Startup Financing (Part 3): Understanding Term Sheets, Government Regulations..and more

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..contd from the earlier post on Startup Financing. This post deals with understanding term sheet, technical terms, government regulations etc; and completes the full circle in the process required to raise fund.

Term Sheet

A term sheet is a document that forms the basis of your engagement with the investor. It sets out the “terms” on which the investor will invest in your business, your obligations under this document and the rights that you give up to the investors or other parties involved.

If you get to a stage where the VC gives you a term sheet, it will be the strongest sign yet that the VC is interested in investing in your business. The VC will lay out the terms of the investment. Term sheets usually have an expiry date, i.e., if you do not accept the terms by a certain date, the terms of the engagement will no longer be valid.

However, please remember that a term sheet is not a legally binding document for either party. The investors can still walk away if they choose to. The term sheet will lay out all the important clauses that will form the key part of the definitive agreement between you and the investors that you sign at the closing of your deal. Once you have this definitive agreement, then the terms are legally binding to both parties.

If you are raising VC money and have never looked at a term sheet in your life, visit your favourite search engine and spend time understanding the basic terms that form a part of this document. At a very minimum, you must understand the following:

- The type of security you are issuing to investors: Is it common equity, convertible equity, preferred equity etc. What rights do holders of these instruments have and under what conditions do they lapse or convert into a different instrument

- Legal structure: What is the legal structure into which the investors are investing

- Technical terms such as: Liquidation preference, anti-dilution, protective provisions, drag and tag along rights, redemption rights, vesting periods and lock-ins. There are many other terms that you might need to know, but under no circumstances should you take the above terms lightly. They will directly impact your ownership interest in the business (especially in case things go wrong), or they will come into play when investors or you want to exit or raise more money

Earlier we talked about how entrepreneurs should strive for a fair valuation. I want to add that the valuation should be seen in the context of the different terms that you negotiate as a part of the VC’s investment into your business. Many first-time Indian entrepreneurs strive for a high valuation without realizing that the terms you get it on are probably equally, if not more, important. There is no point in getting a high valuation at the cost of horrible terms that could marginalize your say in how to run the business or drastically reduce your effective ownership in case things do not pan out the way you planned.

When you are negotiating with a VC, be willing to give and take a bit. Be open to taking a lower, but fair, valuation if you can get it on favourable terms. Lets take a stylized example to demonstrate what I mean.

In my first round of funding I want to raise $2m and am willing to give up only 20%. That is a pre-money valuation of $8 million and a post-money of $10 million ($8m + $2m = $10m). I propose giving the VC 20% of the company and keeping 80% for myself.

The VC wasn’t totally happy about this but ultimately agreed on the condition that he/she gets full anti-dilution protection and a liquidation preference of 2x. I say who cares about these terms because these are only for a worst case scenario. I got a good deal on the valuation and still retain 80% of the company. Ah….I can hear the sound of money in my ears.

After 1 year of bad execution, I run out of money very quickly without being able to hit any meaningful milestones. I have no option but to show up with my begging bowl at my current VC’s doorstep. The VC looks at the business and says the firm isn’t interested in investing because I have not hit my milestones. But, I am granted permission to raise money from some other VC. When I go to other VCs, they say they are interested in putting up $2 million but value the business at only $4 million post-money, i.e., they will take 50% of the company. Because I am desperate, I accept these terms.

This is where the first round VC comes in. Because the VC has anti-dilution provisions, he/she will exercise that. Because my second round valuation is lower than the value at which the first round VC put in money, the first round VC will ensure that any dilution is first suffered by me. If these anti-dilution provisions were not there, both the first round VC and I would suffer a 50% dilution, i.e., my share would come down from 80% to 40% and the VC’s comes down from 20% to 10%.
But, because the VC is protected, he/she will demand that I suffer dilution first before they do, i.e., my share goes down to 30%, old VC stays at 20% and the new VC gets 50%. Ah….I can hear the siren of the ambulance coming to resuscitate me.

In an alternative scenario, I don’t raise a second round of funding but find an outright buyer for the business. This buyer is willing to buy the whole company for only $4m. I do the calculation in my head and say thats not too bad. I own 80% so I get to keep $3.2 million and the VC who owns 20% will get the rest. I am feeling good about this and the sound of money is in stereo now.

My first round VC, who sits on the company’s Board of Directors, agrees to the sale. And here is why the VC is so quick to agree. The VC knows that he/she has a liquidation preference of 2x, i.e., at the time of the “liquidation” of the company, in this case as defined as sale of the company, the VC will get to recover 2x his/her initial investment before I get any return. So, at the sale price of $2 million covered up to 2x, the VC will end up taking the full $4 million of proceeds. Unless I can convince the buyer to pay more than $4 million, I am going to end up with nothing from this sale. Was that the woofer that just burst…..

In my naiveté I was overly aggressive on valuation during the first round of funding and gave in on terms that I thought didn’t matter at all. The reality turned out to be that they did matter a in a big way.

If I had been more reasonable and raised the initial $2 million at say a $ 4 million post-money (giving up 50% of the company to the investor), maybe the VC would have been willing to give me better terms because the $4 million valuation is not that risky. Maybe, I could have had less onerous anti-dilution and liquidation preference clauses.

Of course this is a stylized example, but the purpose of sharing this is to explain that don’t be stubborn over the wrong issues because they might end up hurting you. Also, if you are raising money for the first time, the above example shows why you need the help of someone who is more fluent in the language and functioning of terms sheets. Adult supervision can only help you.

Adult Supervision

So who are the people you can look towards for advice during the process so that you can avoid making naive mistakes?

Here’s a list of potential types of people you can seek help from:

- Other entrepreneurs

- Entrepreneurial organizations such as TiE Chapters all over the country

- College professors who might have experience in advising start-ups

- Lawyers and bankers who are familiar with the fund-raising process

How Many Investors Should I Have Invest in the Round?

Ideally, you should get those investors who you feel have the most value to add to your business. Often, you might want to raise money from different investors in the same round because you are looking for different types of expertise and resources from your investors. There’s nothing wrong in this up to a point. As a practical matter having too many investors can pose a logistical and decision-making challenge, especially because the Indian Companies Act is not kind to start-ups at all. The bureaucracy around corporate governance will slow you down and cost a lot in resources.

Figure out who is going to be the lead investor and if the other investors will agree to whatever is decided by the lead investor. The more investors you have, the more paperwork that you might end up creating for yourself. You don’t want to be distracted by investor relations all the time. Running around, just to get signatures on documents from all your investors for, approvals on every small decision you need to make on a daily basis is not going to be fun at all.

Government of India Regulations

India continues to be a highly regulated economy. Foreign capital cannot freely be invested in many sectors. Most VC money in India is foreign capital, i.e., not raised domestically. Many sectors have FDI (Foreign Direct Investment) caps and restrictions. You might need FIPB (Foreign Investment Promotion Board) approval to raise money from foreign investors. The Reserve Bank of India might have some restrictions on your ability to use foreign capital for certain types of activities. You might need to declare when your money is entering the country and who your investors are.

Please be aware of what the restrictions are for your industry and your business. This is again one reason why you need adult supervision through the fund-raising process if you have not been through this before. Have a good lawyer who can help you think through these issues, because your VC will expect you to have answers to a lot of these questions.

The US Dollar

As you probably observed in the term sheet example above, I was using US $ figures. This is the de facto currency for analyzing investments in India. Its all well and good to negotiate using $ figures, but your costs are likely going to be in Rupees. This is a big problem in the current context of a weakening US $.

Please make sure that you don’t end up raising a $ amount which in Rupees turns out to be less than what you need for your business. Otherwise, you will be exposed to currency fluctuations that can hurt you. This will have implications on the dilution you suffer today and in future rounds and the margin of safety you give yourself for fund raising. If your negotiations and investment closing drag on for a few months, as they often do, the $ figure you negotiated might be very different in Rupee terms due to dollar depreciation.

No harm in stating the Rupee amount that you need but using $ figures based on prevailing exchange rate. Even better if you can sign all the agreements and close your deal quickly.

And talking of closure, thats exactly what we are going to do now. The next post is going to be on Legal and Accounting issues for a start-up. Highly practical stuff that can save you a lot of trouble and make your life very easy so you can enjoy the stereophonic sound of all the money that you are about to make…..

If you have any questions or comments please email them to startup@iTrust.in.

Interesting Links

http://www.berkshirehathaway.com/letters/2007ltr.pdf

Pages 7-8 of Warren Buffett’s latest investment letter have a wonderful description of types of businesses and their respective needs for capital.

http://blog.pmarca.com/2007/07/the-pmarca-guid.html

Marc Andreessen on how much funding to raise. Very well written and articulated.

http://www.feld.com/blog/archives/term_sheet/

A very informative and easy to understand series written on term sheets by Brad Feld and Jason Mendelson. You might need to localize some terms/concepts for the Indian context, in case the Indian Companies Act requires you to.

The author is a co-founder of a financial services start-up, www.iTrust.in.