For the first time time in more than a year, venture capital financing saw a decline in the past quarter. For founders, this drop could raise concerns about securing capital, making them more likely to bend to investors’ terms and ignore details they wouldn’t otherwise.
Because founders make an effort to gain support, legal due diligence can sometimes be overlooked. Failing to wade through the fine print could mean landing yourself in an unfavorable deal early on, which future investors will often try to replicate. This results in a difficult-to-break cycle of bad investment conditions.
Negotiations can be daunting, especially when investors have more experience, knowledge and resources. Investors also know that negotiations don’t stop at the agreed terms – valuation limits, discount rates, matching rights and board control all need to be reviewed and discussed.
Before switching to investing, I was a partner at a law firm specializing in business matters. I’ve outlined a few legal areas below that I recommend founders focus on, as well as some tips for fine-tuning negotiation skills.
Make sure you look beyond the immediate round and avoid creating problems for later because you don’t want to have a difficult conversation now.
Research industry rounds to determine valuation limits
A valuation limit is the maximum amount at which an investor can convert a SAFE (the stock contract between you and your investor) into stock. 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 stock conversion will be capped at $1 million.
Your investor will want to set a low valuation cap as this will give them a potentially greater percentage of your company on the next round. However, a low valuation cap is not always good for a startup, as it can dilute the company’s value and deter new investors from participating.
You and your team run the business, so you need to negotiate to avoid disproportionate future dilution. Look at companies with a similar maturity level and in the same industry. Examine their funding rounds and understand the rate of growth (particularly the KPIs) that has caused their valuation to rise.