What Should You Expect When a VC Invests in Your Startup?
Synopsis
A VC investment changes more than your startup’s bank balance. Here’s what founders should expect after signing a term sheet, including due diligence, legal documents, board seats, ownership changes and investor rights.
Receiving a VC term sheet may be the apex moment in a founder’s fundraising process. However, a signed term sheet typically does not equal capital in your bank account. It is still not quite a done deal between agreeing to the deal and delivering the investment.
The deal is then agreed upon, lawyers review the contract, and the VC conducts due diligence on the company records, updates the cap table, agrees upon board structure and signs final legal documents. In an ordinary priced VC round, this process takes several weeks depending on the corporate degree of responsiveness, whether there is investor pressure, and how a lot work is needed (larger queues take longer). This means some deals are taken to close faster, while others take longer because of legal ownership issues that need to get sorted.
As a first-time founder, this stage is confusing because the attention constantly goes to price and amount being raised. But the terms surrounding control and ownership may matter just as much. It could change who is elected to the board, what kinds of decisions require investor approval, what percentage of the company’s shares founders and employees own (and how those shares are divided among them), and whether a sale would be beneficial for all involved parties. For this reason, the term sheet should ideally be seen as an outline of and agreement to the deal, and the final documents serve to transform that outline into obligations and rights which are legally enforceable. Lawyers often use template financing documents on venture financings, but the actual documents will differ based on the details of a deal and its jurisdiction.
After Signing a VC Term Sheet What Happens Next?
Generally, the first action item is engaging a lawyer who specialises in startup fundraising. Your counsel will evaluate the term sheet and ascertain how what was agreed should translate to the final agreements. While this is happening, the VC conducts or finishes its due diligence on the company. This concept is called due diligence, but to boil it back down to something a lot more digestible, the investor wants to make sure the business, numbers, owner and paper trail match what the founder said. As an example, Cooley has sample due diligence documents which consist of corporate records, documentation for stock and option issuances and data on the company, etc.
This includes everything from financial records to customer contracts, employee agreements, intellectual property ownership, previous investments in you, company formation documents, taxes and or other important documents. Not just to be looking for mistakes. The investor is trying to determine whether the company is in a condition that it anticipated at the time of agreeing to the investment. If, after the checks, there is a significant problem that was not foreseen, the transaction may have to be renegotiated or even fall through. This is exactly why founders should be as fully transparent during this stage and not hope an issue will go unnoticed.
Meanwhile, lawyers start drafting final agreements from the term sheet. They may provide for the purchase of shares, rights of the investors, voting rights, board structure and transfer rights in future rounds depending on what shape this round takes. Documents commonly used in US-style venture financing include a preferred stock purchase agreement, investors’ rights agreement, voting agreement and right-of-first-refusal & co-sale agreement.
Founders also love this timing to confirm that the final documents actually reflect the business deal they negotiated. The critical terms can often be well summarised in a term sheet, but the detailed agreements will describe how those rights operate. Discrepancies in wording can make a big difference depending on the items voted on by the board, approved by investors, and information around future fundraising as well as sale of the company.
How Much Time Does it Take to Close the Deal?
A VC investment never has just one timeline. A simple round in the early stages can happen quickly, while a high-priced round can take much longer. For simple seed financings using a SAFE, one recent fundraising guide puts the timeline at possibly just days but priced rounds utilising more complicated financing agreements could take weeks from term sheet to funding. A third source for practitioners calls 60 to 90 days a standard duration overall, but states that much longer periods are possible when there are large legal or ownership issues at the closing table.
The major and basic stages are generally clear-cut. The first stage is legal checking and due diligence. The company and investor finalise the documents. The cap table is reviewed and amended The board structure gets put in place. Fulfil any required company approvals. In the end, everyone signs and the investor wires the money over.
Most often, the longest delays came from issues pre-dating the signing of the term sheet. Longer Cap tables than they should have: Sometimes founders simply forgot or did not bother to properly structure their equity especially at the startup stage, missing founder agreements, unclear ownership of intellectual property, untracked employee options, and old convertible investments can all add extra work. Data rooms that are clean and well organised simplify the process; since investors and lawyers generally keep asking questions of the founder, having everything in one place allows you to have a back-and-forth, provided that they can find at any time what they need.
Which is why we would never want to slow down at the moment a term sheet gets signed. Now is the time to get a bit more organised. If you are able to keep accurate records and answer questions quickly, the closing will be much easier.
Does the VC Get a Board Seat Automatically?
No. A VC does not get a board seat simply because it invests in your business. The board structure is negotiated in the course of the investment. But the general, when leading a large funding round, will request a board seat. Particulars on how many board seats there will be and who has a right to appoint them are usually specified in the term sheet.
Having a board seat means the investor has an official role to play in company governance. There is a distinction, which is based on not merely being a shareholder.
The board has access to decision-making facts, and the members of the board are data points with responsibilities for coordinating the business. So it follows that a VC board seat affects how a founder manages the company. You will still likely be the CEO, your ownership stake is probably quite large, but now big choices will have a board of investors helping to make those decisions (not just you).
Their boards can exist in a whole variety of structures. A board of an early-stage company may consist of a few founder representatives and an investor representative. It can mean more investor seats and independent seats with a larger round. There is no magic number that a startup must hit. The specifics are the details in your documents and whether one side can control the board.
Others may request a board observer role instead. An observer is typically allowed to come to board meetings and learn about the company but does not have director voting power. As a founder, you should know the difference: A board seat gives you voting power while an observer role usually provides visibility without casting a vote on the board
What Are Protective Provisions?
Protective provisions are rights by investors to approve certain key decisions the investor makes regarding a company. These are distinct from the VC sitting on a board seat. That means an investor can prevent a specific decision even if that investor does not control the board.
These rights usually only apply to specific material events, not just any general day-to-day business decision. Depending on the transaction, such primary triggers can encompass an issuance of additional shares in a new class, changes to the governance documents of the company, sale of the company, acquisition of massive debt or any other major change in direction. The precise list is negotiated and can vary from deal to deal.
Suppose you want to raise another round of financing. If the investor has an anti-dilution provision stating that it must give its consent before certain new shares can be issued, such as in a next round of financing you may need that approval to close. This does not mean the VC controls your business. That means the investor has negotiated a right to ensure that certain interests are protected.
Founders need to meticulously parse the list instead of using boilerplate language for every protective provision because of this. Rights on major corporate events are common; demanding an investor approve routine decisions may go unsought. An investment agreement that is well written should specify clearly which decisions will require investor consent and, where applicable, when such rights should be extinguished or minimised.
What happens to the Cap Table?
Your cap table tells you who owns how much of the company. Ownership stakes change after an investment by a VC, as the investor gets new shares in the company (except if it is structured a different way). The founder's share percentage will almost always shrink, as there are now more shares and the investor owns a piece. (studylib. net)
Say a founder has 80% before an investment and the early employee pool owns 20%. Existing shareholders are then diluted if a new investor receives 20% of the company post-investment. The investor then owns a portion of the business which is why their percentages decrease. Of course, this does not imply that the founder has lost the same value in rupee or dollar terms, as after investment YooMayYoo is worth substantially more than 1 crore.
The pool of options is also a relevant piece to this puzzle. Investors usually prefer that the company set aside a pool of shares for upcoming options to employees. The method of creating that pool can also have an impact on how much existing shareholders are diluted. The important question being asked is whether the option-pool increase occurs pre- or post-money. That fact could significantly alter the final stake of an early-stage entrepreneur.
This is not why founders should be requesting a post-round fully diluted cap table. You should include the number of shares currently outstanding, any options and other rights to purchase shares and of course the new investment itself. Do not rely only on the headline valuation. Have your lawyer or finance adviser give a detailed picture of what your ownership will look like on the other side of the deal.
What Is a Liquidation Preference?
Liquidation preference means that the way money will be distributed in case of a sale, wind-down, or other transaction with proceeds to shareholders has been determined. This matters because VC investors receive preferred shares, not the same type owned by founders.
When it comes to liquidation preferences, the most typical structure is a 1x non-participating payout. So essentially, if an investor invests $5 million into the firm, a 1x preference would provide that investor with the right to receive up to $5 million first in line before the residue is allocated among the other shareholders, subject to the specific legal terms involved. An investor generally has the option to choose which outcome is more favourable (i.e., a non-participating structure better allows an investor to avoid receiving both amounts if converting to ordinary shares would provide the investor with more money).
It matters when the company sells for an incremental gain to the money you put in. A founder might, for instance, glance at the final sale price of his or her company and assume that the proceeds will just be split up in accordance with ownership percentages. You have a liquidation preference, which may not be true.
Then you have participating versus non-participating, which can lead to very different results. With a participating structure the investor will often then receive its preference first, and also share in the remaining proceeds. The terms should be modelled before the investment is signed, because they directly affect what founders actually receive at an exit (not just at sale time.)
What Else Do They Get?
A VC investment may come with many rights, besides a position on the board. Investors might also receive financial statements and business updates through information rights as well as other relevant company details. These can take the form of rights associated with one or more future financing rounds, transfer of shares and an impending exit for a unicorn. The rights depend on the investment docs exactly.
For example, a right of first offer can give the company, or specific investors, the opportunity to purchase each share of any stock that a founder or other shareholder wishes to sell. Co-sale rights can permit investors to sell their shares alongside a selling shareholder. These rights seek to protect the investor, by establishing how shares are transferred from one owner to another.
Another crucial provision is the drag-along right Put simply, if the sale of a company under contract receives shareholder and other party assent by the required majority, then the provision may compel a reluctant shareholder to take part in that sale. This is to ensure that a tiny shareholder cannot impede an accepted deal.
None of these rights automatically imply that the founder lost control over the company. However, combined they alter the dynamic between founders and investors. This means the founder is not making all big calls on their own anymore. The investor has invested in the company and has negotiated certain rights that are designed to preserve their investment.
What Changes After The Money Comes In
The relationship transitions from fundraising to governance, once the deal is closed and cash flows into the company. The VC is now a real shareholder with the rights provided in the investment docs. When the investor has a seat on the board, its representative joins the company’s board. If others were involved in the financing, the company will also have to comply with reporting, approval and meeting requirements that were agreed.
This changes the game for founders, also moderately; You still run the business, but there is more accountability around your financial performance, spending, strategy and big decision-making. Board meetings become part of the weekly/p bi-weekly routine within a company and investors may clamour for at least some useful financial and business updates (any async channels out there) every 2-3 weeks since top-notch flow is generally assumed. The board can also challenge you on growth, costs, hiring, cash burn and future fundraising.
What you need to take away from this is that VC equity buy-in is not just a cash deal. You are giving away a piece of your ownership along with new privileges, and obligations. An investor is not simply handing you money; it is purchasing an equity stake with certain protections.
This is why a proper authorisation of control should be before the influx of money. The rights established by them are much tougher to modify once the final agreements are signed
Before signing of it, what a founder should check
Founders are best served knowing five things before they accept a VC investment: who owns what, after the round; who controls the board; which decisions need investor approval; what happens if the company is sold; and what rights investors have over future shares and information. These questions encompass way more than the headline multiple.
Request a post-investment cap table including the option pool. Find out exactly how many board seats each side receives. So once again, read the protective provisions, what decisions can be blocked. Get a handle on the liquidation preference and model out what different sale prices would mean for you. Review rights like ROFR, co-sale and drag-along provisions.
And most importantly, just because someone calls it a standard clause doesn’t mean it’s harmless. Normalised terms can still have a huge impact on your business, and normal can be very relative to funding stage/market/country/deal structure. A startup lawyer who does venture financings as a regular part of their practice can demystify for you what the language means for your company.
It is not to deny all investor protection. VCs need fair protection from the money they put at risk. So the thing is, you want to understand the trade, right?
Final Takeaway
The VC saying yes is not the finish line for fundraising. This is the first step of the closing phase. Post-term sheet, expect legal work including due diligence, cap table checks, board conversations for approval as well as the final agreement and company sign-off before the money is yours to use.
The larger change, when the investment closes, is not that your bank account balance is higher. You’ve switched your ownership structure, an investor may now have a board position, and certain big moves could need the investor's blessing, along with new fiduciary duties around reporting and governance.
The top lesson for a first-time founder is simple: Do not obsess about how much money the VC is putting in, or what valuation they are proposing. Know what that investment does with your ownership and control is not a shot across the bow. Your cap table (the way ownership is divided; also the board makeup, investor veto rights & exit terms) has a decade or more of implications for how your company develops.
Keep in mind that there is no one “normal” deal for all startups when it comes to VC. Terms depend on terms, investor, company and negotiation. The safest rule of thumb is that you: understand every relevant provision, model its impact on your holding and exit strategy, and have reputable startup counsel review the final documents before signing.”
At Inspirepreneurs Magazine, covering entrepreneurship, business failures, and the human stories behind the world's most ambitious founders. She writes at the intersection of strategy and storytelling.
