Terms of Engagement
For startups raising
funds, the initial giddiness of receiving a term sheet fades as the nuts and
bolts of the business are held up for scrutiny by investors. But a few crucial
factors can help entrepreneurs navigate the complex due diligence process.
One spring afternoon in 2013,
Advitiya Sharma, one of the 12 IIT-Bombay alumni who founded Housing.com, stood
in an office room holding his breath while facing investors. When all parties
in the room finally signed off on a $2.5-million (Rs 16 crore) investment in
the startup, he let out a sigh of relief after a few intense weeks of worrying
over the due diligence process that his one-year-old company had just gone
through.
“We didn't know legal clauses and
terms, we were engineers. We had a chartered accounting and legal firm explain
to us each term and condition logically so we understood it before signing,“
said Sharma, now 25. The online real estate portal has since negotiated $121
million (` 770 crore) in funding from Nexus Venture Partners, Helion Venture
Partners and Japan's SoftBank Capital.
Behind all the glamour of
institutional fundraising, there is a lot of handwringing involved for an
entrepreneur when their company's every detail is pored over before a signature
is made on the dotted line. In the context of startups, due diligence can be
divided into two stages: Pre-investment, when investors and analysts typically
conduct basic business diligence, after which they offer a non-binding term-sheet
to entrepreneurs; then begins the in-depth review.
The process is far from being a mere
formality, and its rigor varies with the growth stage of each company. New
startups have fewer structures and processes to be agonized over. More
established firms will be subject to meticulous diligence, but can bank on
results from previous funding rounds, especially if an existing investor is
pitching in again.
“When we know how old the company is
we think of what potential issues they may have, what baggage they carry. Accordingly,
we decide the scope of diligence,“ said Natarajan Ranganathan, managing
director and chief financial officer at Helion who has handled more than 200
shareholder agreements for the firm since 2006.
While due diligence, which takes two-four
weeks, may seem tedious, it is all rather simple, said Aashish Bhinde of
Avendus Capital, a reputed banker whom technology startups turn to for
fundraising.
“An investor looks out that all
regulatory compliance is in place and that the entrepreneur hasn't taken
advantage of loopholes in the system. For example, do you have all the licences
in place? If your model is disruptive, are you lobbying proactively for
change?“ he said.
Besides self reported metrics,
venture firms seek formal and informal referencing on founders as well as
feedback from customers, suppliers and past investors. Rarely does something
come up that would sabotage a dealthe dropout rate is less than 10% and
companies can usually correct minor slip-ups and inconsistencies. Housing was a
case in point. “The lawyers helped us with many new things we didn't know about
as a growing company, like registering for regulatory compliance, licences
all those were put in place during the Series A process,“ said Sharma.
More serious red flags are raised if
a company's books do not match up to initial calculations during the business
diligence phase, or if it breaches critical regulations, particularly for
cross-border corporations. Disputes within the founding team regarding
intellectual property and equity ownership, common in more mature markets, can
also be reason for caution.
Otherwise, “sometimes it could just
be that the investor is looking to invest in the industry and talks to one
company first, gives a term sheet and then sees that another company is doing
better or is a better fit, or is giving a better valuation,“ said Aprameya
Radhakrishna, cofounder of online cab aggregator TaxiForSure, which raised
funds from Accel Partners, Helion and Sequoia Capital before it was sold to larger
rival Ola earlier in 2015.
While locally based venture capital
firms conduct due diligence in-house, global investment firms operating in
India without on-ground offices outsource the responsibility to local financial
and law firms.
Yet in India, there's a huge amount
of insecurity surrounding the grueling process, said Anil Advani, managing
partner at Silicon Valley-based startup law firm Inventus Law. “What investors
say is that they don't have the tools to do diligence. For example, there are
no easy tools to find the credit or criminal history of founders. And law firms
do not have a real-life perspective of how a startup would run or should be
run, which can result in friction,“ he said.
So how can an inexperienced
entrepreneur sail smoothly through due diligence? “When the company's starting
up and is not really worth anything, that's the best time to clean everything
up before you get to the $10 million stage,“ advised Advani.
“An entrepreneur should just focus
on building a product,“ said Sharma of Housing. “For everything else there is
help.“
Evelyn Fok and Aditi Shrivastava
ET26JUN15
No comments:
Post a Comment