Venture capital (VC) funding is like a high-stakes game for startups. It’s a chance to get the cash needed to grow fast. But, it’s not all smooth sailing. There are tricky legal issues that can trip founders up. Understanding these pitfalls is key to success. In this article, we’ll explore some of the key legal pitfalls associated with VC financing and how founders can mitigate these risks to ensure the long-term success of their ventures.
What is VC Funding?
Venture capital funding involves investment in early-stage companies with high growth potential in exchange for equity. Unlike traditional debt financing, where a company borrows money and repays it with interest, VC funding entails investors taking a stake in the company, hoping for substantial returns on their investment when the company grows and eventually exits, either through acquisition or public offering.
Now, let’s see how this plays out in real life. Take for instance, Company A, a tech startup with a groundbreaking app poised to revolutionize the industry. In its early stages, Company A needs funds to develop its product, expand its team, and scale its operations. Venture Capital Firm Y, which sees the potential in Company A’s vision and offers a substantial investment in exchange for a share of ownership. This infusion of capital allows Company A to accelerate its growth trajectory, bring its product to market faster, and capture a larger market share.
However, alongside the promise of growth and success, VC funding also brings a set of legal challenges and potential pitfalls that founders must know and consider in advance.
1) 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.
2) 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.
3) 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:
- Requiring a two-thirds majority instead of a simple majority (51%). This makes it more challenging for any single investor to trigger the provisions.
- Negotiating the timing of the provision, such as stipulating that it cannot be invoked for a specified period, like the next five years.
- Specifying that drag-along rights apply only to common stockholders, excluding preferred stockholders from this provision.
- Mandating board approval for any sale. However, founders should be aware of the legal complexities, particularly in states like Delaware.
- Attempting to establish a minimum sales price. Although investors may be hesitant to agree to this condition, it provides additional protection for founders.
4) 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.
5) 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.
At Retrieve Legal & Tax, we understand the intricate nuances of venture capital financing and stand ready to assist founders at every step of the process. From negotiating terms to drafting agreements and beyond, we are committed to helping founders achieve their entrepreneurial goals while safeguarding their interests and ensuring long-term success.