What you need to know about structures favored by VC versus structures favored by the founder

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Silicon Valley startups looking to attract venture capitalists tend to focus on dressing the room, but doing so at the expense of some important aspects that could ultimately save them.

The world of VC has become very busy to say the least. In 2020, startups had the highest median venture capital investments since 2008. Yet startup founders set terms up front that have desperation written all over it. Startups that are willing to submit to disadvantageous demands (out of misunderstanding or desperation) appear out of options, which is why they should never set pre-established conditions. And for reasons beyond comprehension, many top startups have indeed chosen pro-CV structures in their business form and initial capital.

Here’s what startup founders need to know to avoid completely eliminating founders favored structures as they seek to attract investors.

Rethinking the typical structures of VC

The mantra of first-class startups taking the venture capital route includes: Delaware C-corp, the 10 million-share model, one share class (common common stock), and a four-year Founder’s Acquisition (probably with a cliff) with double trigger acceleration.

This is widely considered to be the “right” structure for VC-focused startups, because that’s what VCs want. Venture capitalists like Delaware corporations, and they will generally want to invest in C-corps. They don’t want anyone other than themselves to have shares with special rights. And VCs want founders whose shares are vested so they stay with the company. They also don’t like single-trigger acceleration, as an acquisition may depend on the rest of the founders and other employees after the exit deal. Incentives to stick around diminish if founders and employees aren’t stranded after an outing.

When founders get to the point where they choose structures, they tend to forget that they can set whatever conditions they want, and don’t always know that alternative structures don’t necessarily cost more than the default. favored by VC. In fact, they can be less expensive. Additionally, founders can send the wrong signals by making all of their initial choices based on the wishes of the venture capitalist, essentially avoiding any choices that would protect their long-term interests. Here’s what the all-in on the venture capital structure tells investors:

Related: You Think You Need Venture Capital Support To Start Your Business …

There is a need for Venture Capital Funding – Founders Don’t Care About Control

Everyone knows that if a founder does not need VC funding, there is little reason to choose the default VC structure. There are many other structural options that may be more beneficial to founders, leaving investors to wonder why a founder would adopt such unfavorable structures by default. The VC-default structure does not offer the founders any protection vis-à-vis future employee shareholders / service providers.

Why would the founders not put protective provisions in their initial structure that would allow them to retain strategic powers, such as control of the board of directors? Especially if no one prevented them from setting these conditions from day one? This leads to fragile credibility and less negotiating power when it comes to Series A. Equities are easy to structure to allow for the most effective liquidity options for founders. The standard VC structure does not provide for this. Founders will have a hard time pushing for this as part of a Series A after failing to do so on incorporation day.

If a founder goes to a large law firm specializing in Silicon Valley, the structure above is what they will get. (And that’s the one that the law firm’s most lucrative VC clients want the law firm to push.) But does that mean startups should go this route just because that’s what want VCs? Not necessarily.

Related: Financing: What Is Entrepreneurial Capital Versus Venture Capital?

How to integrate a structure favored by the founders

To remain advantageous while still being attractive to VCs, it is crucial that startup founders understand the different structural choices and types of share classes that can protect and offer options to founders.

Founders generally care about high valuation, maintain as much control as possible, do not bear all the risk of loss, and share cash as much as possible.

Sometimes founders, especially those who have been exposed to the start-up practices of large law firms, will rightly question whether these more founder-friendly structures are Actually attractive to VCs. It’s worth a small business to evaluate the incorporation documents written for their company, even if those documents were written by the most well-known companies in Silicon Valley.

Let’s say a smaller firm offers amazing advice on how to make founders-friendly adjustments to a venture capital-focused structure, and the large law firm bristles. The key to dealing with this setback is understanding exactly where the advantage lies.

Take the state of incorporation or the structure of the entity. Going from an S-corp or LLC to a C-corp is not difficult, nor is going from a California corporation to a Delaware corporation. A knowledgeable startup lawyer can do these things without conflict. There are good reasons to choose jurisdictions other than Delaware. S-corps and LLCs can offer tax advantages that are not available in a C-corp structure, and there are many rights and privileges that the actions of the founder can be imbued with to ensure a level of control of the founder even afterwards. dilution.

Then come the classes of shares and special rights. If the founders decide to ditch them in their Series A, they sure can. The marginal cost of doing this, in the context of your Series A, will be nothing, assuming the founder has a smart startup lawyer who sets up those share classes for them in the first place. From a founder’s share rights perspective, some of the possibilities include ensuring that the founder’s shares can still elect the majority of the board of directors, delimiting that each founder’s share gets multiple votes per share (shares control) and have protective provisions that require the vote of a majority of founder’s shares before major corporate events, such as an acquisition or a dilutive event

There are other ways to change structures without scaring investors. If a VC wants to invest in a startup, they know that all of these initial setup terms can be changed at negligible cost. That’s not what’s going to prevent a startup from getting funding – so founders should consider alternative structures and VC founders-friendly hybrids that will pave the way for long-term success.

Related: The Rise of Alternative Venture Capital

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