What are the most common terms and conditions in venture capital agreements?

I prioritize fairness and transparency in determining valuation and dilution. Valuation is more than just applying financial models; it's about understanding the unique stage, potential, and traction of the company. I use a variety of methods like market comparables and discounted cash flows, always considering the specific dynamics of the startup. Negotiations are key, and I focus on clear, open communication to reach an agreement that respects the interests of both investors and founders. My goal is to find a balance that reflects confidence and aligns long-term goals, laying a strong foundation for a successful partnership.

Valuation refers to the estimated worth of a startup, often a subjective measure influenced by market trends, the startup's potential, and investor interest. It's a delicate balance, as overly optimistic valuations can lead to future challenges in funding and credibility. Dilution, on the other hand, occurs when a startup issues new shares, reducing the ownership percentage of existing shareholders. While necessary for raising capital, it can be a double-edged sword, potentially diminishing control and value for founders and early investors. Both concepts are pivotal in the VC world but require careful navigation to avoid pitfalls like overvaluation and excessive dilution, which can undermine long-term success.

Em minha trajetória no capital de risco, destaco a essencialidade de balancear as dilui??es iniciais. A avalia??o da empresa é crucial, determinando a participa??o dos investidores e a dilui??o dos acionistas. Métodos como comparativos de mercado, fluxos de caixa descontados e múltiplos de receita ou lucro s?o comuns. Contudo, a oferta e demanda de capital, o estágio da empresa e a habilidade de negocia??o também s?o determinantes. Achar um meio-termo na avalia??o é chave, evitando assustar investidores com valores altos ou prejudicar fundadores com valores baixos.

While the valuation cap is a key condition, other terms can depend on the negotiation dynamics, the stage of the startup, and the broader investment landscape.

There must be a balance between the structure of an agreement (i.e. liquidation preference, MFN, etc) and the agreed Valuation/dilution. Many founders prefer to give higher liquidation preferences (higher than 1x) than a lower Valuation, thinking about protecting themselves from dilution, but this might be a mistake. While a Valuation might protect them from dilution, the liquidation preference determines the end game value on a liquidity event impacting directly the distributed amount to stockholders that have no liquidation preference or 1x preference; which is usually the Founders case.

The liquidation preference determines which shareholder gets paid first. Typically, preferred stockholders have a higher liquidation preference than common stockholders. This means that they get paid first before the common stockholders receive their money. A 1 time liquidation preference should be standard but if founders push the valuation too high then investors will ask for a higher liquidation preference. Or as well in down turning markets.

Liquidation preference in venture capital is a bit like a safety net for investors, ensuring they get their money back before anyone else in case things go south. It's like calling shotgun on the financial returns of a startup. However, it can feel unfair for founders and employees, as their share of the pie shrinks. Imagine working tirelessly to bake a huge pie, only to find that the investors have already taken their big slices, leaving you with crumbs. It's crucial for balancing risks, but sometimes it tips the scales too much in favor of those holding the purse strings, overshadowing the hard work of those who actually build the company.

There are so many different ways to structure this, however I have seen rare cases where a liquidation preference other than 1x non-participating is beneficial. It either hurts existing shareholders / founders or bites back when the next financing round occurs, as follow-on investors demand similar terms.

VCs often secure board seats as part of their investment, enabling direct oversight and strategic guidance. This can be a double-edged sword. On one hand, it brings valuable expertise and networks, crucial for startups navigating growth. On the other, it can lead to conflicts, especially if VC's short-term exit goals clash with the founder's long-term vision. The balance of power can tilt too far, stifling the innovative spirit that made the startup attractive in the first place. Striking the right balance is key, but often overlooked in the rush to scale.

"Trust is good but control is better" is a phrase used by many executives and investors. The level of board representation and control will depend on the risk involved for the investor which in turn composed of factors such as: - stage of the business - the product - the targeted market - track record of the founder(s) - the relationship between founder(s) and investor(s) and many more. An analysis for VC investors to determine the degree of control requires should therefore begins with correctly identifying the risks involved in investing in the target.

VC should negotiate for a board set to safeguard their investment and to contribute towards the growth of the company. During the investment round there would be a probability to reliqnuish their board seat, which they should be prepared as well.

VC’s will almost always negotiate for a board seat OR control of the board depending on check size. This can be scary and why picking the right VC is key as a true partner. If your interests, expectations, and future plans on how to grow and scale the company they will execute their control and remove founders if they deem fit.

A common alternative to board representation is a board observer right. For example, if an investor is making a comparatively small investment, doesn’t have the experience or time to fulfill the obligations of a board member, etc., but would like to know everything going on at the board level in real time as a condition to investment, a board observation right is a good compromise option.

Anti-Dilution Protection is also like a safety net for investors. When a startup raises more money at a lower valuation, existing shareholders risk their stake getting diluted. This protection is a clause in an investment agreement that prevents such dilution. It adjusts the price per share of the preferred stock held by previous investors, effectively increasing their share count without additional investment. While it's a reassurance for investors, it can be a double-edged sword. It sometimes discourages future investment, as new investors may hesitate, knowing their money could disproportionately benefit earlier backers. In essence, it's a balancing act between investor security and startup attractiveness.

It is a downside protection mechanism that protects existing investors when a company is forced to accept a 'down round' (lower share price compared to what the previous investors have paid). If a 'down round' happens and these provisions are in place - existing investors receive additional shares based on the down round. It is important to understand that the company can experience a 'down round' due to the following reasons - - changes in burn rates - due to some unanticipated issues - poor market conditions - affecting the company’s ability to raise future rounds of capital

Milestones and tranches are pivotal in VC agreements, serving as a risk management tool and a performance incentive. Milestones are pre-defined objectives that startups must achieve to receive further funding. This mechanism aligns the interests of investors and entrepreneurs, ensuring that capital is efficiently utilized towards growth and development. Tranches, the phased release of funds upon milestone completion, mitigate risk for investors by ensuring that startups demonstrate progress and viability before receiving additional capital. This structured approach promotes discipline and focus, driving startups towards key goals crucial for their success.

The milestone-based financing or staged financing is a term usually used in seed- and early-stage investments. This involves releasing funds in tranches upon achieving specific targets such as completing a prototype or securing customer validations. The main aim is to reduce risk in early-stage investments and motivate entrepreneurs to perform and progress rapidly. However, it's important to consider the following to ensure the entrepreneur remains focused on the overall vision and avoids misdirection — — Definition - the milestone definitions must be straightforward and measurable to avoid any confusion — Funding - the allocated amount to reach each milestone should be assessed - any unnecessary financial constraints should be avoided

Milestone based funding is very common especially by Family Offices where they are more conservative in deploying capital upfront. Though some may say that it puts pressure to perform and meet the numbers agreed upon but at the same time it keeps the company on track and focused towards achieving want was agreed upon. The milestones might need revision from time to time on the basis of market realities.

It is very important for a VC to identify and some time to discuss their exit strategy with the founders. Usually VC tend to remain in the business for about 5 years but evenually with the drag along and tag along clauses they can protect their exit along with the founder's exit.

An exit strategy is the plan for cashing out an investment, crucial for recouping funds and earning profit. Common exits include IPOs or selling to a larger company. However, it's often a gamble. Not all startups succeed, making exits unpredictable and sometimes disappointing. Additionally, investors' push for a lucrative exit can skew a startup's focus, prioritizing short-term gains over sustainable growth. Rights in venture capital are safeguards for investors, like anti-dilution clauses or preferred stock, ensuring they get a fair share of profits. But these rights can become overbearing, stifling founders' control and decision-making. It's a delicate balance: protecting investments without hampering the entrepreneurial spirit.

The common exit-related provisions are — — Redemption - granting investors the right to sell their shares back to the company after a certain period - triggered when the company has made moderate progress but isn't expected to provide a big exit — Drag-Along Rights - enabling investors to force other shareholders to participate in the sale of the company - triggered when certain shareholders want to sell but face opposition from other shareholders (often including founders or common shareholders) — Tagalong Rights or Co-Sale Agreements - allowing investors the option to sell the shares alongside the founders or majority shareholders - ensuring all shareholders have the opportunity to exit under similar conditions

Drag along can be extremely dangerous if not negotiated right. Most founders don't put a cap on how much the investor can drag them to get their exit! Allowing upto 2X of equity holding within a drag clause will be the key. Also, exits can be tricky to be given. Founders buy back clause shouldn't be a part as future is incertain.

As the late, great DMX would tell us, “Money, Power & Respect” are the key to life, and as it turns out, venture capital deals. Money, or economics, have to be right for everyone. That means the right amount of capital to grow the business without taking on too much or too little for the right amount of equity in the company. Power, or control terms, have to align with investment size and stage. Maybe that means board or observation rights, information rights or voting rights, or all of the above. Lastly, as to respect, all parties need to respect each other enough to be honest, direct and kind. Don’t argue for the sake or argument but do push on and for the items that matter, but do it respectfully.

I want to share some other terms: Pro Rata is the right of existing investors to participate in future rounds of financing in order to maintain their current percentage of ownership. Veto rights are usually granted to the?preferred stockholders and allow them to exert power to approve or disapprove specific decisions or actions taken by the company that could have an adverse impact on their investment. Optional conversion gives preferred shareholders the right to convert their shares to common shares. Preferred shares come with participation rights and there is a cap at a certain moment, but if a startup scales fast, preferred shareholders can convert to common shareholders and get the unlimited upside.

In venture capital agreements, the right to information is a pivotal term. It ensures investors have access to regular financial and operational updates, vital for monitoring investment performance and making informed decisions. This clause is not just about transparency, but also about fostering a culture of open communication between investors and founders. Such regular updates can lead to proactive support from investors, potentially unlocking additional resources or networks beneficial for the startup's growth.

It's important to be knowledgeable of market terms for your company's stage (eg seed vs Series B financings can be quite different). Having a good venture law firm and staying abreast of the latest financing trends through studying reports from PitchBook and Carta can put a founder in a position of strength going into a financing negotiation.

I would like to add as an important issue to be considered, the indemnifications clause (one side or mutual). This is an important subject in negotiation from the risk appraisal perspective: compensation of a potential future loss.