Is Your Startup Venture-Backable? Key Elements Investors Look For

Securing venture capital funding can be the tipping point that turns a promising startup into a scalable enterprise. But what exactly makes a company “venture-backable”? Beyond an innovative idea or an enthusiastic founding team, venture capital looks for startups that are aligned with the VC landscape in terms of structure, strategy, and compliance. In this article, I break down the key elements that can make your company attractive to investors — from choosing the right business structure to managing your cap table.

Choosing the Right Business Structure: LLC vs. Corporation

For startups seeking venture capital, choosing the right business structure is a must. Most VCs prefer Delaware corporations over LLCs. Why? It’s about simplicity and compliance. Venture funds often have restrictions within their mandates that prevent them from investing in LLCs, especially when it comes to complying with regulations like the Investment Adviser Act of 1940.

VCs also shy away from LLCs due to tax issues. LLCs are taxed as partnerships, which means the profits (or losses) pass through to the individual investors. For VCs, this can create “phantom income” — essentially, they could be taxed on income they never received. This creates extra tax headaches for limited partners (LPs) and can dampen investor enthusiasm.

Practical Tip: If you’re a startup serious about attracting venture capital, strongly consider converting to a Delaware corporation. It removes the legal and tax complications that scare off many investors. While LLCs can work in some situations, the path to VC funding is much smoother for C-Corps.

Ownership of Intellectual Property (IP)

Clear ownership of intellectual property (IP) is non-negotiable. VCs want to ensure that the core technology or product they are investing in is fully owned by the company. If key IP is tied up with founders, contractors, or previous employers, it can derail negotiations. Exceptions do exist, such as in life sciences, where companies may develop IP in university settings and secure commercial licenses.

Practical Tip: Conduct an IP audit early. Ensure that all IP related to your product or service is assigned to the company, not individuals. This reduces friction during the due diligence phase and gives investors confidence.

Avoiding Equity Pitfalls

Managing your equity is critical for retaining key talent and aligning long-term incentives. VCs are particularly interested in seeing well-structured vesting schedules that tie founders and employees to the company. A typical structure would have a four-year vesting period with a one-year cliff, ensuring team members are incentivized to stick around for the long haul.

Practical Tip: Set up a vesting schedule for founders and employees right away. This will not only help with investor confidence but also ensure that your team remains committed. Ensure that service providers are priced fairly at the time of the grant to avoid valuation problems later on.

Acceleration Clauses
Acceleration clauses, particularly in the case of acquisitions, can make or break a deal. These clauses dictate how quickly equity vests if the company is sold. While single-trigger acceleration (where all shares vest upon a sale) can be tempting, it can also scare off buyers who want key personnel to stay post-acquisition. Double-trigger acceleration (where shares vest upon both a sale and the employee’s termination) is often seen as a more balanced approach.

Practical Tip: Use double-trigger acceleration for key team members if you choose to implement any acceleration provisions. This incentivizes employees to stay post-acquisition, aligning their interests with the new owners, and prevents conflicts that could jeopardize the deal.

Control of the Cap Table

Maintaining control over your cap table is essential for long-term stability. VCs want to see that you’ve structured ownership in a way that avoids future complications, such as competitors gaining access to your company’s inner workings. Secondary sales, in particular, can pose risks if unsophisticated or undesirable investors gain equity stakes. Rights of first refusal and transfer restrictions are common tools to prevent this.

Practical Tip: Use rights of first refusal and lockup provisions in your shareholder agreements to maintain control. This prevents shareholders from offloading their stakes too soon and protects the company’s equity structure during critical phases like an IPO.