For the uninitiated, the fundraising process is a daunting yet unavoidable aspect of startup life. It can consume huge amounts of precious executive time slated for product development or other strategically important activities. Fundraising is also something the best venture-backed entrepreneurs embrace and understand completely.
After representing hundreds of start-ups in both Australia and Silicon Valley, we have compiled our top tips for founders to keep in mind during the venture funding process.
Richard Horton, Squire Patton Boggs
Each round of venture funding needs to be adequate to prove a concept or reach a milestone to support an increased valuation for the next round. The key is to give away less for more each time.
The start-up needs to raise the right amount of money on a reasonable valuation. Low valuations can result in excessive dilution, while high valuations often chill future investors or result in loss of face with existing investors (and possible application of anti-dilution protection).
A ‘rule of thumb’ is that each equity round will cost around 20% of the total capitalisation of the company. Founders who keep this in mind will likely avoid serious trouble on the valuation front.
From day one, the best founders will keep a close eye on their cap table and a running tab on the impact of future rounds on their voting power and share in any exit scenario.
In this context, it is critical to understand the typical preferred rights of venture investors, which invariably provide economic and control rights well in excess of minority equity ownership positions. (For example, understanding the total liquidation preference overhang of all investors is a key determinant of a founder’s return on an exit).
It is important for founders to be well informed regarding prevailing market terms for venture investments.
These terms are not set in stone, but there is a finite body of all possible terms and a set of terms which at any particularly point in time are generally considered “market standard.”
Non-market terms typically emanate from inexperienced investors, who themselves are under pressure from inexperienced and nervous investors of their own.
A huge turn off for investors is the so-called “dirty cap table,” a state of having a large number of shareholders and/or significant volumes of equity held by people no longer involved in the business. Founders need to be very frugal about issuing equity to employees or third parties, and avoid being held to ransom by equity claims from former founders and others.
To this end it is most important that all founders’ stock and employee options are subject to standard (4 year) vesting and that a very clear chain of title is established to all company intellectual property rights immediately upon creation.
In addition to track record, founders should pay particular attention to competing investments of prospective investors. Most investors initially shun confidentiality obligations, so founders will have no power to control use or disclosure of any information provided – other than by enforcement of relevant intellectual property rights (in particular patents, if any).
It is also critical to understand the geographic imperatives of your investors. Most Australian start-ups look at funding from Silicon Valley, particularly post Seed/Series A. US investors will not invest in any business unless they can drive to board meetings. This will require any Australian start-up to re-domicile the business (to Northern California usually), undergoing a tax effective roll-over (aka “flip”) and securing appropriate US immigration status for key personnel.
Strategic investments (e.g. from corporate venture funds) are a common alternative to pure financial investments (e.g. from venture funds), but may have deeper and less obvious significance to the start-up. Typically, these deals generally involve a significant grant of additional commercial rights (usually some form of exclusivity or optionality over the business), and may unwittingly result in the grant of a path to cheap ownership. As with any investor, founders should investigate interest from strategic investors thoroughly and not underestimate the skill of their professional deal-making teams or their occasional reputation for collection and misuse of sensitive company information.
The term sheet phase of the investment transaction is where the deal is done. Venture term sheets are beguilingly short and high level, but their impact on founders and the company is invariably profound. Too often we see founders focus on pure shareholdings, naively glossing over the complex detail of a mosaic of investor super-rights.
In addition, although term sheets are stated to be non-binding, they are, in reality, binding upon the founders. On the other hand, the investor usually has a “due diligence out”, i.e. a right to walk away if they discover any problems during their due diligence investigations.
*Richard Horton leads Squire Patton Boggs’ Australian venture capital and tech M&A practice, and splits his time between the firm’s Sydney and Silicon Valley offices.
The firm represents more than100 start-ups in Australia, from all major tech sectors. Contact Richard at richard.horton@squirepb.com.