VC SERIES | Part I – The First Institutional Investor !
Over the last few decades while India went through radical changes, so did the world of venture capital (VC) financing for start-ups. India has emerged as the hotspot for unicorns right after the US and China. Multiple investments and acquisitions are a norm in the fast-paced start-up ecosystem. While seasoned institutional investors are well versed with the legalities of VC financing, first-time founders are often struggling to find their feet in the journey. To some extent, even first-time investors in the Indian market grapple with reconciling global market standards with the nuances of the Indian market. However, first-time investors still have an upper hand because of their in-house and external legal and business teams. To that extent, some parts of our series are directed more towards offering guidance to founders. As we share our expertise and learnings around funding rounds, we hope the series will be helpful for the first-time entrepreneur, as well as a value add for the first-time investor.
Most start-up founders are ‘bootstrapped’ or are funded by friends, family and acquaintances. An important consideration is the stage at which they should approach potential institutional investors. It should certainly be well before their initial funding is exhausted. We have listed down below some preliminary steps that founders should take while seeking out their first set of institutional investors to the stage of getting their first ‘term sheet’.
Get the business started
Firstly, the founders need to ensure that they start off their business, at whatever possible scale; get it up and running. The initial funds should be deployed largely for gaining customer traction. The practical challenges that they may encounter will only be known to them once they have taken off from the ground. This will help them perfect their product offering and help in making a more informed pitch to the investors.
The right investors
Secondly, it is important for founders to identify the leading and potential investors of their sector. Each VC fund will usually have its focus areas for investment based on their investment strategy and as marketed to their limited partners. As the origins of venture capital go, they predominantly only invest in technology start-ups which have a potential to scale rapidly. Within the technology sector, various VC funds will further focus their investments on certain sectors. It very often happens that the founders end up knocking on the wrong doors. It is important that founders do a market study and approach the correct investors for their business.
When to raise?
Most founders have heard terms such as incubator, angel investor, seed investor, Series A round, Series B round etc. It is essential for founders to understand the stage which their company has achieved and accordingly figure out the type and scale of funding they need. Generally speaking, incubator, seed rounds, angel rounds are all investments made into a company at its nascent stage. Series A, Series B, etc., are the subsequent funding rounds and nomenclatures indicating the growth of a company. There are various VC funds investing into a company at an early stage. Depending on the growth of the startup, founders could approach such VC funds for their first funding round.
How much to raise?
Only because VC funds have taken keen interest in the startup and are willing to sign a fat cheque, does not mean that the founders should raise any amount. The effort should be to raise the desired amount at the best valuation possible. It is usually in the initial rounds that founders undergo the maximum dilution. So, founders need to strike the right balance with raising just the amount of funds needed to scale operations. A much better valuation can be commanded during subsequent rounds. Or else within a few rounds the founders would be reduced to a minority holding status. Of course, all of this really depends on the cash intensive nature of the business in question and the burn rate. The VC environment is still not ready to accept shares with special controlling rights for founders unlike the trend in the western countries. Founders should be mindful of this while raising funds in the initial stages.
The investment banker
Another alternative is for founders to appoint an investment banker to help them navigate through their first funding. Setting up a business plan, preparing an attractive pitch deck for investors, crunching numbers etc., are all expertise that an investment banker brings to the table. However, many reputed investment banking practices may not take up smaller size funding mandates. In such situations the best option would be boutique investment banks that have sector specialization. But usually, start-ups manage the funding rounds until Series A or Series B without the assistance of an investment banker for the fund raise. They may however use professional assistance for preparing the investor deck and related documents.
Understanding the investor
Founders also need to understand their investor, their nature of discussions, their risk appetite, and the principal who takes call on the deal commercials. On certain aspects, foreign investor teams are usually more flexible to deal with as compared to domestic investors. Once commercials are agreed with foreign investors, they tend to be more flexible with concluding negotiations for legal documents and ensuring ‘money in the bank’. While domestic investors are quick to close out on commercials, their teams could be a bit rigid about modifying their standard legal documents. But once investments are concluded almost all institutional funds (domestic or foreign) provide complete operational flexibility to founder teams.
Securing a term sheet
Once the founders have started discussions with VC funds for their first funding round, the first important milestone would be getting a term sheet. The term sheet forms the basis of discussions and negotiations which eventually translates into the long-form transaction documents. In that sense, the term sheet is a critical inflection point in the life cycle of a funding round.
What is the importance of the term sheet in the life cycle of a funding round? Are the founders allowed to negotiate and push back on provisions in the term sheet? How should they deal with it? Importance of legal jargons in the term sheet? We will discuss these and more in the next article of this series.
Arun Mohanty | Principal Associate, Veyrah Law; Ajay Joseph | Partner, Veyrah Law
Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.