Venture Capital Financing
The concept of venture capital
The term ‘venture capital’ (hereafter abbreviated as ‘VC’) refers to a temporary equity investment in a company that is usually still young, innovative and not yet listed on the stock exchange, but has high growth potential (referred to in the following as a ‘start-up’). The business model of venture capital is a subcategory of the private equity business, which involves trading equity interests in unlisted companies.
As venture capitalists and financial investors, venture capital companies pursue the goal of investing in a young start-up during a specific development phase and providing their management expertise. In return, they receive a significant amount of decision-making power in the company. While a credit institution obtains collateral for a bank loan and the investor accepts company shares in the case of convertible loans, the investor does not receive any tangible collateral in the case of VC financing, but rather a say in the company. This allows the investor to work towards maximum corporate growth of the start-up during the investment period. Thus, the VC company’s involvement is usually limited to a specific phase of the company. VC companies often get involved with start-ups in the early or pre-seed stage and support the founders in setting up the company.
Advantages and disadvantages of VC financing for the start-up
For start-ups, equity participation by a VC company is particularly attractive because, as a venture capitalist, a VC company does not expect high collateral, as a bank would as a lender. The investor also supports the company not only financially, but usually also with entrepreneurial knowledge and substantive know-how. Start-ups benefit from this, particularly in the seed stage and also in their development phase, the so-called growth stage, in which the start-up is keen to increase sales, productivity and growth.
Since the VC company, as a venture capitalist, is aware of the risk of its investment, liability to creditors and the potential risk of loss, the VC company usually demands extensive entrepreneurial rights to have a say in order to be able to influence the development of the start-up. If the start-up makes a profit during the investment period, the venture capitalist can also expect a high return. However, granting the venture capital firm such rights can lead to a partial loss of control and a ‘loss of power’ on the part of the start-up. To counteract a complete loss of control, a term sheet is negotiated between the start-up and the investor before the investment. This sets out the conditions and rights of the venture capital firm, thereby limiting its influence.
Advantages and disadvantages of VC financing for the VC company
As the capital provider, the venture capital company bears a significant risk. If the start-up proves to be unprofitable or does not generate the desired profit during the investment period, the venture capital company may lose its desired return or even the invested capital. At the same time, the investment also offers the venture capital company the opportunity to exert influence on the start-up and to control the company’s development.
What should be considered when using venture capital?
Start-ups that can imagine obtaining VC financing for their young company should consider several important aspects. Topics such as the investor’s potential influence, securities and the exit of the capital provider are of particular importance. It therefore makes sense for a start-up to consult an advisor as early as possible who can not only support the VC financing but can also help with the planning and preparation of the financing. Not only must the investment contract be legally secure and free of errors, but changes to the articles of association, for example, must also be taken into account. We would be happy to support you in this and provide you with legal advice.
When is legal advice necessary and useful for a start-up?
VC is perhaps the most important form of financing for start-ups, but it also entails certain risk factors for them. In addition, a large number of legal and tax peculiarities must be taken into account in VC financing. Therefore, legal advice and support is required from the investor search, through the investment and up to the exit of the VC company.
It makes sense to discuss potential VC financing as early as the start-up’s orientation and planning phase (pre-seed phase), to determine whether such financing is an option and to explain the pros and cons of this and, if necessary, discuss alternatives.
Likewise, legal advice is advisable when looking for the right investor, because the investor must be a good fit for the start-up, bring the appropriate expertise and the interests of the VC and the start-up should be appropriately balanced.
The creation and negotiation of the term sheet is also a key point, where we can provide legal advice, because the term sheet is at the beginning of every investment and forms the first framework of the investment conditions. Among other things, the amount of the investment, the duration of the investment and other important details are agreed here. It is important in this phase that the start-up and the investor are equally protected. Legal advice is particularly important during contract negotiations with a VC company, because the VC company will demand a say in the start-up, which can have fundamental effects on the corporate structure. Here, we can use our advice to identify risks and, if necessary, work out compromises so that the framework agreements set out in the term sheet can be implemented in a legally binding manner. In our advisory services, we pay particular attention to ensuring that the interests of the investor on the one hand and the interests of the start-up on the other are balanced fairly for both parties. Precisely because a VC investor usually only wants to participate for a certain period of time, we pay particular attention to the design of an exit clause.
When is legal advice on the part of the investor necessary and useful?
A venture capital company also has to consider a number of factors before investing. Before investing in a young company, it may be useful to carry out a ‘due diligence’ process. In doing so, it is important for the investor to get a precise overview of the economic, tax-related, financial and legal situation of the start-up. We are happy to advise and support you in this process in order to record and evaluate all of the company’s assets.
After the investor is satisfied with the valuation of the start-up, the participation agreement is usually negotiated, a shareholder agreement is concluded and, if necessary, additional contracts are negotiated. These should also be legally secured.
Overview of advisory services
Start-up | VC Company |
· Supporting in deciding whether VC financing is an option | · If necessary, conducting due diligence and evaluating the start-up
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· Selecting the right investor | · Support in negotiating the term sheet
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· Creating the term sheet | · Support in contract negotiations |
· Support in contract negotiations | · Negotiation and drafting of the participation agreement |
· Execution of the investment | · Payment of the investment amount |
Conclusion: Is venture capital recommended for start-ups?
Whether VC financing makes sense for your start-up depends largely on the phase your company is in, what your start-up's finances would look like without an investor and whether it is even worth considering giving the VC company a say in the matter.
As a founder, you should always be aware that during VC financing you no longer manage the company alone and that, on the one hand, a strong and experienced shareholder is involved who, however, also pursues his own interests. On the other hand, your company receives capital that favours the development of the start-up.
It is therefore important to weigh up which factors play a role in the specific case and whether VC financing is an option for you and your company.
Whether VC financing makes sense for your start-up depends largely on the phase your company is in, what your start-up's finances would look like without an investor and whether it is even worth considering giving the VC company a say in the matter.
As a founder, you should always be aware that during VC financing you no longer manage the company alone and that, on the one hand, a strong and experienced shareholder is involved who, however, also pursues his own interests. On the other hand, your company receives capital that favours the development of the start-up.
It is therefore important to weigh up which factors play a role in the specific case and whether VC financing is an option for you and your company.
