A Funding Guide for Data Startups

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Click to learn more about author Devansh Sharma.

According to research by HBR, venture capitalists (VCs) source deals based on the following pattern:

  • Leads through other VCs, colleagues, work acquaintances: 30%
  • Leads through referrals by other investors: 20%
  • Referrals from existing portfolio companies: 8%
  • Leads through cold emails: 10%
  • Leads from direct contact with entrepreneurs: 30%

So, what does that mean to entrepreneurs and data startups?

It’s not only you who are searching for VCs – VCs are also searching for you. Period!

Rather than sending cold emails, it would be better to work on your networking skills, as that’s what the points above reflect. 

Then the big question is: How to network?

Well, this is easier said than done.

The Road to Funding

Out of thousands of companies that apply for funding, fewer than 1% get funded. A typical VC starts with more than 110 opportunities and finally ends up investing in just one startup. 

So, odds are 1 in 110!

A typical investment cycle consists of the following steps:

  • Step 1: Filtering the opportunities
  • Step 2: Meeting the management
  • Step 3: Due diligence
  • Step 4: Negotiation of term sheet
  • Step 5: Funding

Getting a VC interested in your data startup is just the first step, and there are many more hurdles to cross before getting to the final mark: A typical investment cycle takes around 100 days to go from citing opportunity to closing the deal.

One thing that stands out for startups is having a great management team and founders. While Warren Buffett said, “You should invest in a business that even a fool can run, because someday a fool will,” VCs have a different opinion: More VCs believe in investing in the founding team than investing in a great business, but it’s icing on the cake if you get both. 

Let’s get down to numbers now.

Matrices for Valuation 

Let’s start with a shout-out to all my fellow MBAs – all those nights we had spent on DCF means very little to the investors. There are hardly any investors who are forecasting the future cash flows today, and rightly so. 

No one could have predicted that Infosys would be one of the largest IT companies when Mr. Murthy and his co-founders started it with one client. The investment world doesn’t work that way. 

The matrices being used today are very different from the ones that we learnt about in business school: 

  • Cash on return 
  • Cash return vs. cash invested 
  • Internal rate of return 

Let’s also focus on that dreaded topic “The Term Sheet”:

  • Vesting of founders equity: Usually four-year vesting, on a monthly basis, starting from the day the founders work full time in the company. Founders have an option of negotiating the appropriate “acceleration” terms to save themselves in the event of termination by incoming investors. 
  • Liquidation preference: Post dividends, the term sheet has provision on liquidation preferences. Holders of the preferred stocks get preference over common stock holders in case of liquidation.
  • Anti-dilution rights: The conversion rights in the term sheet provide a clause for anti-dilution in the basic provision. This clause is usually inserted in the term sheet for protection. The clause is for protecting the PE fund in case the company sells additional shares in the future at a price below the per-share price paid by investors. 
  • Company valuation: Valuation determines the part or percentage of the company to be sold for the decided investment amount. Pre-Money Valuation + New Investment = Post-Money Valuation (Post-Money Valuation is calculated based on “fully diluted capitalization”; i.e., denominator will have all the outstanding stock and all rights, warrants, and options to acquire stock, etc.)
  • Redemption rights: This gives the right to investors in the company to force the company to buy their shares at the then-fair market value – though this can only be triggered after seven years.
  • Registration rights: Right to register shares with SEC so that the investor can sell on the public market if they want to exit.
  • Lock-up provision: This provision establishes the timing limitations for sale in case of an IPO.
  • Information rights: This gives the right to preferred shareholders to get a copy of quarterly and annual financials of the company in which they have invested.
  • Right to participate: The right to existing investors to buy shares offered in subsequent financing rounds.
  • Employee option pool: This is the one through which the fixed pool is reserved for key employees (existing and new hires) and timing of vesting of the options.
  • Rights for first refusal: The right of first refusal (ROFR) provision gives the company and/or the investor the option to purchase shares being sold by any shareholder before any other third party.
  • A co-sale agreement provides a group of shareholders the right to sell their shares when another group does so while following the same conditions.

Benefits of Having a VC Onboard

If the term sheet keeps the VC’s interest, then what will your business gain from them? 

VCs are a boon to the organization, as they bring with them a lot of experience. They add a lot of value to your organization. They could serve in any of the following roles: 

  • Advisor: The majority of VCs talk to their portfolio companies at least once a week and act as the advisor to the startup founding team, helping them in the strategic decisions varying from identifying niches to identifying markets to product strategic fit.
  • Connect to other investors: The funding is not a one-time activity for startup founders. VCs have a strong network of investors and can play a crucial role in getting other investors on board. 
  • Edge to the marketing: Having the backing of a strong VC speaks tons about the startup and also helps in positioning the company for success and getting more customers. 
  • Operational guidance: There is a huge scope of operational effeciency in startups, so VCs act as a catalyst in bringing that change. 
  • Help in hiring: Hiring gets a big boost through the VC funding, as it brings credibility to the startup and better talent gets attracted towards the startup.
  • Help in attracting board members: VCs can help in getting better board members who can be a strategic fit for the organization and can bring with them a great deal of wisdom. 
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