A good agreement is the one that seeks to maximize the potential upside of the project while minimizing the conflicts with the entrepreneurs. With this objective, the first thing we should do is to reduce the information asymmetries.
The uncertainty and the scarce publicly available information of an startup puts a lot of pressure under the VC. To reduce this uncertainty, normally the VC will perform an extensive due diligence, not only with regard to the company, but also with regard to the entrepreneur. And this is true because the entrepreneur profile is an asset of the company.
The due diligence period can be “exclusive” or not. If you agree and exclusive period to perform a due diligence and closing the agreement, make sure that you have enough resources to sustain the company until you find another source of financing.
VC will also seek “monitoring rights” such as reporting obligations and access to critical information. They will also want to control entrepreneur’s decision making in order to protect the financial downside. VC will insist on having board rights and super majority rights.
The parties should seek to create a solid relationship and in that sense, they should seek to align their interests. To align interests, VC will offer the entrepreneur stock options as compensation. He will also insist on “vesting schedules” under which entrepreneurs (or managers) will earn the stakes after completing some milestones. Employment contracts can also include “buy back provisions”, “non compete clauses” and can set up the circumstances under which the VC can fire the entrepreneur, as well as clauses to lock for a period of time the key personnel of the company.
To minimize the downside, a common security used by VC is “convertible debt”. Using this security, the VC can choose whether to use debt (giving them liquidation preferences) or equity (more lucrative in the event of an IPO). Another structuring instrument is the “preferred stock” under which “preferred shares” get paid out ahead of common stock in the event of a liquidation. Finally, if the entrepreneurs projections were very optimistic, he will have to give up equity. This clause is very common when the future of the company is highly uncertain. Transfer of control clauses are very useful to mitigate the risk when the company is sold. Another common tool is to make investments in stages. At each stage, and once some milestones are completed, VC can decide to invest or not (option to abandon). Another way to minimize the risk is the put rights and buyback provisions under which the company should repurchase the VC´s shares within certain circumstances. Finally, anti-dilutions provisions (“ratches”) will protect VC against a decrease in price of the shares.
To sum up, negotiating with a VC is not easy for an entrepreneur. Different positions, interests and expectations can complicate even more the process. However, those challenges might be seen as an opportunity to align interest between both parties in the benefit of the company and the quest for value.
If you are enrolled in a negotiation like this right now I can only tell you: congratulations and enjoy it!