Prudent investors have their own ways of separating the good deals from the bad. Most times, investments go through a rigorous process of due diligence and then through several rounds of negotiations before the parties finally agree on mutually beneficial terms for the deal.
Read on to find out how the deal-making process goes and what investors can do to protect themselves from foul investments.
Due diligence as a way to verify startups
If a founder’s pitch strikes a chord and investors are interested in the startup, they notify the founder they’re ready to move on to due diligence.
Due diligence is the research of the inner workings of the business. It serves as a means to manage risks and find ways to add greater value to a startup. For venture capital investors, this is also a way to meet their partners’ expectations.
As an important part of deal selection, due diligence helps establish whether a company deserves a spot in an investor’s portfolio. Investors make their decision by answering these key questions:
Does this investment align with the VC fund’s mission and goals?
Is there enough market opportunity for the business?
Has the product launched and is it ready for delivery?
Does the team have a proven formula for repeatable sales?
Is the management team qualified and strong enough to succeed?
The due diligence phase explores these factors further. It provides a deep evaluation of the startup through detailed background checks:
1. Market research
Angel investors endure high risks of putting down their own capital. And venture capitalists are responsible both for themself and their partners. To make sure there’s even a glimmer of hope, an investor needs to establish if there’s a market for the business they’re funding.
During market research, investment analysts investigate the market size and product-market fit, identify the competition, and estimate the startup’s growth potential. An investor needs to determine if there will be enough demand for the product and that the sales will justify the investment.
It’s important to understand that there’s no perfect market. There’s always struggle, so investors need to figure out if a startup has a chance to break through with their support.
Information to gather:
Market size, trends, and growth
2. Financial analysis
Financial due diligence weighs in such factors as cash flow, recurring revenue, current financial standing and projections for the future, and the assessment of the startup’s customer acquisition model. The information discovered plays an integral role in the company’s valuation and determining the size of the investment.
Information to gather:
Revenue and expenses
Profitability over a time frame
Debt to equity ratio
Net assets analysis
Financial growth prospects
Customer acquisition cost
Customer churn rate
Customer lifetime value
Earnings before interest, taxes, depreciation, and amortization.
3. Legal review
Another crucial part of due diligence is the review of a startup’s legal and regulatory compliance. The goal here is to spot any legal or contractual obstacles in the company’s day-to-day operations.
The review comprises of auditing contracts, identifying pending legal claims, defining regulatory and compliance issues, and recognizing outstanding liabilities. Anything that would hurt the coming deal.
Information to gather:
Articles of incorporation
List of shareholders and equity owned
Agreements, bylaws, and amendments
Licenses and permits
Tax returns and annual reports
Pending legal claims
4. Product evaluation
Analyzing the product line is a pivotal part of due diligence. This part of the research shows if there’s actual substance behind the founder’s idea and whether it's viable to bring it to market. Analysts need to determine the uniqueness and appeal of a company's products to its target audience.
Quite often, simply coming out with a unique product isn’t enough. The startup needs to have a plan for sustained innovation and development.
The investor needs to learn about the technology behind the product and determine its quality, key features, limitations, and its potential for scalability.
Information to gather:
Current products and services
Stages of development
Methods of distribution and delivery to customers
Uniqueness and market appeal
Profitability and market share by product
Technical documentation on products and services.
5. Business model
An investor needs to learn if the startup founder understands the mechanics of business and how they plan to make money on their idea. Key questions to answer here are:
How does the company plan to manufacture, deliver, and sell their goods?
What is the perceived value of the product in the eyes of the consumer?
Is there a formula and process set up to gather recurring revenue?
Will the business model be able to scale and adapt to a changing market?
Have the founders prepared a viable exit strategy and plans for IPO?
6. Founding and management team
Angel investors and venture capitalists should also emphasize a great deal on the skills, qualifications, performance, and track record of the startup’s management team. They also need to figure out if the founder has any relevant experience in the targeted market and if there’s enough founder-market fit.
Investors can take advantage of their vast network of industry contacts and ask if anyone had previous experience working with the founder. If so, an investor can dig deeper and find out whether the founder is a good leader and team player, how they react to unexpected business-related situations, and how well they perform under stress.
Information to gather:
The organizational chart of the company
Team’s amount of relevant experience
Professional credentials and previous track record
Company’s culture and values
Company’s relationships with outside contractors
Disputes with current or previous employees.
Term Sheet as a tool for deal structuring and closing
If the due diligence process went well, it is time to structure the investment, present a term sheet, negotiate the terms and provisions, and finally close the deal. The deal’s structure should meet both the startup’s and investor’s financing needs, establish a clear path to funding, and suggest a strategy for the ultimate exit.
So the term sheet undergoes several edits until it is finally signed and the deal is sealed.
What does a term sheet include?
The term sheet outlines the terms and provisions of a startup investment. Its usual contents are company valuation, amount of funding, ownership structure, board composition, liquidation preference, anti-dilution protection, vesting schedule, and other additional provisions meant to protect investors and ensure their profitability.
The most common protective provisions include:
Investment and valuation milestones: used to split investments into payment tranches or adjust the company’s valuation based on the startup’s achievements.
Liquidation preference: entitles investors to receive their returns before common shareholders.
Investment multiples: allows the investors to gain a multiple of the original investment upon exit, for instance, two times the amount.
Participating liquidation preference: gives investors the opportunity to first receive the original return of their preferred shares, and then share the remaining distributions.
Anti-dilution clause: preserves the value of the original investment in the next funding rounds.
Vesting schedule: defines how the right to equity is earned over time by contributing to the success of the company (used to incentivize founders to stay in the startup).
Consent rights: veto rights that investors can apply to control certain business activities and maintain their influence over the company’s operations and business direction.
Exit strategy: stipulates the conditions when a company has to liquidate its shares through an industry sale, a write-off, a sale to another VC firm, or an IPO.
Redemption: gives investors the right to force the startup to repurchase their shares on conditions provided in liquidation clauses (presents a way out of mediocre startups).
Establishing startup value and funding size
The first thing to stipulate in an investment term sheet is the valuation of the company and the amount of capital funded by an investor.
The valuation determines the startup’s financial worth and provides a fair price for the equity stake given to the investor in exchange for funding. It may be estimated using various methods, such as market comparables, financial analysis, and projections, asset-based valuation, or income-based valuation.
Comparable company analysis is one of the popular methods among investors in early-stage funding. It involves making a comparison between the startup and similar companies that have been recently funded. If a similar case is found, the investor can use the valuation multiples and apply them to the startup’s financial metrics to derive its value.
The startup’s valuation determines an investor’s share in equity and may impact the deal terms, including funding size, rights, and protective mechanisms.
Entrepreneurs often tend to be overly optimistic with their projections and provide valuations that are wildly exaggerated, so it’s vital for investors to provide a more realistic assessment. At the same time, crafting a fair deal is the fastest way to achieving mutual goals, so investors should always try to find common ground with the founders.
Equity deals as the mainstream type of deal structure
The key part of the deal is how it’s structured and what each party is entitled to after closing. The most common deal structures are equity deals, debt, convertible notes, and SAFE (Simple Agreement for Future Equity).
An equity deal means that an investor acquires a percentage of the company’s shares in exchange for their contribution. A quick example of an equity deal is something like this:
An angel investor or VC capitalist invests $10 million in exchange for 25% of preferred equity.
Preferred equity is very popular in deals because it gives investors an opportunity to receive their returns before the holders of common equity shares.
Equity structure gives the investors complete freedom in choosing protective provisions in their term sheets. Deals can be structured in a way that favors the investor even if the valuation is too high and they are given a minority stake.
Deals beyond equity: debt, convertible notes, and SAFE
Deals based on debt are simply loans that investors give out to the founders that they pay back later with interest. Debt has priority over equity and has to be paid out first when the company goes public, sells, or liquidates. So investors receive their money before the shareholders.
However, if a company goes bankrupt, it will have no way to pay the investors back. In addition, debt doesn’t give investors the opportunity to win big on the upside, other than just gaining the interest on their loan.
One useful way to give out debt investments is a bridge loan, also known as a convertible note. These types of deals are an interim solution for situations when a startup needs to cover expenses but is not ready for valuation and an official funding round.
Typically, convertible notes translate into equity issued at the next funding round and based on the conditions of that round.
When seed funding with a convertible note, it’s a good practice to agree on a valuation cap (maximum valuation) for the next round. If the valuation during the funding round is higher than the cap, the investment still converts into equity at the agreed-upon valuation price.
Bridge loans are known to be a fast and cheap way to provide funding as they’re based on standard convertible loan agreements. However, they don’t offer as many benefits as an equity investment.
The Simple Agreement for Future Equity (SAFE) is a variation on the convertible note that has recently become a staple for early-stage funding. SAFE is basically a convertible note without a maturity date. There’s no obligation to convert into equity at the next round. It’s somewhat of a prepayment for future equity.
SAFE agreements can be drafted to include security provisions for investors, such as share price discounts and valuation caps. Also, a SAFE does not imply accounting and tax liability. Investors can use SAFEs to offer ways for founders to avoid sizable debt on their balance sheets.
It’s a great tool for negotiating deals where a startup is reluctant to give up preferred stock. At the same time, since the deal is debt-based, during liquidation, the SAFE holders are paid back ahead of shareholders receiving any distributions. Example: YC SAFE Financing
Deal closing: signing the investment agreement
Once the provisions of the term sheet have been negotiated and both the founders and investors are on the same page, it’s time to close the investment. The investment is closed by signing an investor agreement which solidifies the clauses of the term sheet. Based on the chosen deal structure the investor agreement can take various forms:
Share Subscription and Shareholders’ Agreement is signed when the investment is equity-based.
A loan agreement is drafted and signed when the deal involves debt paid back with interest.
A convertible loan agreement is signed if the deal involves the investor giving out a loan that may convert into shares later, at a certain date or next round of funding.
A simple Agreement for Future Equity (SAFE) is signed for the investor to have the right to subscribe for equity shares in the future, without an expiration date.
An Investment agreement is a very complex legal document, even for an experienced investor, so it’s smart to appoint a certified lawyer to prepare and draft the agreement.
Conclusion: the quest for high-quality deals
Due diligence and term sheet negotiations are very important parts of an investor’s deal flow process. Investment in premature companies is a high-risk endeavor, so investors need to do everything in their power to ensure they exit on a high note.
A high-ranking VC firm goes from reviewing several thousand pitches to selecting 100-200 to present to their investment committee, and only a few dozen make it to deal closing. And there’s no guarantee on any of those deals!
Deal sourcing plays a pivotal role here. But you play the cards that you are dealt and you can only do so much if the incoming deals are substandard. Conferences and trade shows are traditional in VC deal sourcing. The majority of deals are referrals that come from networking. But you always feel somewhat limited. So where do you source high-quality deals?
Technology makes it much easier. Entering a digital community like Go Global World endlessly expands your network, connecting you with verified investors, and startups. You get only the relevant startup deals powered by AI Matchmaking. Members get a 10x increase in high-quality deal flow which they can easily manage in one place via an intuitive dashboard.
This is not legal advice.