Insights

Before You Search for Capital, Try to See Your Company Through a VC’s (or its Lawyer’s) Eyes

By Steven Keeler

Venture capital investments are considered riskier than others not only because the company is typically a start-up or in its early stage, but because they often involve technology and market validation risk. In contrast, more mature companies typically present mostly execution and management risk. The better a company understands how VC investors (and their lawyers and accountants) assess these classic start-up company legal risks and why they demand higher potential returns to address risk, the more equipped it will be to attract investors and survive the valuation and due diligence process.

Before a company founder focuses on valuation (the business’ upside) and related dilution, he or she should take all reasonable steps to anticipate how an investor will assess the company’s legal risks and potential for generating a good return to the new money investor. Here are some classic examples of investor “due diligence” areas where a company can improve its first impression with a VC, at least in terms of legal risk, and potentially its valuation:

• Technology and Data Management. In our innovation economy, technology, data and software are the most valuable assets of many venture-backed companies. So, the more effort a company puts into protecting its intellectual property, applying best practices in data collection, processing and storage, and improving the functionality and security of its software, the more comfortable an investor (and its attorneys) will be able to get when it conducts its due diligence review of these assets and any business or legal compliance issues they may present. This is even true if the company is raising money from or selling itself to a strategic corporate investor or buyer. Early technology and data privacy housekeeping can really avoid due diligence issues and the valuation discounts that often come from them.
• Ownership (“Cap Table”) Clean-Up. One of the biggest complaints by VC investors of start-up companies is that they often have too many owners, which can include multiple founders, key employees and early angel and strategic investors. There may also be options, convertible notes or “SAFEs” which have been issued. The company should consider how its ownership structure might be improved or cleaned up prior to a VC raise. If “it is what it is” and cannot be changed or improved, then it is important to at least review and verify the accuracy of the “cap table” and supporting legal documents so that an investor can confirm who owns what portions of the company and how their shares, options, convertible debt or warrants will impact management’s performance and the investor. At times, the investor may even request or insist on changes in the current ownership, vesting schedules and the like, so a company should try to anticipate this so it can negotiate an acceptable valuation and amount of dilution.
• Third Party Relationships. The innovation economy is also characterized by more outsourcing of various tasks by a business rather than doing everything in-house, from product development to data management and software and hosting services. Investors and their counsel will take a hard look at a company’s vendor and other relationships to ensure that the governing agreements and the reputations and capabilities of the third parties do not present any present or future business or legal risks, including compliance with data privacy and security laws and any impact on a future sale of the company.
• Non-Employee and Non-U.S. Party Issues. The innovation economy also involves doing more business with independent contractors and counterparties overseas. This is too often a “bone of contention” in investor due diligence that can result in a deal at a lower valuation or even no deal. Despite the limited resources of most startups, companies should engage employment and international counsel to ensure there are not material questions regarding how the business categorizes its “employees” and “independent contractors” (and including tax, FLSA issues and employment and immigration laws), as well as its compliance with often ambiguous export control and technology transfer laws and potential sanctions.

Most of the vast amount of information out there on raising VC focuses on impressing investors with the company’s story around its products and services and market demand in an effort to get a good valuation and minimize founder, management and angel dilution. That is a subjective and uncertain process to be sure. But, all else being equal, a company that gets its tech, ownership, vendor and talent houses in order before sharing its pitch deck and responding to due diligence will likely increase its value in the eyes of the investor, who is always thinking not only about the upside but potential downsides. Neither a company nor an investor can guarantee that the upside projections will be achieved, but the company can certainly manage some of the legal risks which can slow or kill an investor negotiation.

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