Dealmaking between startups and venture capital (VC) investors is often compared to crossing a river. Both sides — startup founders and VCs — share the goal of reaching the other side successfully, but each faces unique challenges that can make this journey complex and uncertain.
From differing priorities and valuations to legal intricacies and negotiating terms, the process of structuring an investment round is a high-stakes endeavor where clarity, trust, and alignment can make or break a deal.
Stepping Stones, Risk & Approach
1. Finding the Right Partner
The first step for any founder looking for VC investment is identifying investors who share their vision and understand their market. While funding is essential, compatibility with the investor’s expertise, network, and long-term goals is equally crucial.
Risk: VCs often bring valuable experience and networks to a startup, and founders benefit from this strategic input. However, too much oversight can hinder the founder’s agility and creativity.
Approach: Not all money is “smart money,” and founders must be aware of the VC’s thesis, value add and priorities (quick returns v/s the startup’s mission).
Prior to investment decisions, both the parties must lay down individual expectations with respect to support to the founder and reporting requirements of the VC.
This structure allows founders the freedom to operate while benefiting from the VC’s expertise when necessary and avoid misalignment down the line.
2. Valuation Dilemmas
Valuation is often one of the most contentious parts of a funding negotiation. Founders typically want to maximize the company’s valuation, while VCs aim to enter at the lowest possible valuation.
Risk: Startups raising capital at ‘perceived’ inflated valuations might face down rounds (future funding rounds at lower valuations) or lack investor interest during the subsequent round if they cannot meet expectations, which can harm employee morale, lead to investor mistrust, and ultimately erode the company’s value.
Approach: Founders should set realistic valuations (if required, hire experts of the domain or seek guidance in the ecosystem) and back them up with data that reflects market conditions, current & past business performance, revenue potential, and comparable companies.
‘Beauty lies in the eye of the beholder’ — Valuation is no science. It involves subjectivity. It is an outcome achieved through a series of discussions & consideration. Both the parties must resonate with the belief that it’s a partnership and not a one-way street to build a cordial and long-lasting relationship of mutual trust & respect.
For VCs, valuation is a complex union of founder pedigree, due diligence, market research, customer feedback, competitive landscape, scalability and technical evaluations.
Making accurate assessments with limited data is challenging, as early-stage startups often lack the track record or historic cash flows that established businesses have.
Solely relying on the Discounted Cash Flow method for valuation discovery may not be an acceptable approach to the investors as all the inputs in the model are provided by the founders themselves and may be subject to founder bias. On the contrary if the inputs were to be provided by the VCs on their assessment, the valuation arrived through DCF may not be acceptable to the founder. The subjectivity involved in DCF has made it a low preferred model for valuation discovery.
One may consider using multiple methods simultaneously to discover a valuation range for discussion.
Other options include:
- Setting up tranches in funding rounds — conditional installments based on achieving specific milestones
- Using instruments such as Compulsorily Convertible Debentures (CCD) for valuation discovery till a track record of the company is established.
3. Dilution and Ownership Control
‘Dilution’ — the reduction in ownership percentage due to issuing new shares — can be a double-edged sword for founders.
While funding is critical to fuel growth, each funding round can erode a founder’s control over the company.
This often leads to apprehension, as founders must balance the need for capital with the desire to maintain decision-making power and keep their vision intact.
Approach: Founders can negotiate protective provisions, such as voting rights or board seats, to retain control even as their ownership stake decreases.
Equity grants or milestone-based incentives can be structured to reverse the dilution and keep the founder motivated.
4. Term Sheet Terms
Term sheets are the stepping stone of formalizing investment interest, and they set the stage for the legal agreements that follow.
Common terms include:
- Liquidation preferences: VC recoups their investment before other stakeholders in the event of a sale or liquidation
- Anti-dilution: Issuance of new shares to existing investors if the company raises the subsequent round at a lower valuation
- Drag-along rights
each of which have far-reaching implications on the founders’ financial and operational control over the company.
Risk: VCs need to structure deals that protect them if the startup fails to deliver projected results. Terms like liquidation preferences and anti-dilution are perceived by founders as overly conservative or indicative of a lack of trust in the company’s potential.
Approach: Transparent communication can go a long way here. VCs should explain why certain terms standard practice for risk management are rather than an indication of mistrust.
Founders should seek legal counsel (from dedicated experts) to thoroughly understand the implications of every clause.
Structuring terms that balance protection without overburdening either of the parties can foster goodwill and collaboration.
5. Exit Strategy Alignment
VCs enter with a clear exit horizon. Misalignment in exit strategy can create friction if the VC pushes for an exit while the founder plans otherwise. Pressure to exit prematurely can stifle innovation and harm the company’s trajectory.
Risk: Founders’ incentives being tied to short-term goals may lead to founders prioritizing quick wins over long-term objectives, potentially jeopardizing the company’s future and investors’ exit
Approach: Founders should discuss exit expectations early on with prospective VCs. It’s beneficial to align not just on goals but on timing prior to raising investment from the investors.
Further, investors may include equity grants, milestone-based incentives, or vesting schedules that can ensure that the founders deliver onto pre-determined goals in a timely manner.
Structuring compensation that incentivizes long-term success and milestone-based growth safeguards interest of both the parties.
A Balanced Approach to ‘Cross the River Together’
The journey of structuring an investment round is similar to crossing a river.
Both founders and VCs must carefully navigate obstacles and find alignment despite their differing perspectives. By approaching this partnership with transparency, mutual respect, and an understanding of each party’s unique situation, startups and VCs can build a relationship that not only ensures successful funding but also creates a foundation for growth, innovation, and eventual success.
After all, the best deals are those where both parties reach the other side of the river stronger and ready to face the next challenge together.
Author:
Karan Gupta
