A founder’s endgame is to sign an investment agreement and secure financing for their startup. To get to that point, they usually go through a rigorous process of investor due diligence and deal negotiations. A good idea is to also check if an investor is really the great partner the founder is looking for and if they truly hold the founder’s interests at heart.
Read on to find out how the process of founder-investor due diligence works, and what founders should understand in deal terms to land an investment made in good faith with mutual goals aimed at the company’s success.
After a successful pitch: preparing for due diligence
Having a marvelous pitch session is no guarantee a startup will secure funding from an investor. Most likely, they will give the founder the green light to move forward with due diligence. This process allows an investor to find out more about the company and how it works.
Diligence starts with acquiring some basic organizational documents, and it’s nice to have them ready well before the investor asks the founder directly:
Articles of Association
Share Issuance Certificate
Intellectual Property Certificate
These basics are a good starting point. However, proper due diligence goes well beyond. It’s important to also prepare financial reports, growth projections, and documents outlining current major operational processes. Everything a founder has to prove their startup’s good standing.
Investors will conduct their own background checks and in many ways will guide founders through the process. The complete due diligence route includes the following stages:
Business model review
Management team appraisal.
Read our article on investor deal-making for a deeper dive into due diligence and to get into the mind of investors when they’re closing deals.
What’s a data room and why do founders need one
A data room is where a founder stores, edits, organizes, and provides access to information about their business. As we briefly mentioned, it’s important to anticipate what an investor will need during due diligence. Having the appropriate data ready both accelerates the diligence process and makes the founder look good in the eyes of the investor.
Virtual data room tools
Cost-effective tools like Google Drive and Dropbox are the mainstream tools used to create a data room by younger startups. They make it easy for founders to store, edit, and share documents. Dropbox’s DocSend app also provides additional features like insights into document views: how often they’re accessed and by whom.
More sophisticated virtual data room solutions offer an extended rack of features and more control over a founder’s data room. Currently, the top solutions on the market, based on user-friendliness and rich functionality are:
What to include in a data room
Andrea Funsten, a lead investor at RTP Global VC firm, has an interesting post pinned on her Twitter about what an ideal data room should look like. It is based on a real-life situation where a data room sent by an early-stage startup impressed her so much that it made her eager to move fast on the deal.
Here’s what the data room contained:
Deal background: pitch deck, OpEx in the current fundraising round, capitalization table, and commitments from previous rounds.
Recent investor updates for the last 6 months: according to Andrea, this shows her how transparent a startup is with their investors (sharing both the good and the ugly), and more importantly, it allows her to see if there’s any traction over time.
The gist of the business and market: company strategy (long-term vision), product strategy for the next 2 quarters, market sizing, growth strategy, and regulatory strategy.
Marketing and content strategy: explaining the startup’s plans for generating product awareness, business scalability, and increasing demand.
Technology primer: an onboarding document to get up to speed with the cutting edge of the product’s business domain.
Competitive landscape tracking sheet: a list of companies the founders are tracking and an analysis of how the company plans to stand out.
List of asks for the investors: what the founders are looking to get from the deal and any other help needed, including connections, partnerships, or advisory assistance.
Reverse due diligence: is the investor worthy of partnership?
Due diligence is a two-way street. So while the investor is looking into the inner workings of the startup, trying to decide if the investment will be rewarding for them, the founder should also think of what that investor brings to the table.
Here’s a quick checklist a founder can use to diligence their investors:
Have they made an investment in the last 6 months?
Have they raised any capital in the last 5 years?
Are they able to support you with multiple rounds of funding?
Do they have experience investing in your business type?
What’s their decision-making process and how long does it take?
Do you want to be associated with the companies in their portfolio?
Are their portfolio founders happy about their partnership experience?
Can they share any operational knowledge to help you cut corners?
Will their brand or network benefit you in hires, connections, and customers?
By asking these questions founders can decide if an investor is a worthy partner.
Term sheet phase: what founders need to know to get a fair deal
If the founder passes an investor’s due diligence test, they will receive a term sheet. The term sheet is a non-binding document containing the proposed terms for the deal. It undergoes several edits before both sides agree on it. After that, it serves as a template for the legal clauses drafted in the investment agreement. A signed agreement means a deal closed.
Negotiating the term sheet
The deal terms are negotiated until both sides see them as mutually beneficial. Neither the founder nor the investor like to carry all the risks of the investment.
For both sides of the deal, the motivators for negotiations are to:
Raise the needed capital while gaining on the upside
Retain control of the company and its operations
Limit the downside risks and survive the unfortunate exit.
To make smarter decisions during negotiations founders need to apply knowledge of ownership, dilution, and valuation. Many founders try to hold on to their majority stake as much as possible. However, it’s important to understand that control and financial success are mutually exclusive for startups.
Yes, a founder's stake may drop below 30% after multiple rounds of funding. However, with a healthy growing startup that is also nurtured through fundraising, the stake's value increases rapidly. Being stingy over ownership and control only leads to a less valuable company.
Understanding the deal terms
The investment deal is dictated by two key definitions:
the company valuation
the size of the investment.
The valuation determines how much an investor values the company and is usually based on similar investment deals with startups in the founder’s industry. The size of the investment determines how much capital the startup will receive and the investor’s stake in the company.
The investment can be deployed via several different financial instruments. They determine what the investor receives in return for their contribution:
Equity (usually preferred equity)
Equity deals entitle an investor to a stake in the company. Preferred equity is a special type of company stock that is commonly used in startup investments as it allows adding various rules to the deal. Typically these rules are meant to protect the investor in case of downside.
Preferred equity shares are senior to common equity and allow investors to have more claim to the company’s assets than regular shareholders. Most venture investments are typically issued in preferred shares. With angels, founders can negotiate a more vanilla deal using common stock. Common stock keeps founders and investors in the same boat.
Debt-based deals are loans given by an investor to the founder. These types of deals entitle the investor to receive their loan back with interest. A founder and an investor sign a loan agreement with terms that define the size of the loan when it is due, and the interest on the loan.
Some investment agreements allow an investor to hold a security that can be later converted into company shares. There are two types of deals that support conversion to equity:
Convertible note agreement: a loan agreement that allows to convert debt into company shares at a certain point in time or during the next round of funding.
Simple agreement for future equity (SAFE): is a security that can be converted into equity without an expiration date. Investors can convert into shares at any point in time.
SAFE agreements and convertible loans provide a fast and simple way for deal closing as they are usually based on standard template terms.
Special deal terms
Investors use special clauses in the term sheet (such as liquidation preference) to limit their downside and guarantee a certain return upon exit from the startup.
Founders need to understand that while a deal with a better valuation can be great, a deal with a lower valuation but with better terms can often be the better deal. This is because investors tend to tip the scales in their favor when the valuation of the company is too great for them.
To understand how the special deal terms work and their implications, we need to look at a typical term sheet with standard and clean terms.
Typical term sheet: standard and clean terms
Here’s how a standard deal would be structured when offered on founder-friendly terms:
Preferred shares are provided in exchange for the investment in the company.
Standard broad-based weighted average anti-dilution: converts preferred equity share during follow-up investments at a price that's fair for both the original and new investors.
First refusal rights: gives the investor the right to purchase shares from founders or other major common shareholders before they are sold to a third party.
Co-sale rights: gives the investor the right to participate in the company’s sale on equal terms with other shareholders.
Registration rights: allows the investors to register their shares for sale on a public market.
Pro rata rights: allows an early investor to protect their stake by continually investing (at the same percentage) in the company as its valuation grows in later rounds.
Information rights: the right to access the company’s books and financial records, inspect its facilities, and request information.
Liquidation preference: 1x non-participating preference. Gives the investor the right to get the investment amount back in the case of liquidation.
Dividends: X% noncumulative, payable if and when declared by the Board of Directors.
Conversion to common stock: give the investor the option to convert preferred shares into common stock.
Voting rights: investors have the same rights as holders of common stock, plus the right to approve major decisions like changing the Board of Directors or company sale.
Drag-along: a requirement for the minority shareholders to accept the decisions approved by the majority.
Board of Directors: the investor appoints 1 director, founders designate 2 directors, or in the equivalent proportion (so founders retain their authority).
Founder and employee vesting: 4-year monthly vesting with a 1-year cliff.
Funky terms: things founders should try to avoid
Sometimes investors see the deal as too risky and propose funky terms that can cause serious harm to premature startups. Here are some examples of what founders need to keep an eye out for:
Tranched investments: investors request that their investment amount be paid in tranches against the achievement of milestones.
Multiple liquidation preferences (greater than 1x): the investor gets back (a lot) more than their invested capital and before founder distributions.
Full ratchet provisions (anti-dilution): allows the investors to increase their number of shares without investing any money, preserving the same stake in the company.
Super pro-rata rights: guarantee an investor the ability to buy more shares (often ranges from 30% to 50%) than their initial investment in the following investment rounds.
Participating preferred shares: the investor double-dips and gets their returns plus the common stock equivalent portion of exit proceeds, instead of just one of these options.
Cumulative dividends: allows the investor to accumulate their liquidation preference, increasing it every year by the dividend percentage. This is a huge economic hurdle for founders.
Warrant coverage: entitles the investor to an amount of extra fully diluted shares they have the option to buy later at a pre-agreed upon price.
Founders should ask investors why they are proposing non-standard terms and try to get to the bottom of their concerns. If the founder knows what the investor is worried about, they can counter and substantiate their belief in the startup’s success.
Yes, closing an investment deal can be tough. And sometimes the due diligence of a major VC fund is just as stressful as a medical exam. For startup founders, being prepared and having all the information stacked in a virtual data room gives them a strong head start. Investors understand that the founders mean business and are eager to close the deal.
Understanding the basics of term sheets and deal structure also lets founders be ahead of the curve. By showing their savvy the founders can earn an investor’s respect.
Ultimately, an ideal investor is the one that will become the founder’s trusted partner and advisor. These types of relationships are often hard to come by. Entering a digital startup network like Go Global World connects founders with selected and verified investors eager to become partners.
Go Global World’ s AI matchmaking beats pitching to investors 24/7 and gives both founders and investors access to better investment opportunities.