This article has been written by Abhishek Nair, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Abstract
For a large number of startup owners and entrepreneurs the biggest concern lies in a double-pronged question: “How Big” and “How Fast”? i.e. How fast can I build my business and how big do I want to build it. The obvious answer to even achieving the goal that you then set lies in the dangerous word “Money”. Getting money for further business development is not “a piece of cake”. When entrepreneurs think about funding, usually their first thoughts are “How much do we need” and “How do we get funding for our project or company?” And then “Where can we find funding?” or “Who can we ask for funding?”.
Introduction
According to research done by the U.S. Bank and cited on the SCORE/Counselors to America’s Small Business, the reason small businesses fail overwhelmingly includes cash flow issues. 79% of them start out with too little money. CB Insights, a venture capital database, did their homework based on 101 start-up post-mortems to pin down causes on why start-ups failed. 29% of start-ups ran out of money according to this study.
The above studies are cited in order to emphasize the importance of having enough funding not only in the initial stages but also throughout the lifecycle of the business in order to succeed at your business. Before any of that let us not forget that the reason for this failure is not because they didn’t approach an investor but because they failed to pull in investors into their business.
Lack of awareness in contacting investors (for e.g., waiting on a cold call instead of trying for referrals) or even approaching the wrong investor are all things that are bound to doom your startup. This article delves into things you need to keep in mind when you are approaching an investor in order to attract them to your business and gain funding for your entrepreneurship.
So many investors, which one do I choose?
Finding an investor isn’t the tough part, it’s to know how to approach them and convince them that you are going to get the returns on their investment. (Check out https://blog.ipleaders.in/top-ten-angel-investors-india/ and https://medium.com/@gildavcfund/top-10-accelerators-and-incubators-in-india-b5374c53d580 in order to know how to find investors)
The Right Type of Investor for Your Stage
Choosing an investor doesn’t mean choosing the first investor that you see on the internet. Choosing an investor is painstaking work that rewards well if you are able to luck out on the right investor. One of the most foundational steps is checking that you are searching for the right level of investors for your stage or round. Venture Capital is the type of funding that is most in demand. You’ll probably need to be holding angel investors and friends and family funding rounds before all this.
Ability to Fund
For a start-up company raising funds is an off-track task and for that reason, you are likely to not want to waste time searching for investors and go back to focusing on your product. A key question that you have to ask yourself about each and every investor is whether they have the ability to fund or not. Ability to fund doesn’t solely mean whether or not they have enough resources to cover your needs, but also whether or not they are interested in funding you.
Questions to ask
What Percentage of Your Meetings Lead to Term Sheets and how many of them turn into checks?
This question is aimed to gauge how successful your meeting with this investor is likely to be. A large no. of investors are quite reluctant to part with their money and you can keep your expectations accordingly. The second important as a term sheet (or offer) alone isn’t a guarantee of a closed deal. They may have really bad term sheets that no one accepts or they may be extremely difficult to work with and annoying that in the process founders end up going elsewhere for their capital.
If the terms seem too high, you can approach alternate investors but if it seems reasonable then you can ask them why they think that is and how you can lower this number. Even if you end up not going with this particular investor you can still alter your objectives keeping in mind the suggestions of the earlier investor you approached.
How Much Are You Going to Invest and Commit Today?
Get a substantial idea of how much money they can offer upfront. False promises and investors backing out are a huge source of disappointment for all start-up owners.
How Much Have You Raised Your Current Fund?
This will give you an idea if they are meeting with you to invest or if they are fundraising and looking to use you as leverage during their fundraising efforts to show their own investors about their deal flow structures.
If the investor is in financial troubles already or is looking to pay back their own investors the pressure to succeed will be trickled down to you and that is not an ideal condition to work in. Even if it isn’t that serious, it is better to have an investor who has enough funding for a repeat round in case of any urgency. It is even better if they are connected to others with capital and give you referrals for you to work upon.
At the other end of the spectrum, if an investor has not made investments or follow up investments within the last 6 months, it is likely that they are not going to be an ideal investor to rely upon. It is for this reason that it is far better to just move on to another investor who will have enough funds to launch your start-up.
Reputation for Funding Repeat Rounds of Investment
To find a new investor at the start of each round is not just a time-consuming process but also a difficult one. This is the reason why a lot of start-ups prefer going along with a previous investor. While it isn’t always true that an investor would like to fund the same company again or that you would want the same investor again, in many cases it’s a preferred mode of funding. This is why finding an investor who has the habit of funding multiple rounds is important.
Questions to ask
How Many Follow Up Investments Have You Made?
Your goals and needs may differ and that is what should truly lead your process of finding an investor. So, you may not always want the same investor again and you may want to change your investor. Although, if your investor from the previous round has a good relationship with the company, they are still in good financial condition and you have found their control to be appropriate then it is better and far more efficient to rely on them again than starting from scratch again. This question lets you get an estimate on your chance in relying on the investor at a later stage.
How Much Do You Money Do You Keep in Reserve for Follow on Rounds?
This question lets you understand to what extent you can depend on them in the next round. It allows you to measure whether you need to go after a lead investor or can you still depend upon this investor to lead in the next round.
Diversification
One thing few entrepreneurs think about is making sure they are selecting a diverse range of investors, with diverse portfolios. The biggest difference that an investor with a diverse portfolio ensures is a stop-loss mechanism in case of a market crash. Take for example an investor who was heavily invested in the Real Estate market losing most of his money in the 2008 Real Estate Market Crash. While this crash affected the entire world, it began with a housing market crash. Any investor who had diversified might have still lost their money but the majority of it would not have suffered as much due to diversification. This is how you as an entrepreneur can ensure that you do not suffer because of the unexpected losses an investor may face.
Questions to Ask
How diverse is your portfolio?
What moves, entrepreneurial traits or tactics have the investor made which has changed the outcome of their investments? A quick gauge of their portfolio would make you aware of how risky an investor might be despite their resources.
What is Your Top Concern?
This achieves two purposes, a) you know exactly what is wrong with your business model and you know where to work upon, b) if the problem isn’t from your end but from the investors end you can get the objection out in the open rather than getting a “soft no”. Investors with diverse portfolios are at the same time more careful in where they are putting their money into.
Could you introduce me to an entrepreneur of your portfolio that failed?
There are two benefits of this question. The first thing you accomplish is that the investor is able to recognize the sophistication that you have bought into their firm. The second is being able to ask the entrepreneur how the investor behaved during tough times and whether they panic controlled the board or not.
Interest in Being a Lead Investor
Lead Investors are your major investors. This is the investor who sets the terms of financial returns which other investors also follow. Getting a lead investor is a pathway into getting the rest of your investors who are then going to give you further funding.
A lead investor would typically be funding around 15% percent of the total funds that you are looking for.
Questions to ask
How Often Do You Lead Rounds?
This lets you assess the probability of this investor leading your enterprise. An investor with high statistics of leading rounds is typically one with significant influence and can attract smaller investors more often.
Who Else Would Be Interested in Funding This?
This lets you measure how you can proceed in two scenarios:
- If the investor you are talking to has no interest in leading or funding you, you get some names/referrals which help you gain traction.
- If the investor is funding you, the usual co-investors as well as somebody more apt to lead may be recommended.
What could we improve on the pitch?
Being a lead investor means that the investor themselves is now interested in seeing your company grow. An experienced investor can tell you how to improve the pitch in order to gain additional funding and how to improve your pitch deck.
Influence
Every investor commands some level of influence with respect to their peers. A bigger investor with more money has enough influence to lead people into believing that anything they invest in is going to eventually succeed. This influence is sometimes far better than a lump sum by one singular investor who is less well known.
Some of the top tier early-stage Venture Capital investors have a tremendous amount of influence in the venture capital market. If they invest in your company, they could also support you with resources around HR, marketing, subsequent funding rounds, etc. That type of value is something to look after when doing your capital raising efforts.
Moreover, the reputation of your board members will provide a great degree of credibility and belief towards your venture. Early-stage investing is all about trust.
Questions to ask
Who Else Needs to Approve This Investment?
You need to make sure that you are talking to a top-level investor and not a bottom level associate. Otherwise, you might be wasting a lot of precious time. If this is a low-level associate, make sure you know who you really need to convince and what you need to convince them when you reach out to them.
Who Would You Put on Our Board?
Influential and big investors often want to place somebody they want on the Board of Directors. A nepotistic investor would often place one of their relatives in positions of power whereas a good investor would place an excellent and experienced person on the Board of Directors. In many instances, having recognized individuals on your board could help to convince others to join the board as well by making a meaningful investment. Many investors consider boards as an important aspect of any company and often begin their networking from right there.
Easy to Get Along with
An extremely important part of all of this is whether it is easy to get along with all the investors. A “difficult to deal with” investor often results in differences even within your own team. Taking the ideas of an investor is very different from the investor creating a ruckus when you do not go along with what they want or creating a split within the company due to internal conflicts. Make sure that the people that you decide to partner up with are ultimately moral and ethical partners.
Questions to ask
Is This Investor a Fit for Your Brand and Culture?
Investors have their own brand value and you do not want an investor whose brand image contradicts your own brand image. For eg: If you are in the business of children’s products you ideally want an investor who is known for being a family man. An aggressive investor would portray the company in a bad light.
Control & Intent
Last but far from least, in fact, I would argue the most important factor you need to keep in mind is the Intent and Control of the Investor. A large number of investors often are quite dominating and controlling. This dominance may result in great harm to your company and eventual loss of control from your own hands. “Investors are your partners, but not your friends”.
Questions to ask
How Often Should We Expect to Meet After Funding?
There is no doubt that you want your investor to be actively interested in your company. Some investors are much more intense regarding this process than others. Raising money is far more about the added value you can get with these people on your team and with a vested interest in your success than the funding itself. Yet, you don’t want to be weighed down and held back from actually gaining and delivering results.
What’s the First Thing You’d Want Us to Do After Closing?
Get a head start and clear expectation of what they are thinking you should do. Get an idea as to how they wish your company to proceed after you get your money from them. Recognize what changes are they looking to bring within your company.
What Will We Least Like about Your Due Diligence Process?
Due diligence is a difficult process for most entrepreneurs. Investors often have certain aspects they like to focus on more than anything else in your wallet. Recognizing this will allow you to get a head start and make sure that the diligence process goes much more smoothly.
Documentation to send your investors
Once you are done with the introductory process it is time to get in touch with your investors and start sending them whatever documents they require in order to complete your transaction. There are primarily three stages where documentation is required.
First Stage: Introduction To Your Business
The key documentation you want to send to the investor includes:
The elevator pitch
Investors will be qualifying the entrepreneur and their startup from the initial point of interaction. This generally includes the Pitch Deck and the Executive Summary.
Pitch Deck: – A pitch book, also called a Confidential Information Memorandum, is a marketing presence through which you as an entrepreneur can pitch the idea of your business to potential investors. (Check out https://www.cbinsights.com/research/billion-dollar-startup-pitch-decks/ for inspirations)
Executive Summary: – An executive summary is a short document or section of a document produced for helping the investors understand the concept of the product in a short way so that you can save both of your time.
It is important to also mention the business traction that you are already gaining and if possible mention the investors you already have in your pocket. Also explain why you have approached this investor and your resume/CV. Lastly, leave them with some sort of Contact Information so that they can back to you.
Second Stage: Closing the Deal
The business plan
The Business Plan ideally should include the mission and vision of your organization. It should include a brief introduction of your team along with a more detailed explanation of the key problem that your business is solving using your product. Include the customer/target base and the sales strategy you plan to use. A key component of a confident business plan is mentioning your competition and why you are gonna stand out from them. End with your call to action and how you plan to proceed in the future.
Organizational Documents
Investors will check if all government filings, such as Articles of Organization / Incorporation, Authorizations to Operate, and Annual Reports have been filed. Startup documents such as Founders and Operating Agreements, Subscription, Shareholders Rights and Convertible Note Purchase Agreements, if applicable, may also be requested. It is possible for the investor to request various stakeholder tables such as Tables of Shareholders, Option Holders, Warrant Holders, and Debt Holders as well as relevant contact information.
Management & Organization Information
Investors are always interested in knowing the company’s employment structure so they will typically request structural documents such as employee listings, organizational charts, and lists of advisory and board members. Employment Agreements including NDAs, Non-competes, Non-solicitation and Invention Assignment Agreements should also be available on request.
Board of Directors
A list of the members of the Board of Directors, their resumes and bios and their contact information will be required. It is prudent to have good people in your Board as a reputed Board member captures the trust of an investor. Moreover, investors will want to review the minutes of previous Board meetings.
Contact Information
Contact information will be needed for the Founders, the Board of Advisors and the Board of Directors as well as any other high-level management position like CFO or CEO.
Information regarding product/service development
If your product/service has already been developed, an investor will require you to provide the details to manufacture or produce such a product and the estimated price of such a product. If it is still to be developed the investor will want details regarding the development process such as technology being used as well as estimated time of completion etc.
Intellectual Property
Intellectual property includes all documents related to Patents and know-how, Trademarks, Copyrights and Logos. All of these need to be filed appropriately or it will lead to a huge problem at a later stage.
Material Contracts and Development Plans
In order to understand the company’s strategic approach, investors will want to review various planning documents including Financial Plans, Marketing Plans, Sales Plans and Technology Plans. Material contracts which may be requested include Sales Agreements, Supplier Agreements, Joint Development Agreements and Debt Agreements.
Financial documents
Current and previous year financial statements, federal, state and local income taxes, insurance policies, cap tables, lists of liabilities and accounting methodologies are a few of the key pieces of financial data that may be requested.
Information Technologies
Requests related to information technologies will likely include descriptions of internally developed software, product development road-maps, production stacks and details related to any contracted partners.
Environmental Compliances
Environmental documentation may not always be applicable. However, if it is, entrepreneurs should expect requests for hazardous substance listings, descriptions of hazmat disposal methods and copies of environmental permits and licenses.
Legal Information
Investors need to know all the relevant legal information including if there are any potential or pending litigation against the company and the compliances regarding various sectors within the company.
Third Stage: Providing Regular Updates About Your Performance
The relationship with an investor is a permanent one and does not end after you sign the deal and receive money. In fact, that’s just the beginning of your relationship with the investor. As the investor becomes part of your business, you must share regular performance updates with them.
Financial Documents
Financial statements of each year must be sent to the investor including documents such as Balance Sheets, Cash Flow Sheet etc. It also must include the detailed list of expenses which the development team underwent as well as cost predictions. The sales and revenue sheets will help the investor gauge returns. The audit report is also a crucial piece of document that must be sent to the investor.
Information Regarding the Product/Service Development
This along with Financial Documents help the investor understand where exactly the costs and expenses of the company are going. Furthermore, it is also possible that the investor may signify his interest or disinterest in a certain idea, which will help the company to grow in a better manner keeping the investor in mind.
Updates Regarding the Team
Teams are often extremely fluid so it is important to notify the investor of any changes within the team especially in the top management. Layoffs, pay hikes and compartmentalization must also be notified to the investor. You should keep the investor involved over these developments as well, since they can also explain certain operational aspects in detail.
Provide customer feedback
Finally, you want the investor to be updated on customer feedback. It is important to notify the investor about both positive and negative feedback as investors being businessmen are often able to capitalize on such things and change the perspective of the consumers by altering the product model. Sharing the negative feedback could even help your investor to understand the business needs additional cash for product development. On the other hand, you don’t just want to share the negatives. When your customers are praising you, you need to inform the investors in order to boost their faith in the company.
Legal Documents to Prepare for An Investor
NDA-Non-Disclosure Agreement
A Non-disclosure Agreement (NDA) is essential to protect the interests of the company or startup in this case. As an entrepreneur you are bound to approach multiple investors and you would be revealing a lot of confidential information that is strategically important for your company. To protect yourself from those cases, where an investor is not ready to fund you and they are aware of your product/service, an NDA protects you from information being disclosed. It is such a type of agreement were both the parties, Investor and start up, need to consent and sign a Non-Disclosure Agreement under which the rights and exclusivity of the meeting and pitch are kept up between both the parties protecting the information of both parties.
Instrument of Funding
The instrument of funding is the manner by which funding will be received by the organization as far as deposits, assets, innovation, IP rights, and so on. The laws regarding taxes also change with respect to the mode of financing and choosing the most beneficial one is cost efficient.
Investment Terms & Negotiations in Termsheets
The term sheet sets out the terms on which your investor is going to give you funding, be that by taking equity in your organization, a convertible not or even if it is some other sort of benefit. It is a list of all the rights that you are negotiating for in order to provide maximum benefits for both sides. The term sheet isn’t really a legally binding agreement. The term sheet can be prepared by your side or the investor’s, but it is important that a lawyer be involved in this process so that your lawyer may negotiate the most favourable terms possible on your behalf. Liquidation Preferences, Warrants Coverage, Conversion Rights, Automatic Conversion, Anti-Dilution Rights, Redemption Rights, Voting Rights, Dividends, Board Participation, D&O Insurance, Pre-emptive/pro-rata rights, Information Rights, Expiration of Letter are a few terms that investors negotiate upon.
Investors’ Rights Agreement
An Investors’ Rights Agreement or IRA details the rights of the investors with regard to their investment in the company. The key points in this document include the following:
- Right to maintain proportionate ownership: allows investors to maintain their share percentage of the company in the event of future stock offerings
- Right of first refusal: gives investors the right to purchase shares sold by stockholders before they can sell their shares to other parties
- Participation rights: allows the holders of preferred stock at the company’s liquidation to first get paid back their initial investment and then “participate” pro rata (proportionally) in the remaining distributions with the common stockholders
- Corporate governance: lays out voting rights relating to the election of directors and the potential sale of the company
- Information rights: assure investors that they will be made privy to necessary information, such as reports and financial details pertaining to the company
Share Subscription Agreement
The share subscription agreement is a document which also known as a two-way guarantee, in which the subscriber agrees to purchase shares at a fixed price while the company agrees to sell those shares. It provides for the issuance of shares in the share capital of the startup to the investor in consideration of a subscription amount, which is determined as per the valuation of the startup. It also provides a broad outline of what the money will be used for.
Shareholders’ Agreement
The primary purpose of a shareholders’ agreement is to identify the terms regarding the management of the startup, share transfer restrictions and exit rights of the investors. It also provides for the appointment of the investor’s directors on the board of the startup and provides the structure of the board.
Dissolution/Exit Strategy
A dissolution clause should mention what would happen in the event of a dissolution, merger, sale, etc. of the company. There should always be a contingency plan in case of exigencies. If the business shuts down the liabilities and assets need to be distributed to creditors and shareholders/investors. Each party should get their fair share and bear the burden of debt proportionally as mentioned in the agreement. It is better to have this as a clause than to get entangled into a legal battle of time and resources, financial or otherwise.
Conclusion
This article deals in depth with the few key things that any entrepreneur should keep in mind while approaching investors. From your first meeting to an investor, to the exchange of documents and cash to finally the partnership is a rollercoaster that is quite exhilarating and rewarding under the right circumstances. Under the wrong circumstances, it is bound for business failure and this article is a step for you to avoid that possibility.
“You only have to do a few things right in your life so long as you don’t do too many things wrong.” – Warren Buffet
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