Everything You Need To Know About Venture Capital Financings For Startups

One of the biggest hurdles many startups face is capital to finance their operations or propel them into the next frontier. Most of them will turn to banks, online lenders not forgetting friends and family.

However, another form of startup financing exists and it comes in the form of venture capitalists. Often, these investors come either as an individual or as a firm where they provide the startup with capital, new markets, strategy development, new customers and employees among other perks.

While the benefits offered by these firms sound lucrative, finding these firms is an uphill task. Which is why, as an entrepreneur, you must internalize the process, the terms of the deal and other issues which may arise.

This article will take you through a comprehensive guide on venture capital financing for startups.

1. How to Find a Venture Capitalist

Again, finding a venture capitalist is an exhausting task. Therefore, it’s vital to know what these investors focus their efforts on. To do that use these pointers:

  1. The specific industry your business is in. For example, agribusiness, fintech, SaaS and so on.
  2. The stage of the business. Are you just starting out? Is the business at the idea stage or are you already operational and generating revenues?
  3. The business location.

Once you have an answer to the three questions, you can look up to the investor. The aim is to find out whether both of your interests align.

Next, remember these VCs receive tons of emails in their inbox every day. Factor their busy schedule and you can see why many emails go unanswered. With this in mind, you may want to use an alternative route to get your foot through the door.

One of these ways is to capture their attention through the help of a close colleague of theirs, a fellow entrepreneur or even one of their lawyers. Once you get their attention, consider the VCs limited time.

Therefore, make sure you pitch to them as fast as possible while also including all necessary details. An elevator pitch is considered the best for such situations. Afterward, the VC may take time to respond to you and patience at this point is a great virtue to have.

If they fall in love with your idea, they may invite you for follow-up meetings coupled with conversations on various aspects of your business. You’ll also have to prepare a convincing presentation to show the VC’s partners.

If they also love it, you’ll be issued with a term sheet to negotiate on, further due diligence and the final step which is drafting and more negotiations, this time with lawyers to act as evidence.

2. The Term Sheet

Many VC firms will show their intent to finance a startup by issuing a term sheet. With this, chances are you’ll land the financing you need. What remains after term sheet issuance is due diligence and other legal documents.

However, you must know a term sheet doesn’t necessarily guarantee you a deal, but it means the investor is serious about.

In the term sheet, except the following:

  • The company’s valuation
  • Management issues such as the Board of Directors
  • Veto powers for the investors
  • After-closing rights which include the right to future financing and the right to access financial information

The term sheet use will vary in the extent and usage based on two approaches. The first is the short version of the term sheet where only the vital points will be included. This, as argued, allows both parties to focus on the primary issues while the lawyers deal with the rest.

The other approach is the long version where all issues raised by both parties are discussed. This approach allows for faster and easier negotiations and drafting. In addition, they’ll avoid future problems.

3. The Company’s Valuation

This is a critical part of the deal for both parties. In the business world, valuation is defined as the company’s value before new financing is injected into the business. Often called pre-money valuation.

For instance, if the investor wishes to inject $5 million and the pre-money valuation stands at $15 million, the valuation after financing will be at $20 million. Thus, the investor will have a 25% stake in the business at the close of financing.

Keep in the mind, the methodology used to calculate the valuation is not standard, but both parties can agree on one. If the company’s valuation is high, then the entrepreneur will encounter less dilution. Here are important factors affecting a company’s valuation:

  • Past experience associated with the founders.
  • The market opportunity and its size
  • The revenues generated by the company, partnerships formed and existing customers among others
  • Advancements made toward producing a minimally accepted product
  • The business model’s revenue opportunity
  • The business model’s capital efficiency, which determines how much capital the business will consume before attaining profitability.
  • Valuations of similar businesses
  • The attention the company is receiving from other investors
  • The current global economic climate

4. The Type of Venture Capital Financing

The VCs will invest in your company through one of these ways:

A convertible promissory note – The company will issue the investor with a note which they can convert into a company stock during the company’s next financing. Often, this comes with a 12-month maturity period from the issuance date and also comes with an interest ranging from 4 to 8 percent.

The convertible notes are easier and faster than a traditional convertible preferred stock.

  • A Simple Agreement for Future Equity – This is an alternative to the convertible notes and doesn’t carry debts or any other bad credit loan like the notes. In addition, it doesn’t bear maturity or interest. In this method, the investor will finance the company using their own money and then convert it into company stock during the next financing.
  • A convertible preferred stock investment – According to the company’s certificate of incorporation which indicates the privileges, preferences and rights, investors can get preference over the common shareholders during the company’s sale.

5. Founder Stock Vesting

By vesting the founder’s stocks, it means they are incentivized to stay at the company and grow it. If by any chance, the founders’ stock isn’t on a vesting schedule, the VC will request their shares be subject to founder stock vesting.

According to industry standards, employee vesting is done every month over 48 months, although the first 12 will be delayed until they can complete a 12-month service. However, both parties can negotiate on the vesting terms which can include:

  • Whether or not the founders will get vesting credit for their previous service to the company.
  • Whether the shares acquired for cash investment will be subject to vesting.
  • Whether or not a vesting schedule of below 48 months will apply or even whether a vesting schedule should apply at all.

6. The Board of Directors

This is a critical part of the company and will interest both the VCs and the founders. For the VCs, they’ll want the right to install several directors so they can monitor the VCs investments and also have a strong say in the company’s operations.

For the founders, they’ll want to maintain control of the business. However, this will vary depending on the number of shares held. For example, if they own minority company shares, then they will have a minority representation in the board.

As they continue to invest in the company and acquire majority shares, then they will assume the board’s control. The investors may also opt to gain observer rights instead of a board seat. With this move, the investor will only attend board meetings cannot vote. However, they’ll have access to financial information similar to other board members.

7. Liquidation Preference

In business, this is what the investor will get during the sale of the company or any other liquidation before the sale amount is shared among others. Almost all VCs you’ll come across will insist on the liquidation preference to protect their investment against any negative scenarios.

On the other hand, if the company is sold at a profit, then the investor can always convert the money into common stock.

This preference is calculated in multiples of the original investment. Often, this is set at 1x and it means after selling the company, the investor will get a $1 for each $1 invested. However, depending on the investment climate, the liquidation preference could go up to 3x.

Venture capitalist firms are a great place to source for funding for your startup. Understanding the underlying principles guiding venture capital financing is critical to your business if you fancy a chance of breaking through the glass ceiling.