VC financing. It’s competitive, idealized, and often seen as quite a sexy way to raise funds as a startup. But the reality is that it can be fraught with danger for founders – particularly if you don’t fully grasp the future consequences of ceding control in the early stages. You’ll always need to balance terms, conditions, & strings attached against the valuation being offered. Here are some common legal issues to consider when looking at VC financing:
What is VC Financing?
VC, or Venture Capital, is a type of financing that relies on private investors who pay funds into a startup in exchange for equity. In some cases, managerial assistance and expertise are also provided by the investors in exchange for equity, in lieu of an investment.
It is considered a fairly risky form of investment, but startups continue to attract VC financing through the potential for high returns.
The State of VC Funding in 2021.
VC funding saw a bit of a slump when the pandemic started but has since seen record levels of investment. Q1 in 2021 is estimated to be the largest quarter on record for non-traditional investor deal activity. While early and late stage fundings saw record high levels for valuations in Q4 2020.
Benefits of VC Funding
These are 5 common benefits of VC investment:
A good fund will invest in the next round.
If you secure early investment, you’re in a better position to raise funds the next time you need them. Good funds will invest in the next financing round, and they also provide social proof to other investors that your startup is worth investing in.
Your investors may provide support and expertise.
It’s in the best interest of your investors to support you. If your business doesn’t thrive, they lose their investment. Since they want to grow their portfolio, it’s in their interests to help guide your business towards success.
Investors often offer managerial support and expertise as an added benefit to accepting their investment. Depending on the investor, you may get access to office space, financial and legal teams, mentoring, administrative support, and IT infrastructure, amongst other things.
Increased access to networks.
Similar to the above point, professional investors will usually provide startups with access to their networks to help them succeed. This increases the opportunities available to the startup for further investment, as well as opening the door to a pool of potential clients.
It’s accessible for early-stage companies.
Early stage companies can’t always access traditional debt instruments, like loans from a bank or lines of credit. For these companies, VC investment is (comparatively) accessible.
That said, it is a highly competitive environment and finding an investor can be painstaking – particularly in the early stages.
You don’t need to pay investors back.
VC financing is given on the promise of equity – not payback. There’s no maturity date for VC financing. So if the investor doesn’t receive a return, it’s a loss for the investor – not (necessarily) a bankruptcy for you.
Drawbacks of VC Financing
But VC financing isn’t without its drawbacks. Here is a quick overview of some of the more common drawbacks of VC:
- The process of sourcing VC funding is lengthy and requires significant time investment. Founders need to develop business plans and agree upon long-term strategies.
- Highly competitive. For every dollar there is to invest, there are countless startups vying for it. This issue is compounded by the fact that startups want to attract the right investor.
- VC contracts may stagger funding. This often entails startups needing to meet certain milestones before additional funds are released.
- Small investors or angel investors can be more concerned about issues that arise along the way and may want to interfere in day-to-day management. You have to make sure that taking the investment, and allowing these investors into your business, is the right move for your startup.
Legal Pitfalls of VC Financing
Equity is more expensive than debt, but especially if you don’t fully understand your terms sheets.
The cost of equity is always going to be more expensive than debt. While you’re not paying the money out of pocket, you are promising to share your future revenue with your investors.
When you receive a terms sheet from an investor, it will be long, complex, and full of legalese.
The risk is that, at this point, founders are relatively inexperienced with VC funding and may not know what good terms, bad terms, and the usual terms look like.
To mitigate against this risk, you should partner with an experienced startup attorney. They can advocate on your behalf and shield you from future losses that inexperience may otherwise cause.
You don’t want to cede too much control, too early.
One of the key issues founders face during any VC round is what control is being given up.
While this is an issue that presents itself at every fundraising round, it is particularly critical in the early stages. The consequences of ceding too much control are severe. If too many rights are provided in the early stages, founders have little left to give away at the later stages if they want to retain majority ownership. This makes it difficult to attract further financing.
Founders need to have long-term plans regarding the key control terms, like control of the board – and how many seats are being given up – as well as retention of veto rights. When you seek investment, you do need to stick to those long term plans if you want to retain control over your startup.
You need to be conscientious when negotiating drag-along rights.
A drag-along right is a provision in a VC agreement that empowers a majority shareholder (or group of shareholders) to force the minority shareholders to sell or liquidate the company.
These provisions are non-negotiable for investors. But, for founders who want to retain their stake in the startup, drag-along rights can be tough to swallow. It is critical that founders negotiate drag-along right provisions intelligently in order to not be forced to sell in the future.
Founders can negotiate structural protections to limit investor power to force the sale of a startup, including:
- Require a ⅔ majority, instead of a 51% majority. This makes it more difficult for any investor to trigger the provisions.
- Negotiate timing on the provision. For instance, you can stipulate that the provision can’t be relied upon for the next 5 years.
- Outline that the drag-along rights are only granted to common stockholders, not the preferred stockholders.
- Require board approval of any sale (be Delaware aware: case law makes this tricky in the First State).
- Founders can try to stipulate a minimum sales price. Investors are unlikely to agree to this term, however.
Founders need to embed limitations on warranties, covenants, and representations.
Founders should also push for limitations on the warranties, covenants, and representations during the sales process. For instance, you should ask for several liability (instead of joint liability) to ensure that each founder isn’t held responsible for representations made by investors or other founders. These provisions essentially protect you from being held responsible for the actions (and words) of others. Consider materiality and knowledge qualifiers to limit the scope of the representations and warranties that you are making.
Get your agreements in writing.
Founders: ensure all your agreements are in writing, no matter how insignificant they might seem. Certainty is essential – and having agreements in writing promotes certainty.
Top 5 Tips for VC Financing Success
Plan for the long term, as best you can.
Business planning and strategy come into it, but you should know what your ultimate exit plan is by the time you start seeking investment. The answers to these questions should guide the type of investment you seek.
Find the right investment fit.
This can be tricky, given how competitive VC investment is. But, it is essential that founders and investors are working towards the same goal.
Hire a startup attorney, ASAP.
The difference legal counsel can make in slowing the dilution of control is staggering. Hiring a startup attorney means you have someone on your side to negotiate and advocate on your behalf. It also means having someone available to explain your legal obligations and to act as a sounding board for legal compliance.
Startup attorneys are experienced in managing startup issues on a startup budget. It’s best to find an attorney who has significant experience overcoming the hurdles startups face, particularly in the early stages.
Take time to understand your obligations.
You need to understand the small print and your obligations under VC contracts. It’s one thing to have an attorney advocating for you, but take time to understand what the impact of certain changes to the contract mean for your startup today and what it might mean in the future.
Remember that these documents are legally binding and can come with significant and expensive consequences if the agreements aren’t followed.
Focus on what you do best, outsource the rest.
Startup founders are increasingly encouraged to focus on their specific areas of expertise and should outsource the rest. Success follows focus. And focus may come easier if you surround yourself with a team who can take care of whatever you can’t.
If you need an experienced startup attorney to negotiate and advocate for you during financing rounds, reach out. We’re here to help!
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