Venture capital (VC) is equity financing that professional investment funds provide to early-stage, high-growth companies in exchange for an ownership stake, usually preferred stock. VC investors accept a high risk of loss in return for the chance of an outsized return when a company is acquired or goes public. In exchange, they typically negotiate economic preferences and a say in major company decisions, so founders trade some control and ownership for capital and support.
Many founders start with savings, revenue or money from friends and family, then reach a point where growth requires more capital than those sources can provide. Before approaching venture investors, it helps to understand how VC fits among funding options, how VC funds work and what the legal terms of a venture deal mean for founders.
Where Venture Capital Fits Among Funding Sources
- Bootstrapping. Funding growth from founder savings and revenue keeps full ownership and control but can limit speed.
- Friends and family. Early checks from people who know the founder. These are still securities offerings and need to comply with securities laws.
- Angel investors. Individuals, usually accredited investors, who invest their own money at an early stage, often through SAFEs or convertible notes.
- Venture capital. Institutional funds that invest larger amounts across stages, from pre-seed and seed through Series A and later rounds.
- Debt. Bank loans and venture debt do not dilute ownership but must be repaid and often carry covenants.
Venture capital is not right for every business. VC funds look for companies that can grow very large, because a few big successes must make up for many losses across a portfolio. A profitable business with steady but modest growth may be better served by other financing.
How Venture Capital Funds Work
A VC firm typically manages one or more funds organized as limited partnerships or LLCs. The firm’s partners (general partners) make investment decisions, and outside investors such as pension funds, endowments, family offices and wealthy individuals (limited partners) supply most of the capital. Fund managers commonly earn a management fee plus a share of the fund’s profits, called carried interest.
That structure explains much of VC behavior. Funds have a limited life, so investors need an exit, usually an acquisition or IPO, within a number of years. They also reserve money for follow-on investments in their strongest portfolio companies.
Stages of Venture Funding
- Pre-seed and seed. Early capital to build a product and find market fit, often raised on SAFEs or convertible notes. See our article on convertible notes and SAFEs.
- Series A. Typically the first priced preferred stock round, often led by a VC fund, to scale a product with early traction. Learn more in our guide to Series A financing.
- Series B and later. Larger rounds to expand into new markets, build out teams or prepare for an exit.
Key Legal Terms in a Venture Deal
A priced VC round usually starts with a non-binding term sheet and ends with a set of definitive documents, often based on the model forms published by the National Venture Capital Association. Terms founders should understand include:
- Valuation and option pool. The pre-money valuation and whether the option pool is expanded before the investment, which affects founder dilution.
- Liquidation preference. The right of preferred stockholders to receive their investment back (or a multiple of it) before common stockholders in a sale. A 1x non-participating preference is common in many markets, but terms vary.
- Anti-dilution protection. Adjustments to the conversion price if the company later sells shares at a lower price, usually on a broad-based weighted average basis.
- Board seats and protective provisions. Investors often receive a board seat and the right to approve certain actions, such as new senior securities, a sale of the company or changes to the charter.
- Pro rata rights. The right to buy into future rounds to maintain ownership percentage; see our article on pro rata rights.
- Drag-along, right of first refusal and co-sale. Provisions that govern how shares can be transferred and how a sale of the company is approved.
- Founder vesting. Investors often require founders’ shares to be subject to vesting so a departing founder does not keep unvested equity.
Venture investors also conduct due diligence on the company’s corporate records, capitalization, intellectual property ownership and contracts, so organized records make a real difference in how smoothly a round closes.
Legal Considerations for California Startups
- Entity choice. Most VC funds invest in C corporations, frequently Delaware corporations. LLCs and S corporations are generally not suitable vehicles for institutional venture investment without conversion.
- Securities compliance. Every financing is a securities offering. Startups usually rely on Rule 506 of Regulation D and file a federal Form D and a California notice where required.
- Tax considerations. Stock in a qualifying C corporation may be eligible for the qualified small business stock exclusion under Section 1202, which can make a meaningful difference for founders and investors; see our article on the QSBS exclusion.
- California reporting. California has enacted a law requiring venture capital companies with a sufficient connection to the state to report aggregated demographic information about the founding teams they invest in. Founders may be asked to complete voluntary surveys as a result.
The Founder’s Trade-Off
Venture capital can bring substantial capital, experienced advisors, recruiting help and credibility. It also brings dilution, investor approval rights, pressure to grow quickly and an expectation of an exit. Founders who understand the terms before they sign are in a stronger position to negotiate the points that matter most to them, such as board composition and protective provisions.
The Takeaway
Venture capital is a powerful tool for companies with large growth potential, but it is a long-term partnership with investors who will have economic preferences and a voice in major decisions. Knowing how funds work, what each funding stage looks like and what the key deal terms mean helps founders choose the right capital at the right time.
Frequently Asked Questions
What do venture capitalists get in return for investing?
Venture capital investors usually receive preferred stock with rights such as a liquidation preference, anti-dilution protection, information rights and approval rights over major decisions. They often also receive a board seat.
What is the difference between angel investors and venture capital?
Angel investors are individuals investing their own money, usually at an early stage and in smaller amounts. Venture capital firms invest money pooled from outside investors through funds, typically in larger amounts and with more negotiated terms.
Do I need a Delaware corporation to raise venture capital?
Not always, but most venture funds prefer to invest in C corporations, and many prefer Delaware corporations because of their familiarity with Delaware law. California corporations can also raise venture capital.
How much equity do founders give up in a VC round?
It depends on the valuation, the amount raised and any option pool increase. Each round dilutes existing holders, so founders should model the effect on the cap table before agreeing to terms.
How Sutter Law Can Help
Sutter Law advises founders on preparing for venture financing, negotiating term sheets and closing seed and Series A rounds through our venture capital practice. Contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
