Startup funding, term sheet and due diligence decoded

Corporate Law & Intellectual Property Rights | By Editor | Last updated on Nov 22, 2019

Startup funding in India has seen a rapid growth. With such growth, the complications in deals have also grown in leaps and bounds. Hybrid instruments of negotiation have come into pictures. Modes of financing have changed. Hence, it becomes very important to understand the pros & cons, nitty gritties of what a startup in getting into. In this article, “Startup funding, term sheet and due diligence decoded”, we answer all your queries relating to Funding & Term Sheet Assistance.

What are the various sources of funding?

Nowadays, when we talk about funding, we tend to synonymize it with Venture Capital or third party investment. The case, however, is not so. Venture Capital/Angel Funding is only a part of the entire story. Funding simply means inflow of money for running the business or expanding it. There are various sources of funding like seed capital, friends and family, incubators, etc.

2. How can Taxmantra help me in securing Funding?

The key to a successful funding is a successful business pitch supported by a business valuation and a strong internal control system to pass the Due Diligence Check of the Investors. Taxmantra has been assisting start-ups and SMEs in securing funding for their business by assisting to prepare a suitable business pitch, reviewing and assisting with Term Sheets, Share Purchase Agreements and Shareholding Agreement, setting and updating up internal control systems. We have been part of $100 million + success stories in 30+ years of our operation.

3. What is a Term Sheet?

A Term Sheet is a non-binding agreement which sets forth the basic terms and conditions under which an investment will be made. It serves as a template to develop more detailed legal documents. A term sheet is a basic tool for negotiation. However, it is not an agreement. Hence, it is not legally enforceable.

4. What are the basic elements of a Term Sheet?

Basically, the following few are the elements of a Term Sheet:

Investment Structure
Corporate Governance
Dilution and Exit Rights
Other Covenants

5. What are the things I should consider before availing Investment?

Here are some important things to consider before getting into a marriage with a VC:

Are you doing it for the right reason? Do you really need to raise money?
Are you raising it from someone who is right for you? Two people can be brilliant individually but they may not be compatible together.
Are you reading the fine print? Have you understood every aspect of the deal?

Are you seeing the VC as a partner or someone external? Have you made any effort from your side to make this partnership work well?

6. What are the clauses to be kept in mind while signing the term sheet?

Business Valuation
Liquidation of Existing Equity Shareholding
Liquidation Preference Structure in case of dissolution of company
Restrictive Provisions with respect to Approvals Required from Investors
Drag Along Rights
Tag Along Rights
Ratchet Rights
Escrowing Founder’s Shares- Founder’s Vesting
Exclusivity

7. What should I take care of in Business Valuation Clause?

In this, make sure you understand the effect of including the option pool in the fully diluted pre-money valuation. Take help from an expert and understand the concepts of pre-infusion and post-infusion values.

8. What should I take care of with respect to liquidation preference in case of dissolution?

The liquidation preference defines the return that an investor receives in case of dissolution of the company. The investors get the first share which is typically their invested capital plus 50% to 100% returns on top of it. The remaining is then split between all the shareholders including the investors in proportion to their shareholding. In a nutshell, in case your company is sold, you might end up making a lot less than the investors irrespective the shareholding pattern. Another very important fact is that the terms put in place in the Series A are often carried over to the Series B and beyond, so make your choice carefully. What seems unimportant at this stage may have a tolling effect in future. Quiet honestly, Series A funding gives you the stepping stone for leveraging your terms. Hence, it becomes very important to understand the nitty gritties.

9. What is meant by “Restrictive Provisions with respect to Approvals Required from Investors”?

The investors will be party to some of the key decision making in the company. Among other approvals that you need to take from the investors, you need to have their approval before raising another round. Problem arises when the business valuation for subsequent funding does not tally with the investor’s expectations. Many a deals have been lost because the investor wanted a higher valuation despite the entrepreneur being ok with the offer. So net result, you lose out to the wishes of your investor. Sometimes, the list of the key decision-making items may extend beyond strategic matters to operational matters.

10. What is meant by “Drag Along Rights”?

This is a right that enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms, and conditions as any other seller. Though this clause was intended to be used in good faith, however, check should be conducted and all such clauses should be modified to protect the interest of the founders.

11. What is meant by “Tag Along Rights”?

This clause states that when the founders sell their shareholding; the investors will also get an exit. Also referred to as the “co-sale rights”, this clause was generally brought in to protect the rights of the minority shareholders. However, care has to be taken whether the reverse applies or not, i.e. in case the investors sell their shares, there is exit provision for the founders or not. There have been instances where the majority investor sold their shareholding to a large corporate leaving the founders high and dry.

12. What is meant by “Ratchet Rights”?

This is an anti-dilution often used by the investors to protect their rights at times of future rounds of funding. A full-ratchet anti-dilution protection allows an investor to keep his percentage ownership remain the same as the initial investment.

13. What is meant by “Escrowing Founder’s Shares- Founder ‘s Vesting”?

This is a critical area and a very common area to review and understand from the founder’s perspective. You need to have a check on the details of vesting period, for eg: date of commencement of the vesting terms, the vesting schedule, duration and alteration.

14. What does Exclusivity mean?

This is a very common clause. Generally, the investor puts a restriction on you that you do not talk to any other investor for some time. This is a fair and square request but be sure to check that the time period is not too long.

15. What does Due Diligence mean?

“Due Diligence” is nothing but an investigation to assess risk.

16. Why a Due Diligence is conducted?

A due diligence is conducted to assess the risks associated with the Investment like:

Check the Internal Control Systems are in place or not
To calculate the financial risk involved
Judge the awareness of the business owners
Assess the team structuring and Operational Processes in place
Verify the claims of the pitchers
Excavate undisclosed risks
Know more about the founder’s personal lives and his circles

17. What is the process of Due Diligence?

The process of due diligence generally consists of the following processes:

Investor appoints a team
Definite Mandate is set for the team
Confidentiality Agreements are formulated between parties
Due Diligence Questionnaire and checklist is prepared and circulated
Investigation takes place
Due Diligence Report is formulated and circulated

18.What are the things to keep in mind to hack the due diligence investigation?

Secretarial practices should be in place
Ownership of Intellectual Property should reside with the Company and not the Director(s)/Shareholder (s)
Statutory Registers, Minutes and Resolutions are recorded timely and correctly
State Specific licenses and permits have been obtained or not
Proper record of all the filings with the Government department till date should be in records of the Company
Internal Agreements and contracts between shareholders or directors should be reduced to writing
Check the formulation, maintenance and renewal of contracts with service providers and vendors
All structural changes in company should be duly recorded with the RoC and should take place as per standard guidelines of the Companies Act, 2013
All the compliance related filings should be up to date.
Litigation issues, if any should be properly recorded and if possible sorted as early as possible.
Best to appoint an inspector internally to set everything in place before the due diligence check from the investor is due.

19. What do investors look for in a startup before funding?

Investors look for a number of things in a startup. A lot varies from investor to investor. However, in our communication with various investors, we found that few things are more or less common. Some of these are:

It is all about the TEAM. The team’s background, credibility and experience.
The product-market fit. What problems/needs/deficiencies of the market do you solve? How do you solve those problems? What percentage of market experiences those problems?
What traction are you able to gain? How many customers you have gained? Metrics about leads, conversion, website visits.
What will you do with the money invested? How do you plan to spend it?
The unit economics-existing and proposed. This is more or less the driving factor. We have discussed about this in the later part of this blog.
SWOT Analysis. What are your strengths and weaknesses? What are the opportunities for survival and growth? What are the threats that can pose a hurdle?
Exit avenues.
The relationship between spending and growth.
Can your business self-generate funds or is likely to sustain on external funding?

20. How should I raise funding? What are the various instruments to raise funding?

Funding can be raised through issuance of various securities like:

Preference Shares- the most popular class being that of that Compulsorily Convertible Preference Shares (CCPS)
Equity Shares
Convertible Debentures
Convertible Loan (less common)

21. Investors look for MVP? What is MVP?

MVP means Minimum Viable Product. This is a product which has sufficient features to gather validated learning about the product and its continued development.

22. What is Unit Economics?

Unit economics are the direct revenues and costs associated with a particular business model expressed on a per unit basis. The fundamentals in this case are:

Lifetime value (LTV): the amount of revenue a single unit generates during the entire duration of their usage of your service.
Cost per acquisition (CPA): How much it costs to acquire one unit.

To the extent that LTV exceeds CPA, there is a business.

23. Why is unit economics important?

This is a simple concept: the direct expenditure you incur in your business should not be higher than direct revenue earned, on a per-unit basis. Unit economics indicate the strength of the core values of a business and is used to determine whether a business model can be successful and profitable.

If a business is not making money at the smallest data point, there is all probability that it will not make any at any given point. Most hyperlocal and foodtech startups are incurring losses at the basic unit level.

24. Do investors look for unit economics?

Now, investors are no longer content with just the overall projection and valuation of a business. They intend to strengthen their investment cores. As a result, they are focusing more and more on unit economics. The valuation and projections are being validated. Milestones are being cross-sectioned and profitability has emerged as the determining factor for further investment. Startups are having to pass the stringent due diligence investigation of investors. Obtaining and maintaining investors are no longer a cream job.

This, in turn, has led to an increased awareness among startups. They are forced to put across practical projections and realistic figures. As a result, the billion $ valuation figure is becoming a myth.

25. What has changed in the Indian startup funding scenario?

Today, the Indian startup funding scenario is at its unpredictable best. While 2014 and 2015 witnessed huge funding rounds, with the emergence of food-tech startups, hyperlocal and aggregators, in addition to e-commerce platforms, 2016 has had a mellowed beginning. Apart from the slowdown of funds inflow, we now hear more of startups shutting down and merging or conglomerating.

26. What is Business Valuation?

Business Valuation is the process of determining the economic value of a business or company. Valuation can make or break a business deal.

27. What are the factors to be considered for Business Valuation?

There are various factors that are to be considered for business valuation. For eg:

Nature of Business
Promoter’s Background
Goodwill
Earning Capacity of the Firm
Asset Liability Position
Forecasted Growth
Relative Valuation of similar businesses
Expected Turnover
Earning Capacity of the entity

28. My investor is from US. Are there any additional compliances?

Yes. In case of a foreign investor, you need to comply with the RBI compliances as well.

On receipt of funds:

File “Advance Reporting Form” to the RBI, within 30 days of receiving funds from foreign investor along with prescribed details and KYC documents.
Issue shares within 180 days from the date of receiving funds.

On issue of shares to foreign investors:

Report in specified form (FC-GPR) to the RBI, within 30 days from the date of issue of shares along with prescribed documents.

DOWNLOAD OUR PRESENTATION: GETTING READY FOR FUNDING

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