When a startup has come up with growth plans and strategy to scale its business, it is time to look at the financial resources needed to achieve those plans.

The startup will work out the amount it needs to raise and consider the type of investor it wants on board. It will also explore the different aspects of fundraising, including what instrument to issue, the structure of investment and the extent of influence the investor will have on the company.

There are two broad categories of investors it can approach – strategic investors or financial investors.

Strategic investors bring with them industry expertise and possible synergies when working with the startup. They are not investing purely for financial returns but also to reap the benefits of collaboration and exchange of expertise.

The growing number of innovation labs sponsored by major corporations show their burgeoning interest in being strategic investors.

On the other hand, financial investors like funds and venture capitalists invest with a view of gaining a financial return from an eventual exit from the investment. Financial investors may also bring a bevy of contacts from other businesses in their investment portfolio that may benefit the startup.

Structure of fundraising

Depending on the stage of the startup, the fundraising may involve the issue of shares or some variation of a convertible instrument eg convertible preferred shares or notes.

In issuing shares to the investor, the current shareholders of a startup will have their ownership diluted immediately. By issuing convertibles, the dilution will happen only upon the eventual conversion of the instrument to shares.

In an issue of shares to investors, the company will crystalise its valuation at the point of issue. If the startup is at an early stage, for example, in the pre-seed or seed stage, arriving at a valuation may be a highly subjective affair.

Also Read: The holy grail of fundraising for startups

That is why many investors of early-stage startups prefer to subscribe to convertibles where the conversion price is set, for instance, at a discount to the price of a future round of investment. This postpones the need to arrive at a valuation to a later stage when there is more of an operating track record to be relied on.

Valuation of startups is subjective because projections may not be that strong an indicator of the future of the business. The business idea may not be validated in some cases, and even if validated, the product offering may undergo substantial revisions.

Also, startups are usually not profitable and are cash flow negative, especially in the early stages. Performance metrics and evidence of traction may provide some colour to the investor, but the investment case is based mainly on the potential of the business.

Regardless of whether it is a share or convertible issue, it is likely that the investor will insist on having certain veto rights over major decisions to be made by the company post-investment.

The company will typically need to have the investor agree on events like major disposal of assets, taking on borrowings, making distributions to shareholders, etc. There is a level of control that founders will need to give up when bringing on investors.

Interaction with investors

Startups should keep in mind that especially in the case of financial investors, the valuation they invest at must make sense from a returns perspective. Funds and venture capitalists are looking to achieve multiple times their money upon exit of the investment.

Putting forward their investment case, startups should illustrate how the funds raised will allow them to expand and scale to hit the exit valuation such investors look for. Highlight the targeted metrics it intends to achieve and how these translate to financial projections that point to an attractive exit valuation.

A big part of the dialogue between the interested investor and the startup will occur at the due diligence stage. This is where the investor will query, investigate and verify various aspects of the startup before finally deciding to invest.

Also Read: 9 elements of every new venture that investors expect

Founders should anticipate the concerns of investors, furnish in suitable detail the information requested and suggest practical solutions where the investment case is weak.

It is useful for founders to get their house in order before the due diligence starts and make sure it has details of its operations, key metrics and financial performance in an accessible format.

The startup can decide the appropriate level of detail to disclose depending on the depth of discussions. As such information can be sensitive, startups should be cautious in handing it over to potential investors who may be competitors or are in a ‘fishing expedition’.

Another big part of the negotiation process will involve discussions over the legal documentation, which will encompass agreements like the term sheet, subscription or investment agreement and shareholders’ agreement.

It is useful for founders to have some knowledge of the standard terms that go into such agreements.

For example, the general terms in standard SAFE (Simple Agreement for Future Equity) and VIMA (Venture Capital Investment Model agreements) documents are good reference points for pre-seed or seed-stage investments.

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Image Credit: Fabian Blank