MONTH : APRIL 2024

Decoding the Founder-VC Relationship: #3 Closing the deal

In the last edition of the Founder-VC series, we spoke about the aspect of Due diligence. Given that the VCs research has led to a yes, we will now delve into how we can close out the investment smoothly. We will touch upon negotiations between the Founder & VC, Understand better the documents that are being signed off on & How the Founder & VC plan to work together going forward!

 

Negotiations:

Valuations in the startup world are more or less dependent on the VC and the founder agreeing on the funding quantum and desired stake. No VC, whether they operate in the seed stage or Series A or finance growth rounds, uses techniques like the Berkus method or Scorecard Valuation method or First Chicago method or even anything resembling the DCF method.

How it works is like this: Angels / microVCs back idea-stage or near idea-stage startups to reach the stage at which a seed VC would fund them. The seed VC funds the amount that should propel the startup to reach the stage at which a Series A VC backs it. The Series A VC then funds them to get to the stage at which a Series B backs them; and so on till the IPO. Each stage has a funding amount (and a stake target) along with a rough set of qualifying criteria. Eventually, as the startup gets closer to listing, the valuations converge with those of similar listed entities.

Keeping this in mind, Negotiations can take place from a more qualitative headspace. We encourage founders to focus on:

1)     Understanding your leverage

2)     Maximizing trust

3)     Focusing on Value (not just valuation)

4)     Strive for collaboration

 

 

 

The Docs:

 

Term sheet:

A term sheet is a blueprint for the business deal. It’s usually the first real piece of paper an investor hands you upon deciding to invest. This document outlines the conditions for a particular investment. Lawyers frequently use the term sheet to draft legal documents to close the deal, though it’s not legally binding in itself.

Some vital parts of a term sheet include:

Funding – Stipulates how much money you’ll receive and what conditions you’ll be receiving those funds.

Corporate Governance – This portion outlines who’s in charge of the company; VC-friendly vs. entrepreneur-friendly stockholders can influence your company significantly.

Liquidation and Exit – These are also part of the economics of the deal; who gets what money upon an exit event

Negotiating conditions on the term sheet is a reasonably standard procedure for entrepreneurs and VCs to trudge through. However, you must fight for the right things. Otherwise, you may end up feeling duped or extinguishing the deal altogether.

 

Founder’s Agreement

A Founders Agreement is a legal contract that governs the business relationships between the founding team. should provide a framework for the relationship between the company’s founders, outlining their respective rights, obligations, responsibilities, and liabilities. It also provides a roadmap for decision-making and conflict resolution.

Key clauses:

·        Intellectual property – A clear description of the IP; who owns it?  

·        Transfer of ownership provisions – Is there a lock-up provision, or can founders transfer shares immediately? Is there a right of first refusal? How will the Foundersexits be governed?

·        Intellectual property – A clear description of the IP; who owns it?  

·        Transfer of ownership provisions – Is there a lock-up provision, or can founders transfer shares immediately? Is there a right of first refusal? How will the Foundersexits be governed?

 

Shareholder’s Agreement:

A Shareholders Agreement is a legal document that outlines the rights, responsibilities, and obligations of the shareholders of a company. It is usually longer and more complex than a Founders Agreement and is put in place typically at the time a start-up issues shares to external investors.

Key clauses:

·        A Right of first refusal gives the holder a priority right to buy or refuse to buy any existing shares from another shareholder before that shareholder can sell to a third party. It is closely related to a Right of First Offer, meaning the shares must first be offered to the holder of the right of first offer before it can be offered to anyone else.

·        Drag-along rights allow majority shareholders to force minority shareholders to sell their shares to the same buyer on the same terms as agreed to by the majority shareholders. Drag-along can be an important right to ensure that a minority shareholder does not block the sale of the company.

·        Tag-along rights give minority shareholders the right to “tag along” when shareholders want to sell their shares. So, when shareholders propose to sell their shares to a third party, the investor with a tag-along right may also sell a portion of their shares to the same buyer at the same price.

·        Anti-dilution rights are an example of an investor protection clause. It protects investors from excessive dilution of their shareholding in follow-up fundraising rounds when you raise funds at a lower valuation and issue new shares at a lower price than the investor paid. It allows investors to maintain their ownership percentage when new shares are issued. Anti-dilution rights can grant the investor additional shares for free or allow the allocation of proceeds to be adjusted upon an exit.

 

 

Roadmap:

Until the deal is closed, both the founder and VC assess if this is the right fit. However, it's crucial to acknowledge the company and all its stakeholders such as employees, customers, suppliers, and the community around it, as they are an important part of the VC/founder relationship. Once they are partnered up, it's vital to collaborate effectively to build the company they envision and work together to achieve their common goals. This relationship will start by brainstorming ideas on how to best use the funds raised by combining the founder's vision with the expertise of an experienced investor.

But there are times when interests diverge and what is best for the Company and its stakeholders may not be what the Founder and VC agree upon. This creates a conflict situation and VCs are often caught in the middle of it.

 

We will explore this relationship further as we continue our Decoding VC series by sharing our approach to working with the founders we have invested in and the best practices to ensure a productive relationship between the founder and the VC.

Validating Your Product's Fit

Today it has become relatively easy to build new products - AI tools have made this job much simpler than in the past. However there are very few products that turn into a solution for customers

Here we talk about validating your product's fit

Deep Understanding of Your Target Audience

Achieving solution fit begins with a profound understanding of your target audience. Dive into comprehensive research, surveys, and interviews to unearth insights into their pain points, challenges, and aspirations. Develop detailed buyer personas to navigate your product development journey with precision.

Example: For instance, if your SaaS product aims to optimize supply chain management for manufacturing companies, delve into their specific pain points, such as inventory management and demand forecasting challenges.

Aligning MVP with Customer Needs

Craft a Minimum Viable Product (MVP) that directly aligns with your audience's primary needs. Your MVP should address a specific pain point and deliver unmistakable value. Steer clear of feature overload at this stage – simplicity is paramount.

Example: If your B2B SaaS targets HR departments with employee engagement solutions, ensure your MVP concentrates on critical needs like performance evaluation, avoiding overwhelming users with unnecessary features.

Establishing an Iterative Feedback Loop

Instigate an iterative feedback loop by engaging early adopters from your target audience. Gather their feedback, scrutinize usage patterns, and adapt your product accordingly. Continuously iterate on your product to enhance its resonance with market needs.

Example: Suppose your SaaS product assists project management teams with task tracking. Engage initial users to comprehend their workflows and challenges, then refine your solution based on their feedback.

Data-Driven Validation through Key Metrics

Immerse yourself in data-driven validation by meticulously tracking key metrics such as user engagement, conversion rates, and customer retention. Assess how effectively your product addresses user pain points and drives tangible outcomes.

Example: If your B2B SaaS provides data analytics solutions, monitor metrics like time saved in data processing and accuracy enhancements, showcasing your product's tangible benefits.

Conducting Comprehensive Competitive Analysis

Undertake a thorough competitive analysis to grasp how your product distinguishes itself in the market. Identify gaps that your SaaS product fills better than competitors, and leverage these differentiators in your messaging.

Example: If your SaaS product offers communication tools for remote teams, research existing solutions and highlight your unique features, such as real-time translation and seamless integration with project management tools.

Conclusion: For a product to become a solution is an evolutionary journey that demands understanding, adaptation, and innovation. By deeply comprehending your audience, aligning your MVP, engaging early users, analyzing metrics, and differentiating from competitors, you'll steer your B2B SaaS product towards effectively addressing the needs of your target audience. Remember, product-market fit isn't a static milestone; it's a continuous voyage of refinement and advancement.

Why valuing startups is difficult?

First things first: Why Early-Stage Startup Valuation Matters

Valuation for early-stage startups affects fundraising, equity allocation, acquisition potential, and success. Factors such as below determines the value of an early-stage startup,

  • market size
  • growth potential
  • competitors
  • management team
  • intellectual property
  • customer base & traction

 

To make educated decisions and garner the interest of the right investors, startups must have a firm grasp on the importance of valuation.

It is important to understand that when VCs back early stage startups, there is very little data — performance or financial that is available. The VC is fundamentally betting on the team, the size of the problem they are after, and their ability to create and execute on the product / solution to the problem they are after.

 

Challenges in Early-Stage Startup Valuation Methods

Startups, particularly those in emerging industries, have unique challenges that might render conventional analysis methodologies ineffective. The following are such challenges that early-stage startups must overcome.

 

1) Insufficient historical data

In the early stages, companies require significant financial data. However, using financial data for predictive purposes is more challenging and riskier. During the initial years, companies often experience negative cash flow as they strive to generate more revenue while incurring high overhead costs. Additionally, technology marketplaces may require more context due to limited available data.

2) Lack of Comparables

Startups frequently propose ground-breaking technologies or unique business strategies that may lack proven standards or comparables. It is difficult to locate comparable businesses for value reasons due to this uniqueness.

3) Elevated Failure Rate

Studies show that 90% of new businesses close their doors within the first decade, indicating a high level of uncertainty. Therefore, startup valuation must reflect this reality. There is a strong correlation between a company’s longevity and the likelihood of bankruptcy. The time it takes for a startup to progress from concept through the minimum viable product (MVP) stage to a fully commercialized product varies widely.

4) Dependence on Funding Rounds

To support their expansion, startups often rely on multiple rounds of funding. Valuations may fluctuate between funding rounds based on investor opinion, market conditions, and the company's development, complicating the valuation process.

 

How do you make sense of Startup valuation?

 

a. Understanding Uncertainty

There are three categories of uncertainty: estimation uncertainty versus economic uncertainty, micro uncertainty versus macro uncertainty, and continuous versus discrete uncertainty. Estimation uncertainty can be reduced by gathering more or better information, while economic uncertainty is harder to mitigate. Micro uncertainty focuses on the company itself, such as its business model, while macro uncertainty encompasses factors beyond a company’s control, like interest rates and government policies. In most valuations of publicly traded companies, macro uncertainty dominates the discount rate. Continuous uncertainty involves fluctuations that occur regularly without a major impact on a company’s cash flow, such as exchange rate fluctuations under normal conditions. Discrete uncertainty, on the other hand, involves rare events that can have disastrous effects, like a sudden 75% devaluation of a company's main operating currency.

 

b. Pricing an Early stage startup

Valuation at this stage is a simple arithmetical calculation. No VC, whether they operate in the seed stage or Series A or finance growth rounds, uses techniques like the Berkus method or Scorecard Valuation method or First Chicago method or even anything resembling the DCF method. The eventual valuation emerges once the VC and the founder agree on the funding quantum and desired stake.

The $ funding amount is the perceived amount thought of by the seed VC to get the startup to the next stage (Series A). The % equity stake is what the VC has determined as the desired target stake to hold after the initial round.

 

c. How Multiparty staging works?

Staging works like this: Angels / microVCs back idea-stage or near idea-stage startups to reach the stage at which a seed VC would fund them. The seed VC funds the amount that should propel the startup to reach the stage at which a Series A VC backs them. The Series A VC then funds them to get to the stage at which a Series B backs them; and so on till the IPO. Each stage has a funding amount (and a stake target) along with a rough set of qualifying criteria. Eventually as the startup gets closer to listing, the valuations converge with those of similar listed entities.

 

d. Focus on the Stories

Entrepreneurs often overestimate the value of their company. However, one should take this into account as it may reflect the founders' level of ambition and serve as an interesting qualitative measure of their chances of success. A good valuation combines narratives with numbers. When valuing a company, every number in your valuation should have a narrative attached to it. Similarly, every narrative about a company should have a corresponding number attached.

 

e. Aswath Damodaran on Valuing Late-Stage Startups

Damodaran recommends homing in on a few essential variables. For young companies, he focuses on six factors. The first three apply to the business model: revenue growth, target operating margin (to capture profitability), and sales-to-invested-capital ratio (to reflect how efficiently growth is captured). The other three metrics are related to risk. One is what does it cost you to raise equity. And the second is how much does it costs you to raise debt. The last risk-related metric? The likelihood that your company will fail.

The component to measure riskiness itself is cost of capital. With higher growth and higher reinvestment, Damodaran expects to see higher risk. A valuation that shows high growth, low reinvestment, and low risk should raise questions. If there are internal inconsistencies, we need to have solid reasons for them.

 

Conclusion

Rules of thumb for founders to consider while raising pre-seed round for Indian founders:

  • Raise for 12-15 months of gross burn or 18-24 months on net burn:
  • Keep dilution between 8 to 12% at pre-seed
  • Target valuation range = Rs 10-15 cr
  • Seek investors who are the right fit:
    • Previous experience
    • Level of involvement and value-add
    • Ability to support in future

 

Each VC fund has a sweet spot for its typical preferred cheque size, and its stake target. This is often a range, and not specific figures. We at Malpani Ventures, have a $100K–500K preferred cheque size, and a 10–15% stake target. We have determined from our investing experience, that this amount is sufficient to cover 15–18 months of burn (revenue less expenses) in the companies we fund, and within this period, they will be able to raise the next round (from a Series A VC).

We would recommend founders to find the right investors who best align with their vision and plans for executing the business. Most founders will want to (& should) raise at the highest valuation possible, however, that should not be the only criteria for seeking investment: Seek an investor who not only pays a fair price but helps you polish your rough thesis into actual execution.

Decoding the Founder-VC Relationship: #2 Due Diligence

We continue the Founder-VC series by diving into the diligence process that VCs employ while evaluating a possible investment. The diligence process itself builds on themes that we explored earlier like- Market Potential, Team Strength, and financial traction.

This process helps investors avoid problems, figure out if a startup is likely to succeed and negotiate good deals. Doing thorough research minimizes the risk of making Type-1 errors and improves the chances of supporting startups that have a right to win. The significance of making smart decisions in the unpredictable world of venture capital, protecting investors' money, promotes the requirement for a stringent diligence process.

Now that we know the importance of due diligence in VC, let’s break down each venture capital due diligence process component.

 

 

The Components of Due Diligence:

 

1)     Assessing the Product/Service

Value proposition: What problem does your product or service solve? This often involves a demo from the founders to showcase how their product/service works.

User stats and info: We check things like- how often people use the product, What the interaction time with the product is, and other relevant metrics to gauge customer stickiness.

Customer feedback: It’s important to ensure that there isn’t any disconnect between the product and the target audience. This involves getting on customer feedback calls, understanding their use case, and developing an ICP (ideally the founder’s job)

Development stage: What stage is the product at right now? What are its accomplishments? What are the near-term and medium-term goals? We ask founders to come up with a timeline for these goals.

  

2)     Founder-Diligence:

Early-stage startups, by definition, haven’t been around long enough to help investors assess their potential. Hence, due diligence at this stage starts with VCs checking the founders’ backgrounds. We make reference calls and talk to as many people as possible, including founders’ former colleagues, customers, and investors. Questions to founders would generally revolve around:

Personality traits of the founders: Are they Diligent, resilient, curious, and optimistic.?

Founders’ professional background: How does the founders’ previous experience align with the market?

Past achievements: What have they accomplished in their careers? Have they excelled in sales, recruited a strong team, or helped their previous employers enter new markets?

Founders' relationship: Do they know each other well and what have they achieved together?

 

3)     Business Model:

Founders need to demonstrate clarity in how they plan to make money. This involves founders having a complete understanding of their costs, revenues, and the plan to scale.

Pricing strategy: Will it be through selling directly, subscriptions, advertisements, or licensing?

Distribution channels. How is the product reaching your customer, and what was the rationale for choosing that method?

GTM strategy. How are you going to introduce your product or service to the market and get people to use it?

 

4)     Market Analysis:

Venture capitalists analyze the target market to gauge its size, growth potential, and competition. They assess market dynamics, customer segments, and the startup's unique value proposition to evaluate market fit.

Differentiation: How will this startup stand out and outperform competitors?

How many countries are visible in the picture & how does its GTM differ in each market? Is the startup aiming for a large enough market? What is the plan for expansion?

 

5)     Financial due diligence:

Comprehensive VC due diligence involves studying a startup's financials to assess its economic viability, revenue model, and capital requirements. Investors look for potential issues in the financials and ask for metrics like customer lifetime value, customer acquisition cost, retention rate, and revenue. The specific metrics depend on the industry, such as annual recurring revenue, churn for software startups and user acquisition & engagement stats for EdTech startups.

 

6)     Legal and Regulatory Compliance:

Assessing investment risks through due diligence helps identify potential risks that might arise in the future. This includes evaluating the startup’s financial health, legal and regulatory compliance, intellectual property protection, and potential liabilities. Assessing and identifying investment risks through due diligence early in the process allows investors to make informed decisions and consider risk mitigation strategies.

Regarding intellectual property rights: Are your intellectual property rights sufficiently protected? Does your startup rely on licenses from others? Do you have any patents? How easy would it be for competitors to copy your technology, Company structure and rules. How is your company organized?

 

7)     Exit Strategy:

Investors conduct due diligence in startup investments to evaluate potential exit options, such as acquisition or IPO. This includes gathering information to create a plan for a return on investment.

Exit plan and vision: When do you think you can exit? Being transparent about your timeline enables investors to assess if their investment objectives align with your startup’s strategies.

 Having a clear exit plan shows investors that you’ve thought things through and have a solid roadmap.

 

8)     Valuation:

The thorough examination significantly influences the success of an investment, especially when determining a valuation. It assists investors in confirming whether the proposed valuation is realistic based on the company's financials, market potential, and competitive positioning. It also empowers investors to negotiate terms if necessary. We will explore Valuation dynamics between Founders & VC in the future.

 

Wrapping Up:

Due diligence is pivotal in venture capital investments, encompassing scrutiny of startup finances, market viability, management, IP, and competition. This process enables informed decision-making and risk mitigation. Additionally, it aids startups by offering feedback, refining strategies, and fostering transparency between investors and founders.

In the dynamic landscape of venture capital, due diligence remains paramount. As technologies, industries, and business models evolve, rigorous due diligence is indispensable. It guides through the complexities of the startup ecosystem, enhances the prospects of entrepreneurial success, and propels innovation.

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