founder, therefore, cannot be overstated. Far from just being someone who reads and drafts documents, a good lawyer will be able to negotiate on your behalf and spot strategic fits.
“A good lawyer will make or break a deal, literally,” says Van Malderen. “I actually think instead of using an investment bank, just get a good lawyer. The lawyers will do everything because you can also get stuck up for hours on a specific clause, and if the lawyers just call each other, they get it done in 10 minutes.”
Ultimately, knowing that you may be getting a raw deal as a founder and being able to do something about it are two different things when your back’s against the wall.
“Everything being equal, the investor will be the powerful part in this, especially in the current environment,” says Nielsen. “If you need money, you need money, and it’s difficult to kind of play hard to get or say no.”
This is especially true for the newer or first-time founders who may have unrealistic expectations of what they will get to keep on the other side.
“You cannot, as a 20-odd-year-old who’s never done anything and doesn’t have any track record, expect to raise a Series A and be the only person with a board seat and the only person with any shareholder voting rights. That’s just egomania. It’s not going to happen,” says Keen.