Idea-stage startups' contracts spell fear. Founders – guard against unscrupulous investors!

29th Jun 2016
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As a new entrepreneur, have you lived in fear? Sometimes, raising the first round of money from venture capitalists (who sometimes take more than 50 percent, and who care only about the valuation) can make an entrepreneur quiver in fear. But this is a cardinal mistake. When an entrepreneur signs a contract with a fund that promises him the moon, it’s quite likely a sign of trouble. There are many entrepreneurs who have been edged out of their own companies because investors have had the legal power to do so. India is indeed a startup nation, but our entrepreneurs need lessons in protecting their interests. Quick money to build a company can be a temptation that makes even the strongest of minds stumble and a first-time entrepreneur is no match for it. Tread carefully! YourStory is in possession of term-sheets that make the founder a second-grade person in his own company.

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Here is why it happens

Over the last 18 months, there has been a startup boom in the country, and with it there has been a rush to raise capital. According to data available with YourStory, this year, there were 150 seed rounds whose deal values ranged from $50,000 to $1.5 million. In 2015, there were more than 350 ideas were funded. Only 65 got to series-A. The rest are just chugging along slowly. Now here is the problem: 25 percent of these ideas have already shut shop. Most startups that raised seed rounds collapsed because they did not have a business proposition. But the same was not the case with some startups whose founders found a business proposition, and were yet shunted out because the funds controlled their daily activity.

There are several companies that got the wrong end of this stick. Legally, VCs could never be wronged because the entrepreneur had signed a contract. However, there must be founder protection – enforceable in a court of law – and that can only happen if entrepreneurs structure term sheets to protect their interests. A couple of entrepreneurs in the foodtech and logistics space, on condition of anonymity, told YourStory how being “naïve” is not an option in the startup world.

Here are a few mistakes that were made in the beginning that led to the closure of one company and the ousting of the founders in the other.

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So read the whole term-sheet. You may now know what each term means. But you should find out.

Say no to a “full ratchet anti-dilution” clause: In this clause, the VC says that because the company has no tangible value, they would like to get a higher value for it. But one year down the line, they will likely protect themselves from share price reduction. In a down round, they will also be taking additional bonus shares and financing it at a lower price per share. This means they could own a higher stake in your company and a low valuation. Many idea-stage startups end up giving up a higher stake to VC funds and subsequently, everything that follows is not in the hands of the entrepreneurs. This also reduces the pre-money valuation in the next round if the amount invested is the same as the amount raised previously. What this does is reduce the share value in the company.

Vesting period: If the fund fires you, make sure the vesting period “holds” or at least make sure you get paid well if you are asked to leave. At least make sure the contract has a “good leaver” clause in place for you.

Work with funds that can add value and bring expertise. Do not work with ones that invest money because they have it: When you meet a fund, find out if they have expertise in your field or the market that you have operated in. It is entirely an entrepreneur’s mistake if they sign up with a fund that does not have the required expertise to build and guide the idea. Such funds bet on short-term gains, and if it works, they make a lot of money in Series A for providing zero expertise. So remain in control, and do not let others take control of the idea.

Not having control of the board leaves every decision in the fund’s control: Having one board seat and leaving the rest to the fund will result in the entrepreneur not having control over the company’s operational decisions.

No control over the committed money: Make sure the money is in the company’s bank account and make your own decisions. If you adopt a milestone-based release approach, you have no control over the external factors that may hamper the business. This can hinder your ability to protect the company because you have to go back to the fund for the money to be released. So, if they are releasing money in tranches, make sure you don’t have to justify the reasons and that the VC understands the external conditions that affect the business. Sometimes an entrepreneur’s decision may be right, but the funds may not believe in why they have to release funds. Investors also have reason to protect themselves because some entrepreneurs may not be good businessmen. But some may argue that if the fund is betting on the idea, why not give the entrepreneur a chance to get it right.

Be the leadership: Select leaders to work with you. Do not let funds bring in leaders above you. There have been several instances where funds have brought in leaders and fired the founders. These entrepreneurs can be fired because they have a diluted majority control in the seed stage and have no control over the board.

Unfortunately, in India, entrepreneurs are yet to fully understand laws, finances, and the nature of business. They are the victims of the boom that promises gold when in reality there is a lot of work ahead of them as soon as investor money comes in. Stay smart! Funding is what everyone wants, it’s the carrot dangling in front of your eyes. But remember that it can be a trap set to for you.

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Some term sheets can be downright unreasonable. Here are some clauses that some funds enforce

  1. All Key Management Team members will have the title of Founder and Director subject to investor discretion.
  2. Key Management Team members are subject to investor approval.
  3. Key Management Team members will be compensated with a total salary of Rs XX lakh initially. The Board will review this annually.
  4. Key Management Team founding members will be reviewed every six months with the first review scheduled in every financial year. The Board will conduct the review jointly. In the event the Investor Nominee Director registers dissatisfaction with the performance of Key Management Team members in two reviews, their vesting schedule will stop with immediate effect till further notice from the Investor.
  5. The Board and Investor will jointly search for a CEO. Investor retains the sole right to approve and appoint a CEO.
  6. ESOP Pool: Post-money ESOP pool of 10 percent of total shares outstanding to be created.

Experts speak

“Entrepreneurs should not dilute a 50 percent stake at the idea stage. Serious funds will never take such ideas seriously when they are on the lookout for Series A,” says Sarath Naru, Managing Partner at Venture East. Today there are too many ideas, and serious funds will bet only on good ideas. There are, however, several early-stage investors who will provide funding without validating the idea.

“It is important that the ecosystem finds strong value in a startup and the startup should find value in a fund. The founding team’s pedigree and the intellectual property of the company are the primary parameters that a serious fund invests in,” says Naganand Doraswamy, co-founder of IdeaSpring Capital. He adds that while ideas will continue to be funded going forward, the good ones will clearly partner with the right funds. It’s the entrepreneur who needs to be smart about it all.

If you’re an entrepreneur, do share some of your experiences with your investors in the comments below.

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