Attracting Investments in the US: Which Mistakes Cost Startups the Most?

Securing investments is a crucial objective for virtually any startup, and every year, an increasing number of young companies from across the world seek investments specifically in the US. In this piece, Sergey Ostrovsky discusses how startups attract investments in the US, and analyzes the mistakes that can be most costly for young companies.

Foreword

Attracting investments is a key task for nearly any startup, and with each year, more young companies look for investments particularly in the US.

Some lucky ones manage to receive a Term Sheet from an investor, but many founders are unprepared when it comes to substantive deal discussions. Poor preparation can lead to negative consequences: mistakes can significantly lower the startup's valuation, lead to the loss of investment, or even result in losing control over the company.

In this material, I've identified several points where, in my opinion, startups most often lose ground when attracting investments. It should be noted that in the vast majority of cases, attracting investments in the US will require a local corporation, so I'm assuming that your startup is registered as a corporation in the US.

Company Valuation

Let's start with the most obvious - company valuation. The share of the company the investor will receive for their money primarily depends on the startup's valuation, so founders and investors rarely agree on this point at first.

Startups often begin negotiations with investors without knowing how to value their company. In such situations, founders have to rely on the first valuation offered by the investor, who ends up with a larger share of the company for the same amount of investment.

Sometimes founders know the value of their company but cannot defend or convincingly justify it. In this case, the startup has to significantly lower its valuation during negotiations or agree to the investor's valuation. The result is the same - further dilution of the founders' and employees' shares.

We have participated in many company valuations, and there are various approaches since situations and applicable valuation methods differ from company to company. This topic deserves a separate discussion.

Speak the investor's language and be ready to present key startup KPIs, such as lifetime value, customer acquisition cost, etc.

Down Round

A high company valuation is good, but only if it matches reality. A not-so-obvious mistake is closing a financing round at an inflated company valuation.

A down round can have several negative consequences for the company. Preferred shares, which (usually) are owned by past round investors, are often protected against dilution (anti-dilution protection), and when a down round is closed, this mechanism usually activates. In short, each preferred share can by default be converted into a common share, initially at a 1:1 ratio (coefficient). In the case of a down round, this coefficient increases, as does the investor's share in terms of common shares, diluting the share of other shareholders who typically hold common shares.

Moreover, for investors, a down round can be evidence that the company is experiencing negative growth, and for employees, it can be demoralizing.

Control Over the Company

Those who watched the series "Silicon Valley" will surely remember how the main character lost control of his company after signing papers during fundraising that his rather eccentric lawyer advised against signing. Although the events shown in the series are fictional, such situations are encountered in real life more often than one would like.

The company is managed by the CEO, but decisions on key issues are made by the board of directors. It is important to understand this because if, for example, an additional share issue, a change in the option plan, etc., comes up, the decision will be made by the board of directors. Furthermore, it is the board of directors that appoints the CEO and primarily oversees his activities.

It is common practice to grant investors a place on the board of directors; moreover, an experienced investor can become a valuable advisor for the startup.

But if the team does not want to lose actual control over the company, most seats on the board of directors must remain with them.

An alternative option is to involve an independent director on the board, and investors and founders have the right to appoint an equal number of board members; in such a case, neither side (as a general rule) will be able to block the board's decision-making.

Blocking Rights (Veto Rights)

When an investor has blocking rights, it means that certain decisions within the company cannot be made without their consent. Typically, these decisions concern major issues such as the sale or liquidation of the company, changes to the structure of share capital, the status of preferred shares, and the number of directors.

In my opinion, blocking rights should not be given to a specific investor, but to investors as holders of a particular class of shares (preferred). As a lawyer, I see a significant risk in allowing one investor the power to block important company decisions because, as is well-known, you cannot please everyone. Moreover, in such a situation, corporate blackmail is possible.

It’s a different matter entirely to entrust blocking rights to investors as a class of shareholders. In this case, the realization of a blocking right (usually) requires the consent of a majority of investors, which establishes a certain mechanism of mutual restraint among them.

Liquidation Preference

Liquidation preference is an investor's right to priority payment in the event of a liquidation event, such as the sale of the company, the sale of major assets, reorganization, or liquidation. There are different variations, but more often than not, the investor is given the right to receive the amount of investment with a multiplier (e.g., x2).

Imagine you manage to close a deal to sell the company for $5 million – potentially a successful exit. You begin preparing the transaction, during which your lawyer informs you of a problem: it turns out that the “some sort of” liquidation preference you granted to investor A. at the pre-seed stage is a participating preference with a [x4] multiplier. Since A. invested $1 million, $4 million must be paid from the proceeds of the company's sale to him, after which A. will participate in the distribution of the remaining funds as an ordinary shareholder. In the described scenario, the exit no longer seems so successful, does it?

I hope the above situation illustrates that the question of liquidation preference is quite significant both for founders and for all shareholders of the company.

Finder’s Fee and Agreements with Consultants

If you are a young startup looking for investments in Silicon Valley, be prepared to meet people promising to help you attract investment in exchange for a finder’s fee (a percentage of the investment amount).

It sounds reasonable, but in practice, it's not so simple: contracts offered by these intermediaries may require the payment of a finder’s fee from the total amount of investments attracted by the company.

To avoid this, the contract must clearly state that the intermediary receives a percentage only from the amount they directly helped to attract, and furthermore, your relationship must not be exclusive.

It should also be noted that having a company "laden" with finder’s fee agreements is negatively perceived by investors, who want their funds to go towards product development and business scaling, not commission payments.

Unpreparedness for Due Diligence

The issue here is straightforward. The startup must show the investor a transparent corporate and organizational structure, primarily concerning the financial component and intellectual property rights.

During the Due Diligence process, the project's corporate structure, relationships with key team members, presence of debts, loans, dubious contracts, involvement in disputes and litigation are all checked. The flow of funds through the company must be transparent and understandable.

If in the Due Diligence, the lawyers and auditors of the investor identify issues that the company cannot immediately rectify, the investment deal may be at great risk.

Undoubtedly, investments are a complex matter, but if you've decided to seek funding – do it right: prepare for the deal yourself and get your company ready. And another thing – never ignore the details, otherwise, it might backfire badly.