Vertex Partnership Group posted on 06 Apr 2021
With finite time and resources, startups only have a small margin for error as they grow, so laying down a strong foundation is crucial to set them on the path to success. This includes managing the fundraising process as well as understanding the legal documentation and potential cyber threats that may impact business operations.
While obtaining financing is important, striking a good deal is equally vital for their survival. Startups must be conscious about how to protect their interests during financing negotiations and how to work optimally with law firms. They should not neglect important post-funding steps such as creating term sheets and complying with the due diligence process.
Cybersecurity is another crucial basic consideration, especially as many startups are reliant on digital tools and technologies for business operations. Not being properly fortified can leave them vulnerable to cyber threats, which can have devastating consequences.
Choosing the correct financing option
Startup funding options can loosely be split into two categories: equity or debt. Equity financing includes preference shares, warrants, government funding and grants. Debt instruments cover Simple Agreements for Future Equity (SAFE), convertible loans or notes, venture debt and government loans.
Both types of financing will suit different startup needs. Founders should therefore consider three key aspects that will be affected by this choice: transaction cost, control and valuation.
1. Transaction costs
These costs tend to be lower for debt instruments as they are easier to understand and the deal process is shorter. It is less complicated for founders and investors to negotiate terms and the company’s stakeholders remain unchanged. However, the dilutive effect is less clear and having too much debt may affect the company’s future cash flow. In contrast, equity financing processes are more complex and therefore more expensive but are not so reliant on a consistent future cash flow.
Since debt does not require founders to grant typical shareholder rights such as info and voting rights, founders retain more control over their business. Equity financing involves the issuance of shares, which creates new company shareholders that have a say in decision-making. The trade-off is the potential strategic value – shareholding investors tend to be more involved in the company and are more incentivised to provide insightful advice and business opportunities, which can often be more valuable than simple monetary assets.
Valuation both affects and is affected by the chosen financing option. According to Chan Hiok Chiou, Investment Director at Vertex Growth, “If the founder thinks that their company will be worth much more in the next equity fundraising round, issuing a convertible note may be more sensible. The dilutive effect will be reduced when the note converts at a much higher valuation in the next round, compared to issuing equity at a much lower valuation now.” He also noted that if a valuation cap is requested, founders could end up giving away more equity in future fundraising rounds.
Navigating the deal process with confidence
The first part of the deal process is the creation of the term sheet, which sets out the initial terms for discussion. While the terms are non-exhaustive and non-binding at this stage, founders should still treat the negotiations seriously as these terms will lay the foundations for future negotiations. Deciding upon the right terms is crucial; they must be reasonable, able to cover worst-case scenarios and enforceable in the case of disputes.
Kevin Chua, Managing Director, Investments at RISA Partners Asia said, “Bear in mind the implications of agreeing to certain terms at this juncture. If you allow certain investors to get special terms now, other investors could later ask for the same or even more onerous terms. This could then affect things like exit, control and operational flexibility. Try to make non-favourable obligations and draft terms that are as specific as possible to limit your liability, and do the opposite for terms in your favour.”
Potential investors use due diligence to evaluate whether a startup is suitable to invest in. As such, it is important for startups to be as transparent and truthful as possible in supplying information. Greater transparency will address existing concerns, inspire confidence in the business and accelerate the deal closing process.
“This avoids a post-investment scenario where investors uncover material facts that were not previously revealed, which can severely damage trust between founders and investors, as well as leaving the founders open to legal liabilities,” said Kevin.
Documentation and legal representation
This stage sees lawyers begin to incorporate the term sheet and draft the documentation for the deal. “At the start of fundraising, hire a lawyer experienced in deal completion because the subsequent fundraising rounds will be based on this initial document. If these are not drafted well, it will be very difficult to change the terms in subsequent rounds,” said Hiok Chiou.
Startups should aim to have their lawyers create the first draft to ensure that the documents reflect their preferences. After the first exchange, an issues list will help to negotiate key commercial issues directly with investors. The lawyers should only be instructed to amend the documents to reflect final mutually agreed positions instead of being used as messengers. This will reduce document turn frequency, lower lawyer costs and enable lawyers to focus on finalising the legal drafting.
Implementing proper cybersecurity infrastructure
Investing in cybersecurity is often seen as a big-firm luxury, but it is essential for tech companies in a digital age – especially given the growing importance of data and the sophistication of malicious programs. As many as 36.1 billion personal data records were exposed in the first three quarters of 2020. Failure to protect data privacy can significantly erode customer trust, irreparably damage a business’s reputation and make it liable for damages – all of which can be the death knell for a startup.
Many startups rely on virtual clouds to run their business operations online because of the flexibility and powerful computing capabilities that they offer – a trend that has only grown with the advent of COVID-19 and the need to work from home. A secondary benefit of being on-cloud is that it provides better cybersecurity by default as it has no physical servers to maintain, features basic DDOS protection and simplifies the setup of virtual firewalls – another key component of good cybersecurity.
Startups are often reluctant to invest in building cybersecurity teams. Avihai Ben-Yossef, co-Founder and Chief Technology Officer of Cymulate, notes that outsourcing security services is a more efficient way for startups to conserve resources and still capably prevent and respond to attacks. “Don’t do everything in-house. As a startup with limited resources and a strict agenda, whose primary goals may not be cybersecurity-oriented, you can leverage the external resources of experts through managed services.”
Following cybersecurity best practices
It is important to work towards establishing a solid cybersecurity framework early, particularly for companies that operate in highly regulated industries such as FinTech and healthcare. Cybersecurity frameworks often comprise a large part of the compliance requirements. Ensuring that the company agenda and workflow is compliance oriented as early as possible will facilitate a smoother transition to achieving compliance and prevent costly restructuring later.
Startups should maintain the most up-to-date version of their security software to eliminate exploitable vulnerabilities in their digital assets. They should also segregate critical components such as databases and websites to complicate and slow down hacking attempts. As employees can often be the biggest security vulnerability, it is also important that startup teams have a good understanding of basic cybersecurity practices and be able to identify cyberthreats such as phishing attempts.
The key to having good cybersecurity, says Ng Jing Shen, Chief Operating Officer of 17Live Inc, is leveraging the expertise of others. “Chances are, unless you’re working on a cybersecurity startup, there are others who do security better and faster than yourself. Use them.”
He suggests the following practical tips:
Working smart and steady to win the race
For startups, speed is often synonymous with survival and success. However, they need to ensure that they establish the right foundation to cover all their bases before running full steam ahead towards their goals. Otherwise, this can cause major issues down the line and even contribute to business failure.
Staying aware and informed is key. Founders need to do the research on all available options and understand the terms and best practices for essential processes such as post-financing initiatives and cybersecurity measures. They can also flatten the learning curve by leveraging the expertise of others and taking advantage of the resources and knowledge available to them. It may take more time initially to get it right, but that effort will pay dividends in the long run as the company grows.
Watch the full video recordings below.
Technopreneur Webinar Series #3: Term Sheets & Legal 101 (Part 1)
Technopreneur Webinar Series #10: Cybersecurity & Your Startup
Visit our Youtube channel for more Technopreneur videos.
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With finite time and resources, startups only have a small margin for error as they grow, so laying down a strong foundation is crucial to set them on the path to success.
In the third instalment of our Technopreneur series, we explore how startups can manage the fundraising process as well as understand the legal documentation and potential cyber threats that may impact business operations.