Beyond Term Sheet: Key Things Startups Should Consider While Negotiating Funding

India is currently one of the fastest-growing startup ecosystems in the world, with innovative ventures emerging across diverse sectors. However, for the Indian startup ecosystem to grow and scale, it requires sufficient funding and investment. According to Tracxn Technologies, as of February 2023, only 91 deals worth $1.32 Bn were made, in contrast with the 308 deals worth $4.77 Bn recorded during the corresponding month in 2022. Investors expect their portfolio companies to rectify their unit economics before embarking on fundraising activities.

For startups, negotiating funding deals with investors is a critical process. While getting the unit economics right, startups must also focus on considerations beyond the term sheet, which outlines the basic conditions of the deal being made. 

Due Diligence Works Both Ways 

As a founder, it’s important to keep in mind that just as investors conduct due diligence on a startup, the startup should also conduct its own due diligence on the investor before accepting an investment. It means understanding the kinds of entities the investor typically funds, how much money they usually invest, how long they typically stay invested in a company and their return expectations. 

Startups must speak with some of the companies the investor has invested in to gain insights. Investors may claim to offer access to their network or help with hiring and strategy. It’s important to verify these claims, especially at the early stages of a startup’s development.

The team sheet details the amount of funding offered and the pre-money valuation, as well as projections for the company’s future growth and potential value. By understanding the investor’s expectations for return on investment, founders can align their own goals and objectives with those of the investor. 

Understanding The Investor’s Philosophy

Indian startups must be aware of common mistakes and take steps to avoid them. One of these mistakes is failing to understand the investor’s philosophy and investment patterns, as well as their track record and the value they can provide beyond just the monetary investment. 

Startups must evaluate the investor’s management style. Do they tend to micromanage or make unreasonable demands? It’s essential to comprehend the investor’s philosophy and operating style. Other considerations include the rights the investor is seeking in the term sheet, such as voting rights, board seats, veto rights, liquidation preference and participative preference. 

After an investment term sheet is agreed upon, the company will usually undergo a thorough due diligence process, which involves scrutinising various aspects such as financial records, customer orders, employee records and statutory compliance. However, many startups are often ill-equipped to handle this process as they may lack the necessary data or documentation required for due diligence. 

Private equity and venture capital firms have become more diligent about their investments. It’s one of the key reasons why startup investments have plummeted this year compared to the same period in the previous year. Founders must be aware of the due diligence process that investors must undertake before funding their startup. Founders need to ensure that they are well-prepared and have all necessary information related to finances, compliance, customer orders, HR, etc. in place.

Identifying Mismatch Of Expectations Early On

Founders must also understand the fund’s stage of life and the implications of the term sheet being offered to them. For instance, if an investor invests in a seven-year fund in its third year, they will likely exit the startup within four years. If the founder’s goal is to build the company for the long haul, it can lead to a mismatch of expectations. Effective communication between the founder and investor is crucial, especially when dealing with VC funds, and the founder must understand the Venture Capitalist’s (VC’s) compulsions. It’s important to consider where the fund is in its life cycle and how it may affect your business strategy.

It’s also essential to understand reporting cycles and how often you need to update the VC on your company’s progress. When considering valuation, the startup must assess how much money it needs to raise in the future and how much more dilution it is willing to accept. Dilution can affect the founder’s control and shareholding in the company. 

A common mistake that people make when receiving offers of funding is not taking the time to fully understand the details of the offer. It’s important to carefully review the term sheet and understand each line item. Startups must ensure that the funding deal being offered to them is structured in a way that supports long-term success.