Clinching investment from a venture capital fund may be seen as an endorsement of an entrepreneur’s abilities. But raising money is also fraught with risks.
A number of startups are discovering that a lack of clarity and improper rapport with investors can lead to promoters losing control of their companies or being forced to sell out too early for too little.
Ensure Alignment of Goals between both Parties
Experts are of the view that as more investors get tough in a slowing market, founders must do more to protect their interests by picking the right investor and ensuring there is an alignment in the goals between both parties. It’s vital for entrepreneurs to be choosy about whom — and under what terms — they accept funds from.
Here’s a checklist of the five most important factors that a startup entrepreneur needs to consider before signing on the dotted line.
Choosing the Right Investors
In 2000, when he first raised capital for travel portal MakeMyTrip.com, 43-year old Deep Kalra agreed to terms written on a paper napkin. “It turned out well, but I was very naive and for my next round, I did my homework.”
Founders must speak to companies that have already taken money from the investor they are negotiating with to understand how the going will be during tough times. While valuations matter, the investor offering the highest value is not necessarily the best.
Kalra says when he raised funds from SAIF Partners in 2005 there was an equally good offer from another venture fund. “But we chose SAIF because of the speed with which they moved.”
Time It Right
The earlier an entrepreneur raises capital, the less advantage he has in negotiations.
“It is best not to sell too early, too cheap,” says Krishnan of IIM-Bangalore.
For instance, JustDial, which listed on the bourses in May, raised its first round of funding of Rs 50 crore only in 2006, some 10 years after its launch. Even after raising Rs 580 crore of risk capital, founder VSS Mani and other promoters owned 37 per cent of the company at the time of going public earlier this year.
“There should be only one captain in the ship,” says Mani, 46, who believes a good entrepreneur should retain the board majority and voting rights.
Hitesh Dhingra, 33, whose online electronics retail venture Letsbuy was sold to Flipkart last year, believes it’s best to have the product and the core team in place, along with some revenues, before raising risk capital.
The ideal situation is when the investor approaches you.
Terms & Conditions
A number of clauses couched in legal jargon that are difficult for an entrepreneur to understand could sneak into agreements, such as term-sheets and contracts. These can come back to bite later.
Serial entrepreneur and angel investor Krishnan Ganesh faced such issues at his second company CustomerAsset. When raising a second round of funding at the peak of the dotcom meltdown in the early-2000s, he had to agree to a “drag-along” clause. Under this clause, an investor can insist that the founder sell his stake to facilitate the venture fund’s exit. Within a year of the funding, the investor exercised this option.
“They wanted to sell us like an old car,” says Ganesh, 51. “I did not know the terms and jargon.”
Getting a mentor or a lawyer who will guide the founder through the mine-field of agreement negotiations is important.
Dhingra, who has launched an online matchmaking site TrulyMadly, says he was lucky to have Manish Vij, founder of digital media network Tyroo, as an angel investor in Letsbuy.
“He has seen numerous deals and helped with negotiations when we raised institutional funding,” says Dhingra, who along with co-founder Amanpreet Bajaj held majority stake in Letsbuy at the time of its acquisition by Flipkart. We got a great deal when we sold out partly due to the agreement we had with our investors.”
MakeMyTrip’s Kalra says founders should take advantage of resources like sessions conducted by entrepreneur network TiE to help clarify legal jargon. Negotiate the terms as well and be prepared to walk out even when the money is good if the terms are not conducive.
Finally, all good deals depend on how well a company is doing as well as the expertise of its founder. If the venture desperately needs money, then the founder has to agree to the investor’s terms. Also, an entrepreneur has to make decisions based on what the firm needs at the time of fund-raising.
“If an investor is good for the company, I see no harm in diluting my stake” says Kalra.
He and other promoters held just around 17 per cent stake in MakeMyTrip at the time of its Nasdaq listing in 2010. “But I have not faced any problems in running my company.”
However, iStream’s Ramachandran found out even when the business is doing well, things can go wrong.
It’s all about timing. You need to get that right.
[Editor’s Note: This is a republication from the article that appeared on Economic Times]