It’s almost inevitable that a startup wishing to scale will raise funds from a VC or professional investor at some point in their journey. Any funding negotiation with venture capitalists will have significant implications for the business so getting it right is crucial.
The Impact of Dilution
A critical concept to consider when raising capital is “dilution”. Dilution refers to the effect on existing shareholders when funding is raised through an issue of new shares, i.e. the % ownership of existing shareholders decreases as new shares are issued.
For example; a founder holds 100 shares representing 100% of the shares in a company. The company issues 15 shares to a new investor. After the issue of new shares, the founder has a % ownership of 100/115 shares = 87%. The founder’s ownership interest has therefore been diluted by 13%.
If a business grows strongly, the financial effect of dilution can become very significant. Founders should therefore try to minimise dilution to the extent possible particularly in early funding rounds, however this needs to be balanced with the desire of venture capitalists to have a significant shareholding and upside potential. Cap tables are a key strategic tool used here.
Timing the Raise
A rule of thumb when raising funds is; the more progressed the business, the less dilution will be incurred upon accepting a new investment (since the valuation will be higher). So the longer that funding can be delayed the better.
A common mistake however is to leave too little time to raise funds leading to a situation where the business is “forced” to accept a poor deal, or worse, run out of funds before new funding has been secured.
Fundraising is a time consuming and resource intensive process – and therefore a timeframe of at least 4–6 months should be planned for. A cashflow forecast can help you plan your exact requirements & timeframe more adequately when negotiating with venture capitalists.
Settling on a Valuation
Any funding negotiation will certainly focus on the valuation of the business (see our article on valuations). It’s therefore essential to have a sound basis for your valuation, and to set a range of values (and dilution) that you are prepared to accept.
While it’s understandable to seek the highest valuation possible, an unrealistic or unfounded valuation will leave a poor impression with a venture capitalist and may also terminate the negotiation altogether.
It’s also important to understand that a VC is likely to use proprietary valuation techniques (often based on a target return and investment horizon) leading to a difference in valuation from your own.
Board representation and voting rights
An investment by a VC will often include a requirement that the VC be given Board representation as a Director, and also that a “Shareholders Agreement” be entered into. A Shareholders Agreement is a contract entered into by all Shareholders which governs a range of matters including voting rights with respect to key decisions, the rights and obligations of shareholders and specific provisions regarding the VC’s investment such as liquidation preferences, antidilution protection, drag along rights, tag along rights and vesting schedules.
In these circumstances it’s important to fully understand the VC’s ability to influence or control key business decisions through their vote as either a Director or a shareholder (remembering that certain decisions are voted on by Directors, whereas others are voted by Shareholders).
Do not enter into any agreement unless and until you fully understand all the provisions and potential implications. Where possible, simple and plain English agreements should be used.
Investments by VCs – a business relationship
An investment by a VC is the beginning of a business relationship which should bring both financial and non-financial benefits such as technical skills, networking and customer introductions. A positive relationship based on mutual trust and alignment of interests will always provide the best long-term outcome for all parties.
Negotiating with venture capitalists can be lengthy and complicated and are likely to have a significant impact on the business both immediately and into the future. If you need help with negotiations reach out to the seasoned team at Fullstack whom can help with outsourced CFO services.