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Venture Capital & The Rules of Engagement
Venture Capital has often been touted as the holy grail of startup investments. It provides for startups much needed financing in the early stages where the ground is shaky. Venture Capital finance is coveted and the source of so much cutthroat competition and envy in the market for startup financing. In exchange for loads of money, the founders give up some equity in their business undertaking. In it's simplest form therefore, venture capital allows a transaction of cash for shares. However, there is an often overlooked reality. Venture Capital firms have enough resources to hire an army of lawyers. They have the resources to invest in the most seasoned deal negotiators. Contrarily, startup founders often have nothing than the proverbial dollar and dream. The relationship is therefore skewed from the outset. For this reason, entrepreneurs should be aware of the rules of engagement when interacting with venture capital firms. Here goes,
A. Rule Number One: Study the term sheet
At the beginning of an entrepreneur's journey with a VC, the founder's email will probably receive a term sheet agreement in PDF format. This document can only be ignored at your own peril. The term sheet is a non-binding agreement that details the terms and conditions on the basis of which the investment will be made. Though non-binding, the term sheet provides for crucial aspects such as valuation, share classification and investor protection. Studying this document with a fine tooth comb is important firstly because it reveals both the attitude and objectives of an investor before there is a binding deal and also because it allows the founder to assess whether those terms suit his or her personal goals.
B. Rule Number Two: Dress up for the dance
In many cases with African startups, most founders are ill-prepared for the interaction with the Venture Capital firm. For so many founders, raising capital is viewed as an end unto itself. This should not be the case. Founders must be very well prepared for negotiations and interactions with Venture Capital partners or potential partners. Preparation entails studying one's business model rigorously, preparing to justify your valuation of the company, preparing to argue against restrictive terms among other things. Preparation also entails knowing the nuances of venture capital firms and how they work. This way, one is equipped with a working knowledge of good terms and bad terms.
C. Rule Number Three: Don't give up too much on the first date
This cardinal rule told to many love stricken people going into a debut date is equally applicable to the murky world of venture capital finance. Like in dating, when you give up too much the first time, your value in the eyes of the counter party may greatly diminish the second time. Founders must be wary therefore not to give up too much control, too many shares or too many seats on the board in early rounds of financing. This comes through an ability to negotiate or to get a startup attorney to negotiate for you. What you retain today, will prove useful in subsequent financing rounds.
D. Rule Number Four: The rule against dilution
In most cases, each round of financing dilutes a founder's holding in the company. Some companies go up to five rounds of financing, in which case a founder's holding may be inconsequential depending on how the investment was structured. On the other hand, most VCs insist on anti-dilution provisions which protect their percentage holdings in the case of new share issues. A shrewd founder will also insist on such provisions or at least on a structure which hedges the founder from the risk of dilution.
E. Rule Number Five: It's all about chemistry
This is a fairly simple rule. Things can get nasty where the investor and the founder are looking for different things. Sadly in most cases, founders settle for just about anyone with the ability to write a cheque that does not bounce. This is again due to the highly competitive nature of Venture Capital. The best way however, is to conduct thorough due diligence so that every prospective investor has goals that align with the founder.
F. Rule Number Six: Get it signed
Handshake deals are not ideal, especially on issues of investment and Ownership of companies. Avoid this and get every deal signed. Before signing, enlist the services of a lawyer to go over the paperwork. You will thank yourself in future.
G. Rule Number Seven: Get a lawyer
Most entrepreneurs read a few pages off the internet and walk straight into a deal they otherwise know nothing about. The most important rule of engagement is get a lawyer. Don't confer upon yourself a degree from the University of various search engines and opinion blogs. Get actual professional advice.
Conclusion
These rules are obviously not rules of law. They are also not professional legal advice. However, with the increasing interest in the African startup scene they are relevant now more than ever in the past. The adage goes; you cannot play the game if you do not know the rules. Well, now you do.