What You Need to Know About VC-Favored Structures vs. Founder-Favored Structures
Here's how to identify and negotiate a structure that is in your best interest.
Silicon Valley startups looking to attract venture capital investors tend to hyper-focus on dressing the part, but they do so at the expense of some important aspects that could save them down the line.
The VC world has become very busy to say the least. In 2020, startups saw the highest median VC investments since 2008. Yet startup founders are setting terms on the outset that have desperation written all over them. Startups that are willing to submit to disadvantageous requirements (either out of incomprehension or despair) appear out of options, which is why they should never set pre-ordained terms. And for reasons beyond comprehension, there have been plenty of top-tier startups that effectively chose pro-VC structures in their initial corporate form and equity.
Here’s what startup founders should know to avoid completely eliminating founder-favored structures as they seek to attract investors.
Re-thinking typical VC structures
The mantra for first-class startups going the VC route includes: Delaware C-corp, the 10 million share model, one share class (plain old common stock) and four-year founder vesting (probably with a cliff) with double-trigger acceleration.
This is largely considered to be the “right” structure for VC-focused startups because it’s what VCs want. VCs like Delaware corporations, and they will generally want to invest in C-corps. They don’t want anyone except themselves to have shares with special rights. And VCs want founders whose shares are subject to vesting so they’ll stay with the company. They also don’t like single-trigger acceleration because an acquisition may depend on founders and other employees remaining after the exit transaction. The incentives to stick around dwindle if founders and employees aren’t stuck vesting after an exit.
When founders are at a point where they’re choosing structures, they tend to forget that they can establish the terms they want, and don’t always know that alternative structures do not necessarily cost any more than the VC-favored default. In fact, they may be less costly. Furthermore, founders may be sending the wrong signals by making all of their initial choices based on VC wants -- essentially eschewing all the choices that would protect their long-term interests. Here’s what going all-in on VC structure tells investors:
There’s a need for VC financing – The founders don’t care about control
Everyone knows that if a founder doesn’t need VC financing, there’s little reason to choose the VC-default structure. There are many other structure options that can be more beneficial to founders, leaving investors to question why a founder would default to such unfavorable structures. The VC-default structure provides founders no protections vis-a-vis future employee/service provider shareholders.
Why would founders not put protective provisions in their initial structure that would allow them to maintain strategic powers, like board control? Particularly if nobody was stopping them from setting those terms on day one? This leads to shaky credibility and less bargaining power when it’s series A time. It’s easy to structure stock to allow the most efficient liquidity options for founders. The standard VC structure does not provide for that. Founders will have a hard time pushing for this in the context of a series A after not doing so on the day of incorporation.
If a founder goes to a standard-issue large Silicon Valley law firm, the structure above is the one they’ll get. (And it’s the one the law firm’s much more lucrative VC clients want the law firm to push.) But does that mean startups should choose this route just because it’s what VCs want? Not necessarily.
How to integrate a founder-favored structure
To remain advantageous while still being attractive to VCs, it’s crucial that startup founders understand the different structure choices and types of share classes that can protect and give options to founders.
Founders generally care about a high valuation, retaining as much control as possible, not bearing all of the risk of loss and sharing as much in any liquidity as possible.
Sometimes founders, particularly ones who have been exposed to large law firm startup practices, will rightfully question whether these more founder-friendly structures are actually attractive to VCs. It’s worth it to have a smaller firm evaluate the incorporation-related documents drafted for their companies, even if those documents were drafted by the most widely-known Silicon Valley firms.
Let’s say a smaller firm offers some amazing advice on making founder-friendly tweaks to a VC-focused structure, and the big law firm bristles. The key to managing that pushback is understanding exactly where the advantage lies.
Take the state of incorporation or the entity structure. Changing from an S-corp or LLC to a C-corp isn’t difficult, nor is moving from a California corporation to a Delaware corporation. A competent startup lawyer can do these things without strife. There are good reasons to choose jurisdictions other than Delaware. S-corps and LLCs can offer tax benefits that aren’t available in a C-corp structure, and there are many rights and privileges that founder stock can be imbued with to ensure a level of founder control even after dilution.
Next to consider are special share classes and rights. If founders decide to ditch these in their series A, they certainly can. The marginal cost of doing so, in the context of your series A, will be nothing, assuming the founder has a smart startup lawyer setting these share classes up for them in the first place. From the perspective of founder share rights, some of the possibilities include making sure founder shares always being able to elect a majority of the board of directors, delineating that each founder share gets multiple votes per share (supervoting stock) and having protective provisions that require the vote of a majority of founder shares before major corporate events, such as an acquisition or dilutive event
There are more ways to alter structures without scaring investors away. If a VC wants to invest in a startup, they know that all of these initial setup terms can be changed for negligible cost. That is not what is going to stop a startup from getting funding -- so founders should consider alternative structures and VC-founder-friendly hybrids that will pave the way for long-term success.