Venture capitalists can help propel emerging companies forward with timely investment and advice. However, certain issues, if not addressed, can make a venture capitalist say “No” to funding a company that holds great promise. Emerging companies can take proactive steps to address common concerns of venture capitalists to help secure a “Yes” from those potential investors.
When venture capitalists consider an investment in a promising emerging company, the first question they will ask is “Can you please provide the capitalization table?” Common issues that arise with capitalization include lack of supporting documentation regarding equity, issuing equity to a party in excess of the value that party adds to the company and issuing too much equity early on in the company to third parties leaving founders and management with little incentive to continue to grow the company or little equity available to provide to future key hires, directors and advisors.
Emerging companies can be proactive in maintaining their capitalization table in a variety of ways: keeping an updated stock ledger, being careful about promising equity, being careful about equity grants and making sure to have signed and complete copies of all equity purchase and grant documents, including equity incentive grants. In addition, an emerging company helps to ensure it receives sufficient value by implementing vesting schedules tied to concrete deliverables or tied to time spent with the company. Ultimately, the company wants to be able to accurately identify all parties with equity and be able to explain the value a party brings to the company in exchange for that equity.
Situations can arise in emerging companies when a founder and the company decide to part ways. A venture capitalist sees a red flag if a founder, and not the company, holds and owns the rights to the intellectual property the company uses, especially in the technology industry. Another red flag is if a former founder maintains a large equity stake in the company even though the founder no longer has an active role in the company.
In order to address who holds and owns the rights to intellectual property, founders should assign and contribute all of their intellectual property, and other company assets, to the company. Companies should include a buyout provision in the equity documents which gives the company a right to repurchase equity upon departure in order to address potential ownership issues when a founder leaves. Buyout provisions enable the founder and the company to have a clear end to their relationship. Implementing the appropriate legal mechanisms regarding intellectual property and the equity of founders shows long-term thinking.
Lack of Transparency
Before funding, a venture capitalist will engage in a due diligence investigation of both the company and the founders. A venture capitalist much prefers learning about any potentially troubling news directly from the founders as opposed to finding potential issues through the due diligence process.
Transparency is key in the due diligence process and a company should disclose any actual or potential issues, such as litigation, and explain the steps taken to address these issues. Relationships with venture capitalists are built on trust, and transparency can help foster a mutually beneficial relationship.
Emerging companies can take steps to address the common concerns of venture capitalists. When a venture capitalist sees an emerging company implementing some of the actions above, a venture capitalist will be more likely to say “Yes” to funding that company.