decoding startup investment · first share which is typically their invested capital plus 50% to...
TRANSCRIPT
A PUBLICATION OF TAXMANTRA.COM
Decoding Startup
Investment
TABLE OF CONTENTS
1
2
3
5
Introduction
Business Valuation
Term Sheets & Shareholder's Agreement
-Things To Keep In Mind
Hacking the Investor’s Due Diligence
Contact Us
Introduction
Money is undoubtedly the most important lubricant for your start-up machine and here lies the importance of Investment or fundraising. Approaching investors, negotiating term sheets, arrivingat a decent valuation of business – all the complexities send jittersin a start-up mind.
However, is the process actually that “Complex”? Why moststart-ups are turned down? What do the Investors look for whenthey consider your proposition? What is Due Diligence? Why doInvestors do that? Is it true that no start-up passes the duediligence check? What in the world is a Term Sheet? What is thedifference between a term sheet and a shareholding agreement?Which clauses should you take note of? Yes...there are 99problems and the search for the solution goes on.
This Ebook is an earnest initiative to guide through all thesequestions. This would not only help you understanding theaspects of the valuation of your business, it would also help youunravel the loops of Term Sheet and Due Diligence maze.
Chapter One
Business Valuation
Business valuation is the process of determining theeconomic value of a business or company. It depends uponthe Depends upon purpose of Valuation, Stage of Business,Past Financials, Expected financial results, industryscenario and various other allied factors. Valuation is afactor of negotiation between the investee and investor.Valuation cant looked upon as a standalone process.
What is Business Valuation?
Basically there are two valuation approaches and a dozen Valuation Model. The two valuation approaches are:
Intrinsic Valuation Approach:
IV of asset is determined by the cash flows that the asset is expected to generate over its life period.
Relative Valuation Approach:
Assets are valued on the basis of relative pricing mechanism of similar asset present in the market and thereby performing a comparative analysis.
Methods of Valuation as per Income Tax Act, 1961:
A closely held unlisted company cannot issue shares at a price more than its Fair Market Value (FMV). The excess over FMV is treated as Income for the company and is subject to tax. For calculating FMV of unlisted Companies, Valuation is conducted. For calculating FMV of unlisted Companies, Valuation is conducted. Shares have to be valued either at Book Value or as per Discounted Free Cash Flow method.
Methods of Business Valuation as
per CA, 2013 & ITA, 1961
Nature of the business and the history of the enterprise from its inception
Economic outlook in general and outlook of the specific industry in particular
Book value of the stock and the financial condition of the business
Earning capacity of the company
Dividend paying capacity of the company
Goodwill or other intangible value
Sales of the stock and the size of the block of stock to be valued
Market prices of stock of corporations engaged in the same or a similar line of business
Contingent liabilities or substantial legal issues, within India or abroad, impacting the business
Nature of instrument proposed to be issued, and nature of transaction contemplated by the parties
Factors to be considered for
Valuation
Chapter Two
Term Sheets & Shareholder's
Agreement-Things To Keep In Mind
A Term Sheet is a non-binding agreement which sets forth the basic
terms and conditions under which an investment will be made. It
serves as a template to develop more detailed legal documents. A
term sheet is a basic tool for negotiation.
What is a Term Sheet?
What is a Shareholding
Agreement?
Shareholder’s Agreement is a formalized agreement shareholders stating how the company should be operated. It Outlines regulation of the shareholders' relationship, the management of the company, ownership of shares and privileges and protection of shareholders.
Elements of a Term Sheet
TERM SHEET
Investment Structure
Other Covenants
Corporate Governance
Dilution & Exit Rights
Things to keep in mind while
finalizing Term Sheet
1. Business Valuation-
Make sure you understand the effect of including the option pool inthe fully diluted pre-money valuation. Take help from an expert andunderstand the concepts of pre-infusion and post-infusion values.
2. Liquidation of Existing Equity Shareholding-
Mark the strategic percentages of shareholding.
3. Drag Along Rights-
This is a right that enables a majority shareholder to force aminority shareholder to join in the sale of a company. The majorityowner doing the dragging must give the minority shareholder thesame price, terms, and conditions as any other seller. Though thisclause was intended to be used in good faith, however, check shouldbe conducted and all such clauses should be modified to protect theinterest of the founders.
Things to keep in mind while
finalizing Term Sheet
4. Liquidation Preference Structure in case of dissolution of company-
The liquidation preference defines the return that an investorreceives in case of dissolution of the company. The investors get thefirst share which is typically their invested capital plus 50% to 100%returns on top of it. The remaining is then split between all theshareholders including the investors in proportion to theirshareholding. In a nutshell, in case your company is sold, you mightend up making a lot less than the investors irrespective theshareholding pattern. Another very important fact is that the termsput in place in the Series A are often carried over to the Series B andbeyond, so make your choice carefully. What seems unimportant atthis stage may have a tolling effect in future. Quiet honestly, Series Afunding gives you the stepping stone for leveraging your terms.Hence, it becomes very important to understand the nitty gritties.
5. Ratchet Rights-
This is an anti-dilution often used by the investors to protect theirrights at times of future rounds of funding. A full-ratchet anti-dilution protection allows an investor to keep his percentageownership remain the same as the initial investment.
Things to keep in mind while
finalizing Term Sheet
6. Restrictive Provisions with respect to Approvals Required from Investors-
The investors will be party to some of the key decision making in thecompany. Among other approvals that you need to take from theinvestors, you need to have their approval before raising anotherround. Problem arises when the business valuation for subsequentfunding does not tally with the investor’s expectations. Many a dealshave been lost because the investor wanted a higher valuationdespite the entrepreneur being ok with the offer. So net result, youlose out to the wishes of your investor. Sometimes, the list of the keydecision-making items may extend beyond strategic matters tooperational matters.
7. Escrowing Founder’s Shares- Founder ‘s Vesting-
This is a critical area and a very common area to review andunderstand from the founder’s perspective. You need to have acheck on the details of vesting period, for eg: date ofcommencement of the vesting terms, the vesting schedule, durationand alteration.
Things to keep in mind while
finalizing Term Sheet
8. Tag Along Rights-
This clause states that when the founders sell their shareholding; theinvestors will also get an exit. Also referred to as the "co-sale rights",this clause was generally brought in to protect the rights of theminority shareholders. However, care has to be taken whether thereverse applies or not, i.e. in case the investors sell their shares,there is exit provision for the founders or not. There have beeninstances where the majority investor sold their shareholding to alarge corporate leaving the founders high and dry.
9. Exclusivity-
This is a very common clause. Generally, the investor puts arestriction on you that you do not talk to any other investor for sometime. This is a fair and square request but be sure to check that thetime period is not too long.
Chapter Three
Hacking The Investor’s Due-Diligence Process
What is Due Diligence?
“Due Diligence” is nothing but an investigation to assess risk.
Why a Due Diligence is
conducted?
Check the Internal Control Systems are in place or not
To calculate the financial risk involved
Judge the awareness of the business owners
Assess the team structuring and Operational Processes in place
Verify the claims of the pitchers
Excavate undisclosed risks
Process of Due Diligence:
Investor appoints a team
Definite Mandate is set for the team
Confidentiality Agreements are formulated between parties
Due Diligence Questionnaire and checklist is prepared and circulated
Investigation takes place
Due Diligence Report is formulated and circulated
Things to keep in mind to hack
the due diligence investigation:
Secretarial practices should be in place
Ownership of Intellectual Property should reside with the Company and not the Director(s)/Shareholder (s)
Statutory Registers, Minutes and Resolutions are recorded timely and correctly
State Specific licenses and permits have been obtained or not
Proper record of all the filings with the Government department till date should be in records of the Company.
Things to keep in mind to hack
the due diligence investigation:
Internal Agreements and contracts between shareholders or directors should be reduced to writing
Check the formulation, maintenance and renewal of contracts with service providers and vendors
All structural changes in company should be duly recorded with the RoC and should take place as per standard guidelines of the Companies Act, 2013
All the compliance related filings should be up to date.
Litigation issues, if any should be properly recorded and if possible sorted as early as possible.
Best to appoint an inspector internally to set everything in place before the due diligence check from the investor is due
