first Time in more than a year, venture capital financing saw a decline The last quarter. For founders, this drop could raise concerns about how to secure capital, making them more inclined to bow to investors’ terms and ignore details they wouldn’t otherwise want.
As founders bend back for support, legal due diligence can sometimes be overlooked. Not going into the nitty-gritty could mean that you end up with an unfavorable deal early on, which future investors will try to repeat more often. This results in a hard-to-break cycle of poor investment terms.
Negotiations can be daunting, especially when investors tend to have more experience, knowledge, and resources. Investors also know that negotiations don’t stop at the agreed-upon terms sheet – valuation limits, discount rates, matching rights and board oversight must be reviewed and discussed.
Before moving into investing, I was a partner in a law firm specializing in business cases. Below I’ve outlined some of the legal areas I recommend founders focus on, as well as some tips for improving your negotiation skills.
Be sure to look beyond the immediate round and avoid creating problems later because you don’t want to have a difficult conversation now.
Research industry rounds to determine the evaluation cap
The valuation cap is the maximum amount at which an investor can convert a SAFE (the stock contract between you and the investor) into equity. For example, if your investor valuation cap is $1 million, and your company is valued at $1.5 million in the next fundraising round, the investor’s equity transfer will be limited to $1 million.
Your investor will want to set a lower valuation cap because it gives them a potentially larger percentage of your company in the next round. However, a low cap valuation is not always good for startups, as it can dilute the value of the company and deter new investors from participating.
You and your team lead the work, so you have to negotiate away disproportionate dilution in the future. Look at companies that have a similar maturity level and are in the same industry. Research their funding rounds and understand how much growth (specifically, KPIs) has increased their rating.