When venture capitalists Ken and Glen walked into Moe’s Tavern of Simpson’s fame, Moe served his homemade bourbon. They loved it.
“Moe, you got a great product, a fantastic suit…and we’re gonna give you everything you need. Startup money, branding specialists. Corporate jets, private drivers. If your feet touch the ground, we’ve failed,” they said.
If only it were that easy.
Legal landmines and the importance of navigating them
It’s safe to assume that Moe was blissfully ignorant of the legal issues he may have faced by accepting the offer on the spot from Ken and Glen. If he consulted his lawyers, he’d know that without the proper checks and balances, there are myriad ways in which venture capital (VC) funding can lead to negative outcomes for a company founder.
Startups are often built on their intellectual property (IP), and venture capitalists conduct diligence on the IP. That’s why it’s important that a founder’s intellectual property protection is buttoned-up. Otherwise, the company can be subject to significant financial losses or damages.
The company’s intellectual property should be properly assigned to the employer. Invention assignment language — which gives property rights for anything developed by an employee to their employer, and not the employee who created the property — and confidentiality agreements should be put in place.
Finally, if a founder has not signed the proper intellectual property documents and later finds out that signing is a condition to secure VC funding, an attempt to extract concessions may be made by the founder. Such concessions may include cash payments, additional equity or better investment terms, or even holding onto some rights in the IP itself.
According to Investopedia, a cap table “is essential for financial decisions involving equity ownership, market capitalization, and market value.”
Founders must ensure that any cap table issues are resolved and that all promised equity is properly issued; otherwise, they run the risk of tax issues arising later. For example, if a company does not issue shares at fair market value (FMV), the shareholder purchasing them will be taxed on the delta between the purchase price and fair market value.
If a founder waits until a funding round to resolve cap table issues, they will likely end up needing to use a higher FMV, as the FMV will take the funding round into account.
Sellers must ensure they’re properly set up to take advantage of qualified small business stock (QSBS), defined by Investopedia as “an active domestic C corporation whose gross assets—valued at the original cost—do not exceed $50 million on and immediately after its stock issuance.”
If certain criteria of the sale are met, QSBS can provide a deduction of up to $10 million in gains on the sale. Further, founders should make sure that before they issue shares, their business is set up as a C corporation to avoid potentially large repurchases.
Critical challenges and why they demand attention
It’s not uncommon for legal issues to arise during the fundraising process. Therefore, founders should be aware of what they may be and understand how to navigate them.
Prior to securing VC funding, a founder likely has the last word when it comes to the company’s board of directors. However, once the business is funded by a VC, founders often give up control of their board. It behooves founders to conduct research on how a funder plans to interact with the board.
It’s also important to identify what veto rights investors will have. Investor veto rights could extend to needing their approval for future fundraising or any sale of the company. These are common, but also problematic. Let’s say your lead at Series A can block a future fundraise. And let’s say you are planning to do a Series B. Your Series A lead may want to lead the Series B. If you negotiate good terms with a new potential Series B lead, your Series A investor may insist on leading on less favorable terms and withhold approval for a round with the proposed new Series B investor.
Economic issues may arise during a funding round. For example, sellers should consider what kind of liquidation preference they are giving. According to AngelList, a liquidation preference is a “provision [that] determines the order in which investors get paid back after a liquidity event. These provisions are designed to provide downside protection in the event of a sale for less-than-expected returns.”
It is typical that a founder will grant a one-time non-participating liquidation preference; that is, in the event of an exit, the VCs will be able to secure their share of invested capital before a founder does.
Founders should also be wary of giving away anti-dilution rights, which, according to the Corporate Finance Institute, are “clauses that allow investors the right to maintain their ownership percentages in the event that new shares are issued.” If founders do give these rights away, they should consider how they will be calculated.
When a startup founder is securing VC funding, it’s likely that this will be the first time she is making significant reps and warranties about the business. While most investors don’t sue over breaches, a founder still must evaluate their business from a legal perspective. Unfortunately, this may uncover legal issues not previously considered. Consider the following:
- Is your company qualified to do business in every state required?
- Have you been complying with wage laws vs. paying people in equity or treating everyone as a contractor?
- Have you been diligent in terms of open source compliance?
Doing homework on one’s investors is critical. Issues may arise, but without due diligence, a founder risks the chance that an investor will make decisions unfavorable to them or their company. For instance, if an investor claims to have connections and other value-adds in addition to their money, don’t just take their word for it. Do your homework; find out how those connections can benefit you.
When accepting investor funds, a founder will likely hand over rights to those investors to veto any future decisions. Be sure to identify whether those rights will be exercised responsibly.
It’s important for founders to manage their expectations of how an investor will support their startup after the initial investment. If things go south during the transaction, will the investor support or abandon their business? Look into the investors’ history of behavior during a downturn to ensure their support.
Investors typically have a right to participate in later rounds. However, if the legacy investors opt not to invest in later rounds, it is a damaging signal to potential new investors.
The bottom line
Murphy’s Law dictates that if something can go wrong, it usually will. This is especially true with complex business matters like mergers and acquisitions. Preparing for the worst will ensure that business owners securing funding from VCs will know how to evaluate those investors, ultimately benefiting them and their business.
David Siegel is a partner at Grellas Shah, a full-service boutique law firm.