The above illustration showcases the standard process that typically happens for early-stage companies. The Pitch Process can differ from stage to stage, especially in the later stages there will usually be an established relationship between company and fund.
The Term Sheet
If the Investment Committee is convinced and wants to move forward, they will typically issue a term sheet which is a document briefly summarizing the deal terms.
A term sheet is not binding on a legal level, so there is no obligation for the fund to invest. But not investing after a term sheet has been issued would also contradict the regular modus operandi, hence it would mean reputational damage for the VC.
Often a term sheet includes exclusivity, meaning that a startup usually can then not move forward with other investors anymore.
Valuation
The valuation of a company is the factor that will determine how much equity the founders will have to sacrifice for their financing. There are two distinct types: pre-money and post-money valuation. Pre-money valuation entails the value before the money is injected into the startup. The post-money valuation is the value of the company after the injection (which translates to pre-money valuation plus the amount of money injected).
In later stages, the valuation is based on financial multiples such as the revenue multiple. The height of the multiple depends on factors like growth trajectory, the value of comparable companies, the addressable market, or the competitiveness of the deal. In early stages where there is no financial data yet, the determining factors encompass the team as well their previous experience), the market size, initial traction, first negotiations, the competitiveness of the deal, and whether there is a “hype” around the given topic (FOMO: Fear of missing out at the VC end).
Terms
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Founder Vesting: The VCs want the founders to stay onboard because they often invest in the team - which is especially true for early-stage investments. Therefore founders lose their shares or parts of the company if they leave before they worked a certain time in the operative business. Typically, shares vest over four years. If a (co-)founder leaves earlier, as a so-called “good leaver”, they can keep the vested shares. In case the (co-)founder is a “bad leaver”, they lose all their shares.
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Liquidation Preference: In the case of the startup getting sold, firstly, all VCs would get their investments back before, secondly, distributing the exit money among the remaining shareholders.
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Drag Along & Tag Along: “Drag along” means that if the investors want to sell a company, they can drag along other shareholders and convince them to also sell their shares. “Tag Along” is the right of other investors to participate in the sale of shares if one party decides to sell theirs.
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Control Rights: Often, investors insist on the right to make sure a company is using the investments in the way agreed upon in the funding round(s). Therefore, they aim at making sure that the startup’s management does not make strategic changes (such as changes to the business model, or the sales of business assets), or does not burn the invested money too quickly (by e.g. hiring very costly employees, or by committing to long term obligations that cost a lot of money). Such actions require a green light from investors.
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ESOP/VSOP: There are times where investors see the necessity to add qualified people to the startup team (such as second-line management). In those cases, the founders or existing investors are urged to create a so-called Employee Stock Ownership Program (ESOP) where a certain amount of shares is added to a pool which will then later be distributed to the new employees or advisors. In Germany, because of tax laws, this process is mainly performed through Virtual Stock Ownership Programs (VSOP).
Due Diligence
After signing the term sheet, the fund starts the due diligence process with the goal to find potential risks in the investment. This process highly differs, depending on the stage: In an early stage of due diligence, it is ensured that the company exists in a legal manner, that it was set up correctly, and that the claimed IP exists. This process is accomplished through, for instance, investors talking to the company’s first customers, or through checking the founders' references, and sometimes even psychological evaluations. In a later stage due diligence, deep screening of the financials and the customer relationships, an analysis of cohorts and CLV, or a vetting of second-line management is carried out.
Negotiation of Investment Agreement
During that time, the final Investment Agreement is also negotiated and all participating funds as well as the company have their lawyers examine the agreement. Often, standardized agreements that have been used many times before coming into play and are only slightly adapted for the case at hand. Then, lastly, details, such as founder salaries, are negotiated. If the term sheet is well documented and clear, the investment agreement doesn’t require many changes.
Signing and Closing
Finally, it comes to signing the deal. In Germany, this has to be done with a notary who will read the documentation to the parties in full, usually taking a few hours. This process is called “The Signing”. The following closing then entails the execution of the agreed terms, i.e. the shares are transferred, the money is wired, the new board members are appointed, as the board is probably set up for the first time.
Post Investment
Reporting
After the investment is made, the VCs want to understand how the company is performing. Therefore, the startup is obliged to report their KPIs, which are often agreed upon between founders and VCs. Again, the reporting is highly dependent on the stage of the company In the beginning, it will mainly revolve around qualitative descriptions. In later stages, KPIs entail excessive financial reporting, which many funds require because they are part of a corporate group (CVC), or deal with public funds (especially from the European Investment Fund).
Future Financing Rounds
After the financing round is before the next financing round: Often, founders get from 12 to 18 months of runway (i.e. the time till they run out of cash) and early on the need to plan their next financing round. For the company, it is often crucial that existing investors at least provide an amount that will help them keep their position (a so-called “pro-rata investment”) as otherwise, other external investors might perceive this as a bad sign (assuming they want to put in less money and know the inside workings of the company).
