The art of negotiating a suitable term sheet
This is the fourth installment of a four-part series which aims to help early-stage startups navigate their way through a fundraise. Click here, here and here to read the first, second and third parts, respectively.
If you have a team of good co-founders, are building or have built a product to address a real problem that exists in a large addressable market and have started to show market traction, you should not have a problem finding investors who are willing to listen to you. Attractive businesses are able to attract multiple term sheets.
This is the stage at which entrepreneurs need to think about the possible dilution, valuation and negotiate a good deal with investors.
First off, valuation is an art and not a science. Early-stage investors can demand anywhere from 15% to 40% of the business depending on the cheque size, stage of the business, background of the founders, interest in the deal and overall negotiating leverage the founder has. It is hard to ‘mathematically’ value early-stage businesses because of a lack of clarity on future possible cash flows. I have seen family-run business houses demand 70% of the business for investing $500,000 and angels asking for 10% for the same amount. Some incubators have pre-defined stake requirements.
If you have already raised funds, the last round’s valuation usually forms an important benchmark. If the business has grown and the fundraising environment is upbeat, a valuation over and above the last round is common. However, if a business is underperforming or the fundraising environment is challenging, you must be ready for a ‘down-round’. A down-round doesn’t necessarily mean it is the beginning of the end but might just be a temporary blip.
Too many founders worry about negotiating the last dime on the valuation instead of realising that it won’t really matter if they are able to build a large successful business. Such a business will provide enough upside for investors, founders and (hopefully) employees as small variations in dilution won’t make much of a difference. From a financial standpoint, it is much better to own 5% of a billion-dollar business than 90% of a million dollar business.
Choosing your investors
The typical conditions of a term sheet depend on the sophistication of the investors. Angels typically include other entrepreneurs, senior corporate professionals, business families looking to invest in new age businesses and occasionally venture capitalists looking for personal deals. The less sophisticated the investor (i.e., someone who has not invested in other companies), the more benign the terms of the investment are. It is often better to select investors who can add real value to the business by sharing their knowledge and network. However, very active investors can also micromanage, so founders need to be careful regarding who they choose to partner with.
Managing the complexities of a term sheet
Most of the complexity in a term sheet comes from the ‘exit’ provisions. Since venture capitalists have a defined fund life of five to seven years (often extendable by two years), they have to be able to exit the business and return capital to their own investors, who are known as limited partners. As an entrepreneur, it is your responsibility to provide an exit to your investors. This could come in the form of selling the company, an IPO (rare), a secondary sale of shares to a late stage investor or a buyback of shares. Many deals come to a head on the exit provisions. As a founder, you must realise that investors cannot rely on an IPO to get their exit. If an IPO does not materialise, an exit has to be obtained one way or another. One possible way is to sell the business. In fact, most exits happen through mergers and acquisitions rather than public offerings. Before raising funds, an entrepreneur must remain cognizant of his or her responsibility towards providing investors a reasonable exit. Investors typically build in ‘drag-along’ provisions to ensure that a sale-based exit happens.
Another complexity is when an investor increases his or her shareholding if certain performance benchmarks are not met. Having a startup lawyer specialising in fundraising and corporate finance transactions review such terms would benefit founders.
Fundraising can easily take six months or more so it is advisable for entrepreneurs to start looking out early. Providing regular updates to investors you meet might help you get them up the learning curve faster when you need the funds.
Yes, with subsequent rounds eventually you might lose control and might no longer serve as the leader of the business, but how does it matter if wealth is being created for you?
The author is a former investment banker, an advisor in the technology sector and currently works as a strategy professional in the telecom industry. The views and ideas expressed are personal.