John Weaver
For the first time in more than a year, venture capital funding saw a decline last quarter. For founders, this drop may spark concerns around how to secure capital, making them more likely to bend to investors’ terms and ignore details they wouldn’t otherwise.
As founders bend over backward to get backing, legal due diligence can sometimes go overlooked. Not wading through the fine print could mean ending up with an unfavorable deal early on, which future investors will often try to replicate. This results in a hard-to-break cycle of poor investment terms.
Negotiations can be daunting, especially when investors tend to have more experience, knowledge and resources. Investors also know that negotiations don’t stop at the agreed upon term sheet — valuation caps, discount rates, matching rights and board control all need to be reviewed and discussed.
Before transitioning to investment, I was a partner at a law firm specializing in business issues. I’ve outlined below a few legal areas I recommend founders focus on, as well as some tips to finesse negotiation skills.
Research industry rounds to determine valuation caps
A valuation cap is the maximum amount at which an investor can convert a SAFE (the equity contract between you and your investor) into equity. For example, if your investor’s valuation cap is $1 million and your company is valued at $1.5 million at your next fundraising round, your investor’s equity conversion would be limited to $1 million.
Your investor is going to want to set a low valuation cap because it gives them a potentially larger percentage of your company at the next round. However, a low valuation cap isn’t always good for a startup, as it can dilute the company’s value and deter new investors from participating.
You and your team drive the business, so you need to negotiate away from disproportionate future dilution. Look at companies that are at a similar maturity level and in the same industry. Research their funding rounds and understand the amount of growth (specifically, the KPIs) that led to their valuation increasing.
Doing this will help you set realistic expectations for your own company and articulate a story that your investors can take to their investment committees and/or LPs.
Look to market data to agree on discount rates
The discount rate is the percentage of interest that investors can yield from your company’s life cycle. It essentially determines if your company’s future cash flow will be worth more than the capital an investor puts in. Discount rates typically work in conjunction with valuation caps, and on average, are set at 20%. The discount rate is important because it can impact your economic outcome if your company goes public.
Investors are going to try to negotiate the highest discount rate possible so they can do better in the next round. To ensure that your discount rate aligns with the market, use platforms like Crunchbase and CB Insights to research financing rounds and cross-reference what your investor is proposing.
Even as you negotiate a fair discount rate, be aware of other financial instruments, like liquidation preferences, that can inflate the value of investors’ stock in your business. Work with a seasoned attorney who is well versed in investment legalities and is familiar with current trends.
Take the long view to define matching rights
Matching rights are the pro rata rights that allow investors to participate in later rounds on the same terms. They matter because you need to think ahead and understand that the terms you set in the current round will be visible to investors in the next round, and they may request similar (or better) terms, because they’ll be writing bigger checks.
Sometimes, founders can be so keen for a “yes” from investors, or so worried about scaring them away, that they may concede seemingly small points (for example, liquidation preference or dividends) without considering how investors down the line will view those deal terms.
When it comes to matching rights, trust your counsel and don’t be afraid to put your foot down on points that may complicate later investment. Take care to look beyond the immediate round and avoid creating problems for later because you don’t want to have a difficult conversation now.
Weigh economics versus control to decide board composition
Generally speaking, every new material round of funding will see a new investor seat added to your board. These new seats ideally add value to your company, but it’s important to remember that not every seat needs to be filled.
You and/or the CEO control the seat allocations — just look at Uber’s board, which has 11 seats, but founder Travis Kalanick only filled seven. By leaving these empty, Kalanick increased his control.
Consider different board composition scenarios. You should think in terms of economics versus control — some founders can get both (see Mark Zuckerberg), but most don’t. You have to pick between keeping control for longer or making more money while ceding control to your investors.
Investors bear the financial risk if your startup fails, so they’ll want to protect provisions like having the majority of board seats (as well as the right to block the sale of a company). But be wary of giving away too much control early on.
In the early days, you are the founder and the expert in the space. As you raise more capital and the checks get bigger, more diverse expertise will be needed and you can reduce your influence at the board level. For instance, many technically minded founders struggle with business development, and so it makes sense for them to maintain their seat at the table but let board members with more experience at mature companies take control.
If board composition is an issue for you early on, that may be a sign that you’re not working with the right investors. Early investors should bring value beyond just their capital and should share your vision. Your relationship with them should be symbiotic, not adversarial, and their addition to the board should be frictionless.
The legal aspects of investment should always be a priority, but it’s especially important when funding is scarce and investors hold the cards. Ensure you have an experienced attorney, understand investment dynamics in your market, and remember that you’re negotiating for the long term.
This funding dip is temporary, but the terms you settle on at this moment could shape your company for years to come.
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