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.

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.

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

• Investment Structure
• Corporate Governance
• Dilution and Exit Rights
• Other Covenants

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?

• 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

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.

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.

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.

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.

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.

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.

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.

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.

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

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

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

• 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.