Everyday day we hear of new startups and the number keeps growing. Successful startups rely on technology to solve their target audiences’ problems. Tech startups need funding to grow their business and make it profitable. The more money they get, the higher chances of success for their company. Therefore, venture capital firms come in handy since they invest in startups and support them. However, venture capital firms are very careful with their selection of startups and who to invest in.
According to a 2019 study conducted by Startup Genome, nine out of ten startups are expected to fail, approximately 21.5% of startups fail in their first year of operation, 30% fail after two years, 50% fail after five years, and 70% fail after ten years.
If you’re a startup and you want to approach a VC, the first thing you probably will do is a google search on venture capital firms in Saudi Arabia or top venture capital firms in Saudi Arabia. Let’s say you do meet with one of those VCs and they do decide to invest in you, what do you need to pay attention to?
Below are a few things we recommend you pay attention to:
What are term sheets for and what issues do you need to consider. Term sheets are non-binding even if the founders sign it. It is like a letter of intent, a memorandum of understanding (or MOU), or heads of terms. Startups need to pay attention to the word non-binding, which should appear as a clause at the end of the contract. The idea behind the term sheets is that it encourages the parties to focus on the important commercial matters in the transaction at an early stage. Some venture capital firms in Saudi Arabia may want to have a binding term sheet right away. In other words, once the term sheet is signed the terms set out in the term sheet develop into the ‘shareholders agreement’ that sets out all the commercial rights and commitments by the existing shareholders and the new third party investor in the company.
The investment will only happen once the investee company and the founders have signed a variety of different fundraising documents like subscription agreement and shareholders agreement to give effect to the investment and set out the terms of the shareholders post-investment respectively. This is a binding contract, so it’s crucial to ensure the subscription agreement is simple, identifying the important principals.
Some investors have a binding clause called the “no-shop” clause, where the investor restricts the company’s founders from soliciting and going around with the current investor’s signed term sheet to get a better offer from angel investors, government regulators or venture capital firms. The no shop clause is a common protection mechanism that safeguards deals.
Fees and Costs Clause
Some investors include a clause called “fees and costs for third parties”, where they have founders pay for the fees and costs incurred in the investment process while negotiating the terms sheet or the investment process. This is the costs that the investors pay engaging third-party service providers and professionals like law firms, accounting firms, auditors and so on. Therefore, its important to make sure this clause does not apply to the founders.
Giving more shares to the investors means more control on the founder’s company. Therefore, it is critical to focus early on issues of corporate governance, especially on how the board is constituted and to discuss board composition.
Diluted founders is a term used by venture capitalists to describe the process where a founders percentage in a company gets smaller and smaller with time. Therefore, it’s important to make sure the founders shares do not get diluted unfairly. Founders who need to rely on venture capital to grow their company must surrender some ownership of the company in return for the capital received. A good advice for founders to prevent them from becoming fully diluted is to find investors who share the same business goals.
It may be good to hire a tech startup lawyer in Saudi Arabia at an early stage (especially pre-seed and seed) to help founders vet the investment term sheet and other agreements so that they understand their full legal rights, the pros and cons, and the risks.