A six-point prescription from a CFO to entrepreneurs for maintaining a healthy start-up life in the new year!
Have a founders’ agreement
A founders’ agreement is like vaccination – it reduces the chance of unpleasant events occurring in the future. Even if they occur, the effects will be mild. A founders agreement ensures a clear understanding between co-founders on their roles, what happens when a co-founder leaves or how the board composition will change when an institutional investor comes in. This will allow entrepreneurs to focus on building the business without distraction. The absence of a founder’s agreement may result in the founders getting embroiled in long, drawn-out court battles and prospective investors shying away.
Treat financial investor equity differently from founders’ equity
Like vitamins for the body, a start-up needs all types of investors to grow. However, the terms of equity raised from each type of investor should be carefully considered. A financial investor invests primarily with the objective of generating returns and does not have any subject matter expertise in the business or credibility in the sector. Many angel investors, friends, and family investors belong to this category. Avoid giving a board seat to a financial investor. Ensure fair exit clauses that will allow the company to buy out the financial investor on the occurrence of milestones at a predetermined IRR. Institutional investors will hesitate to invest in start-ups where a financial investor has a substantial stake and say in the company’s affairs.
Have a Business Plan
Like charting a diet plan, the promoter must develop a business plan that they understand and believe in. Dwight D. Eisenhower said, “In preparing for battle, I have always found that plans are useless, but planning is indispensable”. This means that business planning will force the entrepreneur to answer key questions around who the customers are, why they will pay you, and what it will cost to service them. Even if the specific assumptions made in the business plans turn out to be wrong, a business plan would have served its purpose if it guides the entrepreneur to make informed decisions.
Raise the right quantum of equity
Intermittent fasting is the way to go, even with start-ups. Raising too much equity dilutes the founders’ stake, making the start-up ‘unfundable’. Why? A successful start-up will require successive, larger rounds of investment. A higher dilution in an early-stage round can have an extended impact on the founder’s stake down the line. If the founders’ projected stake in the start-up goes below a threshold (usually 10-15%), VCs may not be confident to entrust their long-term money with the start-up.
Further, excess funds will create pressure to deploy the funds at the earliest, resulting in sub-optimal investment decisions. Raising too little equity will keep the founders in a constant fundraise mode. While there is a popular saying that an entrepreneur is constantly raising funds, one should avoid being in a treadmill situation – raising just enough funds to remain where you are. With a quickly diminishing runway, founders often accept money from sources and on terms that they should not be.
Use ESOPs and Advisory Shares with care
It is tempting for entrepreneurs, especially in these times of scarce tech talent, to dole out equity in the form of ESOPs or advisory shares with lax terms and conditions. After all, cash is king, and anything that helps you avoid spending cash should be good, right? Wrong. For a successful start-up, the value of equity grants can turn out to be multi-fold that of their cash remuneration. Rather than minimising current cash outflow, strike a balance between cash and equity grant – it is easier said than done. Besides, if a prospective employee balks at a 3-year vesting period, re-evaluate their motivation for joining you. Ensure that the recipient is aware of the tax implication of the grants. The last thing you want is equity grants to become a compliance / cash flow nightmare for your staff & mentors.
Talk to a promoter who failed to raise equity because they did not file a simple regulatory filing, and you will realize the pain of regret. Compliance is like keeping your blood sugar levels under check. If you do a good job, no one will notice (which is a good thing). If you ignore it, it will haunt you at the worst possible time with potentially disastrous consequences. While many compliance lapses can be remedied retrospectively with fines and penalties, some cannot be – especially filing requirements related to capital raises.
Further, ensure that the company’s valuation changes between two rounds of equity investment are explainable. You can create a spreadsheet justifying any valuation, and such valuations may even be certified by valuers because they rely on your assumptions and representations. But that does not prevent a regulatory authority from initiating an inquiry and penal action. In short, be zealous when it comes to compliance. It will repay you handily.
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Remember the mantra: Healthy Start-up is a Wealthy Start-up.