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Conventional clauses in venture agreements and why you should choose tokenization instead

Conventional clauses in venture agreements and why you should choose tokenization instead

Learn about the incentives of venture capital funds, specific clauses in the agreements to pay attention to, how to get better terms by increasing your bargaining power, and why you should consider an alternative to VCs.

Venture capital funds are one of the first things usually pictured in mind when it comes to risky business financing. VC firms are well-capitalized institutions that input millions of dollars into potentially profitable but risky ventures. Such narratives are created by media that focus their coverage on large venture deals as one of the main things in startups’ lives. What goes largely unnoticed underneath is that the power of these funds and their economic incentives give founders and businesses highly unprofitable terms and make them use lousy governance practices.

VC’s incentive for investing in the individual or company

The principal reason why founders have problems with Wall Street financing is the incentives of these investors and their business model. Venture capitalists invest in very risky projects, at least 75% of which usually fail, 20% return at break-even, and only 5% are profitable. This means that successful investments should cover the costs of other failed investments. This is possible only if profitable companies are sold at a huge profit, at least 20x to 30x compared to the initial investment value.

Such math can be illustrated in a simple example:
Let’s consider a fund that invests in a hundred companies, giving each a million dollars. The investors want to get at least a 10% annual return. Assuming 5 years towards the exit, the fund should return around 160 million dollars to investors.

Let’s imagine that 75 companies don’t succeed so 75 million dollars are lost; 20 companies do just fine returning a break even. This means that the remaining 5 million dollars have to cover the losts 75 million and return additional 60 million dollars to provide profits to investors.
This adds up to returning 140 million, which is 28 times more than the initial investment.

Two implications of venture funding

For companies, receiving capital from venture funds has two implications. The first one is that most businesses are not attractive to VCs at all since they aren’t able to grow much. Such down-to-earth companies should search for other sources of financing, which will be covered further in this article.

Another implication is that dividend-based returns are not enough for VCs, and stable gradual growth doesn’t work either. This means they will intend to push the company to invest in development as much as possible even if this makes the business economics unstable and creates the overall risk for it. If your company isn’t large enough to conduct an Initial Public Offering, investors will push you to be acquired even if you don’t want to, so that they could get returns.

A famous WeWork case is an excellent example of this. The company rented properties in order to set up offices for gig workers and freelancers. Their economics was initially negative, i.e., WeWork was losing money on each building. However, infused by the funds from a venture firm Vision Fund, they beat all the competitors with better economics and grew to a stunning 47 billion dollars valuation. Only when they were preparing for the IPO and did an initial disclosure of the financials, the large public saw that the company was drastically overvalued, and the valuation dropped to 2.9 billion dollars, which is roughly the amount of cash they got as an investment. Finally, firing the company founder from the CEO position became a notorious final chord. This is an example of unbalanced growth and lousy governance that can be created due to the perverse incentives of venture firms.

Specific clauses in the venture terms sheets to pay attention to

There are specific clauses in the venture terms sheets that define power balance and are not less important than the valuation.

Firstly, pay attention to the composition of the board of directors. It’s widespread for founders to not control the board already after the series A financing. This means that investors have indirect control over the company since the board is now able to fire the CEO and hire another one if they find it appropriate. This gives VCs power over the overall company direction, e.g., whether to focus on growth or profitability.

The second standard clause is a “drag-along provision”. It allows investors who jointly control enough preferred shares to initiate the sale of the company. Usually, companies that acquire smaller ones demand to buy 100% of the latter. The drag-along provision means that the founder may be forced to sell their stake if the company receives a lucrative acquisition offer.

One of the most dangerous provisions is the so-called “liquidation preference”. It provides investors with a guarantee of return when the company is acquired. For example, if an investor has 3x participating liquidation preference, it gets 200% of the initial investment at the exit, and then additionally the share of the proceeds proportionately to the percentage of shares held.

The danger of the liquidation preference is that you can get nothing if the company does not grow fast enough or is acquired at a lower value. For example, if an investor invests 1 million dollars at a valuation of 2 million dollars at 2x liquidation preference, and then the company is acquired at 2 million, the investor gets 2 million, which leaves you as a business owner with nothing. Basically, instead of sharing the risk, the investor transfers it entirely to you.

How to get better terms with VCs: increase your bargaining power

The reason why venture capital funds can get such good terms is the high bargaining power: if there is nobody else to provide money and all the VCs are in a similar position in terms of their economic incentives, there is no way for founders to get better terms.

The way particular founders get excellent conditions is through the competition of funds. If a startup is hot enough and several VCs are competing for funding it, there will be some perks.

Alternative fundraising methods for more favorable opportunities

A great alternative to venture capital would be using other fundraising methods with different economics. In particular, a security token offering allows a business to raise capital from thousands of individual investors all over the globe. Negotiating with thousands of small investors instead of one large investor gives a company a stronger position to set its own terms. Also, with a security token offering, the company’s shares can be traded even before IPO, which provides investors with higher flexibility for exit and makes their incentives more aligned with the ones of the business.

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