The protection of venture capital

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Julio Menchaca Vite

Venture capital, which is basically the name given to the risk capital geared to the early stages of a company’s life, such as the seeding phase, start-up and up to about the first 3 to 5 years of a business’s life, is becoming more common in our country.

Its impulse is due to several factors:

  • It is an excellent type of financing alternative to bank loans.
  • In addition to the injection of capital, there are other benefits for entrepreneurs, such as: the signal given to the market that a third party found in them enough potential to invest, the growth of a network of contacts, and the transfer of knowledge from the company, either on the sector, or on company management.
  • The valuation of the company is a result part of a business plan and not of a current state. Therefore, if the business plan is really good, you can get a bigger investment.
  • The return rate for the investor can be very high and in a short-term.

Of the above points, the first three show a number of advantages for the entrepreneur and only the last one represents a benefit for the investor, which is obvious because their main interest is profitability. However, in order to achieve this profitability, great risks are assumed.

The risks can be countless, but the ones that can be generally observed in the projects are: that the team is not the ideal, that the idea cannot be materialized, that even if it materializes, there is no market for it, etc., and its result will always be the total or partial loss of the investment.

In order to protect Venture Capital, as far as possible, from losing its investment, various legal and management formulas can be applied. Here we list some of them:

  1. Creating transparency and accountability policies allowing a periodic economic and management information flow, which will be the same contained in the stakeholder agreement.
  2. Incorporating permanence and exclusivity agreements for the entrepreneurial team members.
  3. Even when there were already any permanence agreements, it can always be the case that one of the founders is withdrawn from the project; therefore, it is necessary to establish detailed assumptions of good and bad leaver, to envisage the valuation by the purchase of their shares for each case.
  4. In the same case of the previous point, in the situation of a departure of a member of the entrepreneurial team, creating clauses of confidentiality, non-competition and non-recruitment.
  5. Setting the business plan as a roadmap and establishing measurable milestones on certain dates. This way you can see if there were deviations from the same, that when negative, would allow the Venture Capital to leave the company. To materialize this point it will be necessary establishing at least two things:
    • Put option: Allowing Venture Capital to sell its share to the founders for the same price of its acquisition.
    • Since it is possible that the entrepreneur team does not have enough liquidity to pay for the put option, the guarantees on the assets of the company must be strengthened.

In return, if there are positive deviations, stock options can be established in favour of the entrepreneurs as a way to reward and encourage them on the fulfilment of the milestones.

Some of the previous formulas can be quite aggressive and it will not always be possible to include them in an agreement, because it depends on the negotiating position of each part, but in any case it is advisable to be prudent in its inclusion, because the relationship with the entrepreneurial team is fundamental for the business to be fruitful for both parties.

This article was published in the reconigzed French media site Le Village de la Justice: Read article.

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