Avoiding Harmful Investment Terms When Fundraising During The COVID Crisis

Are you worried about how to successfully fundraise during the COVID-19 crisis and are unsure of how to move forward? In this webinar, Patrick Rogers, Founder and CEO of Clara, chats with MAGNiTT CEO, Philip Bahoshy to discuss how startups can avoid getting the short end of the stick with investment terms when fundraising during COVID-19.

They discuss many topics, including: 

The shift in fundraising

Patrick says that if you need to raise before Q4, you need to quickly realise that you are in a very different dynamic to where you were in in February, things have shifted rapidly. You have to remember that there are not a lot of people out there with dry powder to spend on new investments, the majority of VCs are focusing on their existing portfolios. VCs are essentially having to look to separate the weak, from who will be alive next year. Those who were keen on looking at new investments 2 months ago, will not be the case anymore, they are instead trying to figure out which elements of their existing portfolio will stay alive.

The top terms founders should be aware of when looking at a term sheet

- Double-dipping. Patrick discusses how sophisticated investors will insist that they get preferred shares, which is separate from common or ordinary (which the founders would typically hold). One of the key elements of getting preferred shares is the liquidation preference that attaches to it, it is kind of downside protection for investors. If they invest at a $20 million valuation and you sell the company for $5 million, that liquidation preference right gives them the ability to say, "I as the investor get the choice to get my money back or I can convert it into ordinary shares alongside the founders".

- Tranching. Patrick uses the example of if an investor says "I want to lead your Series A, we’re going to come in for $4 million and lead the round, but I will give you $1 million on completion, the remaining $3 million, I will provide once you achieve a KPI list that we agree on". This is not the norm. This is a risk for the founder and startup. In order to achieve those KPIs, they need a certain amount of cash to hire people, spend on marketing, advertising, development and more. So, the investor is essentially saying, "I will give you money to see how you do, and if you get to the next level, you will unlock the next tranch". It is a delicate situation to proceed through with your investor. As a founder, you can have the scenario where even if you achieve the KPIs, the investor defaults and you are now in a dispute.

The types of KPIs that would be a hazard to meet

Patrick believes areas such as paid subscribers and revenue numbers. He says that these are very early-stage companies, and in order for a founding team to execute, they need a lot of flexibility. The lead investor may have a board seat, but the board reserve matters of which they have a say or provide input in should be limited. As you are not aware of which way your business will go, especially in this environment. You might need to pivot, which will have nothing to do with the KPIs that were agreed on 6 months earlier.

What concerns there are, if an investor is pushing to have more oversight

Philip says board seats and oversight are important for any startup, but there can be a bit too much oversight if it slows down the running of the business. 

Patrick focuses on two areas:

1. Are you losing the balance of power on the board? Are you giving up board control? Is the balance of power now held by an independent that the VC insisted on including? You shouldn’t give up control of your board at series as a founding team. You should be wary of relinquishing control at an early stage.

2. The reserved matters. In your shareholder agreement, you will agree that a certain list of matters, around 15-20, are reserved for the decision of the board and cannot be decided without board approval. You have to be careful of what board reserved matters you allow to go into your shareholder agreement, and that’s where you should be transparent with your investors, by walking them through your business plan, what your strategy is for expansion, growth and so on. You can effectively pre-agree certain strategy elements to prevent a dispute at board level.

If there are any provisions for founders, if investors pull term sheets that were signed or agreed

Patrick discusses trying in a term sheet, to include some kind of penalty, but he says that this is out of the norm and very difficult. From the VCs perspective, they are the ones who know what they're doing, there is a big reputation-risk involved in stepping back after signing a term sheet. Those who say that "this is a tough environment, your business is great, but we’re getting cold feet, so we’d like to talk to you in 6 months" are unprofessional, but we've seen it happening recently. This is stressful for founders as they have to tell investors why investor x is pulling out.

Patrick says that diligence is not a one way exercise, you as a startup should also be performing diligence on your investors. Talk to the founders of their portfolio companies, ask for their contact details, ask tough questions and get answers. This hopefully will flush out any negative consequence of bad behaviour that can be created.

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Other topics included, more terms that should be avoided, what the market norm is with regards to pay to play provisions, views on Venture Debt and if it is applicable right now, the norm in terms of a discount rate for a seed round, and Tammer from Venture Souq joins the conversation to chat about tranching and an example of when this has heavily affected a company. And much more.

To check out the full discussion, watch the Webinar below now.