What Makes a Venture-Backable Company?
Venture capital plays a pivotal role in propelling startups by providing financial backing and crucial strategic guidance to help young enterprises scale and succeed. To secure such investment, a startup must go beyond showcasing an innovative idea or an enthusiastic team; it must meticulously configure its business setup and strategies to align with the venture capital landscape’s specific preferences and regulatory requirements. This article delves into the critical elements that make a company appealing to venture capitalists, including the optimal choice of legal structure, effective intellectual property management, strategic equity handling, and robust control over the company’s cap table.
Choosing the Right Business Structure: LLC vs. Corporation
Regarding venture capital, the choice of business structure is crucial. Most venture capital funds prefer to invest in Delaware corporations over limited liability companies (LLCs). This preference is partly due to the need for fund managers to comply with federal regulations such as the Investment Adviser Act of 1940 and the Investment Company Act of 1940. Compliance with these regulations can be onerous, and if the opportunity is available to the fund manager, they will often seek exemption. One standard exemption available to private funds and advisers to such funds is available to companies pursuant to a “venture capital” strategy. Unfortunately, there is no clear guidance on whether a venture capital strategy may include investment in LLCs. However, the fund may have mandates within its own documentation limiting them to the investment of equity securities in corporations.
Further complicating matters, many venture capital funds have mandates within their documentation that restrict investments to equity securities in corporations. The tax implications also play a significant role in this preference. Unlike corporations, LLCs are taxed as partnerships, meaning the profits and losses pass through to each member, leading to phantom income for venture capitalists and additional tax burdens for limited partners (LPs). LLCs may allow for distributions to their holders, but startups seldom declare distributions or dividends as they allocate capital and resources towards product and scaling rather than returns to investors. Investment in an LLC would generate phantom income for the VC fund, and LPs may need to contribute more towards their investment in the fund or to an investment opportunity than they had committed.
While there are ways to structure an investment into an LLC that could appeal to venture capital funds, the complexity, and potential headaches often make converting to a Delaware corporation a more straightforward choice.
Ownership of Intellectual Property (IP)
Venture capitalists need assurance that the startups they invest in have clear ownership of their intellectual property (IP). They need to avoid scenarios where IP is contested or owned by external parties, which can jeopardize the company’s value and negotiating power. Exceptions exist, such as in the life sciences field, where companies might develop IP in academic settings and obtain commercial rights through specific licensing agreements. It’s critical for such agreements to ensure exclusive rights for the company, along with clarity on the continuation of licensing rights and any associated financial obligations.
Avoiding Equity Pitfalls
Proper equity management is essential for retaining key talent and ensuring a startup’s long-term success. Venture capitalists look for structured equity issuance, including long-term vesting schedules, to ensure that founders and employees are incentivized to stay with the company. This strategy includes setting up mechanisms where shares vest over a period, typically four years, with provisions to handle early departures or significant corporate events like sales.
Vesting and Acceleration
Vesting schedules help tie founders and key employees to the company’s future by gradually giving them ownership stakes. For founders, this might include conditions allowing share revesting in scenarios where significant time has passed since the company’s inception without a funding event.
Vesting is a mechanism that incentivizes founders and employees alike to remain with the company for a certain time. Service providers are awarded equity, pricing each share at least the fair market value at the time of grant. The company will require that the employees continue to work in their role with the company for four years under which 25% of the total shares will be deemed vested after one year of their start date and the remainder to vest monthly. Once the shares are deemed “vested,” the grantee may exercise that number of shares in the case of an option grant. If the grantee was awarded restricted common stock, the shares will no longer be subject to repurchase from the company.
Additionally, startups must navigate the complexities of acceleration clauses, which can affect how shares vest in the event of a sale. While these clauses can incentivize founders in the short term, they might lead to potential conflicts or loss of opportunities if not managed carefully. In the event of a sale of the company to a third party, the acquirer may seek to keep the business going or, at the very least, utilize the company’s assets. However, retaining the talent used to develop the assets makes sense from a capital expenditure perspective. For this reason, an acquirer will require that a few employees from the startup join on board. With a single trigger acceleration clause, the founder has no incentive to work with the acquirer unless offered an additional package, including cash and/or equity. It can be argued that this additional capital should have been extended to the startup directly instead of select personnel.
Control of the Cap Table
Managing the cap table effectively is about more than just deciding who owns equity. It’s about controlling who enters the shareholder base, especially in secondary sales scenarios. This control is crucial for compliance with securities regulations and preventing unwanted stakeholders, like competitors or unsophisticated investors, from disrupting the company’s financial strategies. Rights of first refusal and transfer restrictions are common tools used to manage these risks. Finally, venture capitalists often insist on lockup provisions in stockholder agreements to prevent premature equity sales around the time of an IPO. These provisions protect the company’s market price by limiting the supply of shares available for sale, ensuring that the IPO can proceed without additional market pressures.
