What should a series A funding process look like? [Step 4: Negotiations and Legal Discussion]
Congratulations, you have achieved what nearly 95% of startups (anecdotal evidence) wont end up doing – getting to a “term sheet” discussion with an institutional investor. After your first VC meeting, usually this step happens about 3-4 weeks later in India and a week or two in the US.
Typically most VC’s and their associate / principal will make a trip to your office between this period. They will want to meet the team, check out your offices and make sure that you are a “real company”. My personal experience shows that you should use your “lack of funds and frugality” to your advantage. Dont try and have them meet you at someone else’s office (has happened once) or try and spruce up your office (keep it clean, but dont go overboard).
Question I get is usually “I am working out of my home / garage”, should I invite them there? Let the investor know that you work out of home and they will usually ask you what your plans are post funding. Most will decline to come to your home, but if you wish you can ask them to meet at a coffee shop near your home / garage.
Most investors like the frugal quotient in startup founders.That shows that you focus on hiring the right folks and building the right product instead of “AC offices” and plush “Aeron Chairs“.
Your investor champion will typically call you with a short message in which she will say the firm is pretty excited about your opportunity and would like to offer a term sheet. She will invite you for a discussion on valuation and quantum of funds, at their office typically, with their associate and/or principal – let me call them “investment professional” or IvP from now on.
The IvP would have done quite a bit of work by this time to review your financial projections and assumptions. They will have also called a few potential customers, a few existing customers, some industry experts and a few of your friends and past acquaintances (yes, this happens in US and India) to get more information about you, the market, customers and other trends.
Then they will give you two numbers of your term sheet – the valuation and the investment. They will say something to the effect “We are willing to invest $1 Million at a pre-money valuation of $3 Million”. Or they might say “We are looking to invest $1 Million for 40% of your company”.
You should be aware of these terms: pre-money valuation, investment quantum and post-money valuation, ownership %.
post-money valuation = pre-money valuation + investment
ownership % (for money invested) = investment / post money valuation – this is also the amount you “dilute“.
So in example 1: If they are investing $1MM at pre-money of $3MM, then your post money Valuation is $4 MM. So the company is valued at $4MM after funding. Since they put $1 MM, they will get 1/4 or 25% of the company.
In example 2: They are investing $1MM and are looking for 40% of the company. Which means the post money valuation is $2.5M and the pre-money is $1.5 MM.
How they come up with these valuation numbers is a series of posts in itself, but suffice to say its part art, part science and largely a function of market conditions (supply / demand). If you have multiple investors competing for your deal, you might get a higher valuation if your company is *hot*. If the investors you are talking to are the only ones who are still interested, and you need the money, be prepared to dilute more.
After this meeting they will let you, the IvP, their lawyers and your lawyers hammer out the other “terms”. The term sheet (pdf file) will have many other conditions and clauses. I wont cover them all, they require a series of posts in themselves and enough people have written about them.
The most important terms are: liquidation preferences, anti-dilution, full ratchet, drag-along, tag-along (called co-sale in the US), ROFR (Right of first refusal) and board representation.
Keep in mind that your company will pay for your legal fees, and also the investors lawyers. You need two sets of lawyers so each party can protect their interests.
Most investors will say most of these terms are non-negotiable, but depending on the deal they will negotiate with you – through the lawyers, obviously. Realize that the lawyers really are the go-between. They wont do or ask for anything the investor really does not want. So, its pointless blaming the lawyers (they are a few errant ones, but they are largely service providers who do as they are told).
What might go wrong and how to fix it?
1. You dont like the valuation or you would like more money (investment amount). That’s negotiable and depends on the deal dynamic. Some investors low-ball and others will give you “fair valuation” Its rare that an investor will over-bid – (A16Z is an exception). Let them know your expectations and be prepared to defend why you think your valuation metric is the right one.
2. They term sheet is loaded with investor-friendly (anti-founder) clauses. Some of those are negotiable as well. I would advice you to pick your battles. Choose 2-3 items you consider very important to you and only negotiate those. The investors typically will do that as well. Most likely you’ll meet in the middle.
3. The lawyers take up endless time splitting hairs. In India, legal advisers will work on a fixed fee for the transaction model, but in the US that’s rare. So in India the incentive by the lawyer is to protect the parties interests but spend as little time as possible so they can bill at a higher rate. In the US though, the incentive is to take the “right amount of time”. Be aware though, that lawyers only do as they are told. Either your investor is telling them some terms are non-negotiable or your are telling your lawyer some issues cannot be compromised. Either ways, get on the call, and fix things proactively.