A Founder’s Guide to Safeguarding Your Company
By: Maryam Naghavi
For many startup founders, venture capital (VC) seems like the golden ticket to growth. It promises the cash injection needed to expand, alongside access to experienced investors who can offer mentorship and business connections. However, the journey from a promising startup to a VC-backed company is full of potential pitfalls—some of which may not become clear until it is too late.
SIP Law recently represented an investor in a Series B negotiation for an AI company that serves as a stark reminder: even the most promising founders and CEOs can lose control of their companies (and in this case, a significant personal investment) if they are not well-advised. The Series A investor, armed with powers previously agreed upon, sold the company right out from under the founder CEO, despite months of careful negotiations on the part of the new investor. This cautionary tale illustrates the often-overlooked risks that come with VC funding.
In this article, I will break down how venture capital can be both a friend and a foe—and what founders should watch out for to avoid losing control of their company.
Venture Capital: The Friend
- Access to Funding – The obvious benefit of venture capital is that it provides essential funding, especially for companies in capital-intensive industries like tech and AI. Without external funding, scaling quickly and staying competitive is next to impossible. VCs are typically willing to invest when others—like banks or angel investors—may be hesitant to do so.
- Expertise and Guidance – Many VC firms offer more than just money (some actually have to in order to qualify for a registration exemption with the SEC under the Investment Act and Advisors Act). They provide valuable strategic advice, thanks to their experience across multiple industries. Founders can benefit from mentorship, guidance in key business decisions, and help in avoiding common startup pitfalls.
- Network Access – Venture capitalists bring with them a vast network of industry contacts, including potential customers, partners, and even future investors. This can be invaluable when a startup is trying to gain traction or scale rapidly in competitive markets.
Venture Capital: The Foe
- Loss of Control – In the case I mentioned earlier, the Series A investor had ruthlessly negotiated a year prior to the sale (and a very well-reputed Wall Street law firm representing the company had shockingly accepted) the ability for the Series A investor to sell the company without the founder CEO’s approval if the latter was not able to sell the company by the end of 2023 for a minimum agreed on valuation to a buyer that was “reasonably accepted to the Series A.” Absent meeting those criteria by the end of 2023, the Series A investor was free to sell the company at any valuation and had power of attorney from the founder CEO to sign the sale documents on his behalf. These provisions put the Series A investor in the driver seat and virtually guaranteed that the founder CEO would be ousted if a buyer was not offering the Series A investor its desired exit price.
- Aggressive Growth Expectations – Once venture capital money is involved, the pressure is on to grow fast. VCs are typically looking for a quick return on investment, usually through an exit like a sale or an IPO. This can push founders to take risks, including scaling too quickly, compromising on product quality, or burning through cash at an unsustainable rate.
- The Fine Print: Beware of Hidden Clauses – The devil is always in the details. Founders may sign term sheets or investment agreements with clauses they do not fully understand—clauses that could one day cost them their company. In the example above, the founder may not have fully appreciated the implications of agreeing to a valuation target and a power of attorney clause. By the time the situation came to a head, there was no legal way to reverse the investor’s authority.
Legal Considerations: Protecting Your Future
To avoid falling into similar traps, here are a few critical things every founder must consider before accepting venture capital:
- Be Realistic About Growth – Venture capital comes with expectations of rapid growth, but it is important to strike a balance between meeting those expectations and maintaining the long- term viability of your company. If you feel pressured into making short term decisions that could harm the company in the long run, do not be afraid to push back.
- Know What You are Signing – When you are negotiating with investors, make sure you understand every term in the contract. Pay particular attention to any clauses that give investors control over future decisions, especially around exits, sales, or valuations. Avoid blank power of attorneys. Always think carefully about any clauses that delegate authority or allow investors to act on your behalf.
- Get Good Legal Counsel –Before signing any agreement, consult with experienced legal counsel— one that actually has the capacity and the care to take care of you. There is a false
narrative amongst founders community that engaging big law is a must for them to raise funds and earn the respect of the VCs. This could not be any further from the truth. Startups, unless they turn out to be unicorns (which is not evident at the start), are not important enough to law firm revenue model to merit a seasoned partner’s time. It, therefore, is very likely that an
associate handles the startup work and is the one reading documents. Find a lawyer whose vision and mission statement align with what you envision for your company.
Interested in protecting your company’s future? Contact me at [email protected] for a consultation before your next venture capital deal.