Following a hyperactive two years for investing in early-stage companies, venture capital deals declined significantly in 2016, according to KPMG’s Venture Pulse Report. More experienced, later-stage investors just weren’t willing to place bets on a saturated start-up market. According to experienced investors, one deterrent to those investments was limited awareness founding teams and early advisers have of governance best practices.
In a start-up climate that is becoming more attuned to company culture, many venture investors we work with say that a working knowledge of corporate governance for early-stage company founders is a critical factor for funding negotiations.
“As early-stage investors, requiring founders to follow corporate governance best practices is critical to fostering transparency and setting a strong foundation for the business as it grows and looks to further rounds of funding,” Alex Katz, managing partner at ff Venture Capital, recently told me during a telephone interview.
Entrepreneurs and founding teams must realize that aspects of control are on the negotiating table in successive funding rounds.
And founders, advisors, and directors of early-stage companies can do a lot to start negotiations with prospective investors on the right track. Specifically, focusing on the following areas will help them to prepare for negotiations:
Understand the key governance issues. The founding team members may view the company as their baby, but when seeking follow-on funding, they need to understand the perspective of potential investors. Venture capitalists (VCs) bring significant assets, including their own counsel, reputation, and limited partners.
The VCs are looking to negotiate terms that give them the most opportunity for success, but also a level of downside protection. Key areas of VC focus will likely include: shareholder rights, board membership and control, executive compensation, hiring and firing of the CEO, and employee stock options and dilution. The founding team will need to develop a negotiating strategy, taking into consideration the control and other governance issues they view as most critical, where they are willing to concede, and their strengths and weaknesses relative to the VCs. They will need to have key advisors and resources lined up in advance.
Get a sense of timing, and be prepared. VCs network aggressively to find deals and often know in advance what companies are raising money, and on what terms. Last-minute approaches by the founders don’t work, even if the company is trying to validate or confirm an existing offer. This is how early-stage companies get in trouble and damage their reputation—so be prepared, but don’t jump the gun.
Manage internal expectations. No matter the size of the start-up, ensure that the founder is transparent with employees and advisors as to how the company is doing, what is at stake in the next funding round, and what happens if the company fails to secure funding.
Is the founder the right person to lead negotiations? Does he or she need additional resources? Also, are current employees on board with the direction of the company and the plans for attracting new investors? Do employees have an expectation for new options or shares or an opportunity to participate? Do they fully understand the consequences if the company fails to obtain new funding?
“Whether setting up founders with a personal mentor, fostering collaboration and communication with the board, challenging strategic decisions, offering new solutions, performing a detailed review of a company’s financial reporting, or providing guidance on key governance issues, it is in our best interests as investors and as company builders to prepare our founders for the next step,” Katz said.
Entrepreneurs must be ready to meet the “increased scrutiny, pressure, and expectations that come with scaling,” Katz said. “And that starts with proper preparation before sitting down to negotiate new funding.”